Tax changes and M&A: Accelerated deals, sticker shock, finding value
Deals will continue regardless of tax changes, year-end "cliff" looms
Tax changes proposed in mid-September by the House Ways and Means Committee are compelling deal-makers to accelerate processes ahead of a perceived year-end deadline. Proposals affecting pass-through entities, capital gains, multinationals and other provisions could shift the pricing considerations in any transaction, although the business value of acquisitions is likely to remain strong enough to keep deal flow steady.
In this M&A edition of “Tax Policy Now,” RSM tax specialists update congressional negotiations, examine proposed tax changes that could affect M&A and explain how deal-makers are reacting to the proposals.
Below is a transcript of the discussion between Jim Alex, RSM tax policy leader; Nick Gruidl, M&A leader in RSM’s Washington National Tax; Jamie Hendershot, director in RSM’s transaction advisory services; and Dan Ginsburg, RSM’s public affairs leader. The conversation has been edited for clarity and length.
Dan Ginsburg: To set the stage, there are two key pieces of legislation currently before Congress. We have the bipartisan infrastructure package, which includes more than $1 trillion to address hard infrastructure, such as roads, bridges, broadband—with no significant tax increases included—passed by the Senate with all Democrats and 19 Republicans on board and currently awaiting action in the House. The other piece is, of course, the reconciliation plan. This recently included $3.5 trillion in spending on social and environmental programs and included a host of tax increases on businesses and higher-earning individuals.
As we all know, despite a series of deadlines and expectations for action, for a variety of reasons, both bills remain in limbo and negotiations continue. So, Jim, let's get started right there. Fill us in on the latest—and specifically tax proposals most relevant for those exploring some sort of transaction in the near future.
Jim Alex: In short, right off, there's concern about these developments in the M&A space. Three things I'd call out, Dan. First, it looks pretty clear that we're in a rising-rate environment, meaning rates seem to be more likely to go up with regard to high-earning individuals. Long-term capital gains for, again, high-income earners, and the corporate rate, are going up; and in the international space, rates are going up as well. The effective dates are kind of a little bit divergent right now, but it's pretty clear that we're in a rising-rate environment. And that's across the globe in other countries as well.
Second, the preferential treatment for partnerships that we found with tax reform under President Donald Trump may be curtailed in a meaningful way, making partnerships less attractive as a choice of entity when you're contemplating M&A-type transactions or transactions overall.
Third, for small business stock, there's discussion afoot about limiting the attractiveness of small business stock, which has existed for several years.
Dan: Great, Jim, that’s very helpful. We could see something from Congress by end of October, although it’s honestly looking more likely that if a deal gets done, we're probably talking about December. The top-line number, which I know is certainly highly relevant for what happens from a tax standpoint, will likely come in below that $3.5 trillion spending number that we had heard previously. So that could mean that tax changes could be scaled back. We'll have to see.
Nick, with this in mind, let's get a bit deeper on some of the specifics around things like capital gains and other proposed changes that would have a significant impact on deal-making.
Nick Gruidl: Sure. I'll just reiterate what Jim said: No good news, really, from a purely tax perspective. With that said, M&A activity across the globe is going to continue to be robust. I think in the world we live in, M&A is going to continue to be a huge aspect. The biggest issue that tax reform or rising rates could pose is pricing.
But with that said, let’s get into a few of the areas a little deeper. The GILTI (global intangible low-taxed income) regime that was put in with the Tax Cuts and Jobs Act, really as part of a way to pay for the significant corporate rate cut, is looking like a little bit of a Trojan horse to allow even more taxation—now, of overseas earnings. And that is along with an increase in the corporate rates. So, from a corporate perspective: higher tax liability. Upon a sale of that corporation, long-term capital gains rates go up. You're going to be paying more on the sell side as well.
Now, with that said, as Jim mentioned, one of the pass-through deductions that was really favorable for partnerships could potentially be very restricted for anyone making over $400,000, depending on what is ultimately finalized. So, again, across the board: higher rates.
So, what does that mean? It’s likely not going to have a sea-change-type effect of people deciding, “I'm not going to invest in a corporation,” or, “I'm not going to invest in a partnership.” It's going to be a matter of what makes sense on a particular deal. So, if you're a private equity fund, and you're looking at making acquisitions, I think you're probably going to be making the same analysis you were before, just understanding the pricing is going to be a little different because corporations continue to have those two levels of tax. That's not going away. That's going to continue to be an issue.
There are not a lot of great planning opportunities coming out of this because it's really more about rising rates. There’s one potential silver lining, as Jim mentioned. The proposed legislation would really curtail the benefit of qualified small business stock, which is section 1202 stock. We've heard some recent language coming out saying, well, maybe that's not going to make it into the final bill. So that's maybe one thing we're hopeful about.
Dan: Let’s talk about section 1202 more. The current House Ways and Means bill effectively eliminates exclusions on small business investment gains for hiring taxpayers. Give us a little bit more on that.
Nick: There's been a lot of pushback from the investment community when that was seen in the proposed legislation. Really, the exclusion has driven a lot of investment into small business. We know small business is a huge employer in the country. And so this is one of those exclusions that can be very beneficial because right now you can exclude up to 100% of the gain on the sale of a qualifying small business. Because of that, in rising rates, this exclusion is even more beneficial than a deduction. Again, we think it has really been a driver of investment in small business, so we are hopeful that will come through unscathed.
Dan: Jamie, let's turn to you. Talk with us a bit about what you're hearing from clients, thinking about how all this may be affecting potential deals, and how you're counseling them to proceed given the uncertainty.
Jamie Hendershot: I totally agree with Jim and Nick—the volume is high. But things are really picking up as we head into year-end. We're fielding a lot of questions from our clients and colleagues, like “How can we ensure that our work will be completed?” They want a lot of their transactions to close by the end of the year—because of Dec. 31 being a cliff, if you will.
On the sell side, sellers are taking into consideration offers that have clear and concise steps on how the perspective buyer is going to be able to close at year-end. And buyers are confirming that they'll be able to close before year-end. In the past month or so, I've never looked at so many pre-letter-of-intent transactions with buyers looking to get their bids in and close by year-end.
Dan: Generally speaking, what are you telling clients? What can they do?
Jamie: There are multiple things, but some of the more straightforward ones are sellers that have sell-side due diligence performed prior to or as they're heading to market, they’ll most likely see a shortened diligence period.
And buyers, they're bringing us in earlier. All their advisors are ramping up as they want to get their diligence underway or even completed before they get to the exclusivity period. So that bid-to-signing time is really shortened. We're seeing the traditional deal timeline move up in the process, getting in pre-LOI, doing the diligence, kicking the tires beforehand, so that the buyers are really informed as they put their final offer in.
Dan: Thanks, Jamie. So, to sum up, deal activity remains high and continues to accelerate out of concern about potential tax policy changes. Expectation seems to be that this pace will continue. And so for those exploring a transaction, it is crucial to follow these policy developments very closely.