How tax reform will boost middle market M&A
After months of anticipation and countless negotiations, Congress finally passed the Tax Cuts and Jobs Act at the end of 2017. Hailed as the most significant change to the U.S. tax code in more than 30 years, Republicans hope that the new legislation will boost the economy by spurring job growth, driving wages higher, and increasing corporate investment in the country. It is too soon to tell whether these goals will be met, but we do know this legislation contains several provisions that have the potential to significantly boost capital investments in the middle market and increase deal flow across the United States. It is important to know the impacts of the new tax provisions to adjust strategies accordingly and reduce tax burdens.
One of the most anticipated changes of the act included a reduction in the corporate tax rate from 35 percent to a flat 21 percent and the repeal of the corporate alternative minimum tax. Both changes became effective after Dec. 31, 2017 and will increase the after-tax profitability of corporations.
We have already seen that some corporations are using these extra savings as compensation incentives for employees but corporations will also be looking for making additional investments in the business which sets the stage for M&A activity. Corporations will seek better multiples by obtaining a return on investment, and with tax reductions, focusing on enhanced cash flow by acquiring middle market companies – especially those that require or produce accelerated tax benefits for “qualified property,” qualified property, as defined by the act, includes any tangible property with a depreciable life of 20 years or less. This includes computer software, machinery, land, property, and other tangible assets.
The act provides an immediate bonus deduction for 100 percent of the cost of these assets for through 2022. More importantly, the deduction is available for both new property and property acquired from a different taxpayer. In other words, property acquired through an acquisition now qualifies. Businesses looking to reduce their tax burden will find these provisions particularly attractive and will be inclined to use excess cash to make investments in middle market companies. Certain asset intensive sectors that will be big winners include pharma, manufacturing, construction, and others that hold and/or produce qualified property.
An important aspect to note about this increased depreciation provision is that acquirers and sellers will need to structure deals as asset acquisitions to receive the upfront deductions. Historically, most acquirers have preferred this form of deal structure. However, it is not always the most advantageous for the corporate seller. Therefore, middle market acquirers will need to carefully consider how to make deals more attractive given that the act does add additional depreciation benefits for the buyside of the deal.
For transactions with significant intangible value, the reduction in the corporate rate to 21 percent may mean that the tax impacts of an asset acquisition are not quite as valuable as it was under a 35% corporate tax rate regime. This is because the tax value of intangible amortization (generally over 15 years) has a lower cash flow impact. Of course, acquirers may still prefer the legal protections with an asset acquisition over a stock purchase.
Another important provision on the buyside of deals is the impact of tax rate changes to pass-through companies. Pass-through corporate structures such as partnerships and LLCs make up 90 to 95 percent of the middle market and are a preferred structure for private equity deals because it alleviates “double taxation,” and allows the flexibility of an exit.
The act provides beneficial deductions to certain pass-throughs including a deduction of up to 20 percent of their business income. However, pass-throughs that fall into a “specified service trades or businesses” such as health, law, consulting, athletics, financial services and brokerage services won’t qualify for the deduction if the taxpayer’s taxable income is more than $207,500 ($415,000 for married individuals filing jointly).
For those seeking to acquire a company, these favorable deductions could present challenges for targets that are non-qualifying businesses. Private equity sponsors will need to consider these challenges and evaluate the tax profile of the acquired business as well as the other provisions of the act, which may impact the timing of a possible exit due to carried interest limitations, new limitations on business interest deductions and net operating losses, and the other tax attributes of the company being acquired.
The act also includes a one-time repatriation tax on accumulated earnings held overseas. The tax rate is 15.5 percent on earnings held in cash and 8 percent on the remaining earnings and is paid over a period of years. The repatriation of these funds by major corporations will likely be invested in one form or another to avoid additional taxes in the future. This could set up a tremendous opportunity for the middle market because corporations may likely use their repatriated cash to acquire companies that complement their core business. Again, like the corporate rate reduction, the act’s impact on freeing capital for investments will put the burden on acquirers to put that capital to work in the U.S. which may result in enhanced multiples.
One final consideration for acquirers and sellers in 2018 is what might happen in Washington. As of now, it is possible that Democrats could retake one, if not both houses of Congress in this year’s election cycle. As we all witnessed from the coverage of the act’s passage, Democrats are not fans of this new legislation, which some have called a “corporate give-away.” If Democrats become the majority, they might reverse the recently passed tax legislation, bringing back closer parity in individual vs. corporate tax rates, which means acquirers need to analyze the current situation, but also think about the future impacts of their decisions. This is especially true as it relates to corporate structures. If Democrats raise the corporate tax rate, the ability to convert a corporation back into a pass-through structure would become much more tax costly.
There is tremendous sentiment that M&A activity in the middle market will surpass 2017 levels this year. Both the size of deals and the quantity of those deals will likely be much higher as both sellers and acquirers look to take advantage of the act’s pro-growth provisions. It is important to realize all of the benefits and potential hurdles the act contains so that all parties will benefit from their transactions.
Even through the Act will have substantial impacts on many negotiating decision points, the business community is hopeful that Congress’ goal becomes reality and that the Act does indeed boost the U.S. economy.
Gary Wallace is the tax department leader for Keiter and serves on the firm’s executive committee. Prior to joining Keiter, Wallace was the CFO for the Riverstone Group, LLC and CCA Industries Inc.