Tax Cuts and Jobs Act adds new considerations for M&A transactions

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 what we do know is that the legislation contains several provisions that will significantly impact deal flow in Virginia and across the United States. For those considering a merger or acquisition in 2018, it is important to note these tax provisions and adjust your strategies accordingly.

Among the most significant changes for deal flow are the changes to tax rates. Specifically, lowering the corporate tax rate to 21 percent. This has created significant buzz because for the first time in a long time, there is a large disparity between corporate and individual rates. Will this have an impact on the favorability of pass-through entities? Pass-through entities are the most prevalent business structure in the U.S. accounting for approximately 90 to 95 percent of companies. They include sole proprietorships, partnerships and S-corporations. To alleviate the rate disparity, the new tax law 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 merge or acquire a company, these rate changes could present challenges. Most private equity/venture capital firms structure deals in some form of pass-through entity because it alleviates “double taxation” and allows the flexibility of an exit.

Given the deduction limits, businesses will need to ask themselves a couple of important questions. First, will specified service businesses have a reduced appeal because of this limitation? Second, are acquirers going to look differently as to whether they form the investment as a pass-through versus a corporate structure because of the 21 percent corporate tax rate? These are significant questions and ones that may impact deal flow structures and could certainly impact how much equity will be needed during a transaction.

Other considerations acquirers will be analyzing more closely are the tax benefits associated with an asset purchase vs. stock purchase. Historically, most acquirers have preferred asset acquisitions over stock acquisitions because of the additional tax benefits of depreciation/amortization of stepped-up asset basis. In other words, M&A activity in the U.S. was more advantageous from a tax perspective when the buyer could step up the basis in the tangible and intangible assets and receive an additional tax deduction through depreciation or amortization. While this approach does not change because of the new tax legislation, the law does reduce the impact to corporate buyers since the corporate tax rate decreased from 35 to 21 percent. With a lower corporate tax rate, the value of those step-ups could be diminished translating to possible higher tax liabilities for the acquirer.  

One M&A tax planning strategy that has been scrutinized but survived with a tweak. Investors often utilize the “carried interest” concept to assure capital gains on an exit event in deal structures. Although the elimination of carried interest was clearly on the radar screen in recent years and was even made a target by President Trump during his campaign, the concept survived in the new law, but the legislation did extend the carry period to at least three years, so you may not see many quick exits.

A highlight for sellers is an international provision that may enhance U.S. deal flow. The law requires corporations pay tax on earnings that are currently offshore. This may lead businesses to repatriate money they are currently holding off-shore. According to Moody's, there is approximately $1.3 trillion that U.S. corporations are holding in foreign countries to avoid our previously high tax rates. The new repatriation tax and forced taxation could spur M&A activity. If U.S. corporations do repatriate their cash, this could open a huge wave of M&A activity as those businesses look to spend and invest.

Another layer of complication that could manifest itself later is what will happen to the makeup of Congress. As of right now, it is very 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.

Economists expect M&A activity in 2018 to surpass 2017 levels as the number of deals and size of those deals increase. Issues that had held some deals back last year, including political uncertainty and consumer confidence indexes, are diminished obstacles this year. However, there is still a great deal to consider if you a planning a deal in 2018. Understanding the new tax law may have a substantial impact on many decision points.

Gary G. Wallace is a partner and tax department leader at Richmond-based Keiter. He has over 30 years of accounting experience in the private and public sectors. He can be reached at [email protected].