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How Tax Reform Will Lead to an
M&A Middle Market Boom

Posted by sb_admin on April 16, 2018
| Blog
| 0

The Tax Cuts and Jobs Act passed in 2017 has been repeatedly called the most significant change to the tax code in three decades. It’s too soon to know if the legislation will improve the economy, but it’s important for businesses to know the impacts of the new provisions, and to adjust their strategies accordingly.

One of the most significant changes was a reduction incorporate taxes to a flat 21%, as well as a repeal of the corporate alternative minimum tax. This will increase the after-tax profitability of some companies, which may use these savings for investments or additional compensation to employees. Both set the stage for M&A. Corporation may seek better multiples, and will likely have better cash flow.

The act also allows a bonus deduction for 100% of the cost of computer software, machinery, and other tangible assets through 2022. Even property acquired through an acquisition qualifies. Businesses who hope to reduce their tax burden can save big, and may use this excess capital to invest in other businesses. Big winners may include construction, pharma, manufacturing, and any business that holds or produces property that qualifies for this incentive. It’s important to note that acquirers and sellers must structure deals as asset acquisitions to benefit from this deduction.

Transactions with significant intangible value may benefit less from the tax deduction. That’s because the tax value of intangible amortization affects cash flow less.

Tax rate changes can also have important effects on pass-through companies such as partnerships and LLCs, which comprise 90-95% of the middle market. Pass-through corporations can now deduct up to 20% of business income. But those that fall into a “specified service trades or businesses” category, including athletics, consulting, law, and financial services will only qualify if taxable income is less than $207,500 ($415,000 for married couples filing jointly).

Owners seeking an acquisition should be mindful of the challenges associated with targets that don’t qualify. PE will need to consider the tax profile of each individual business rather than allowing an apparently favorable tax climate to spur a thoughtless boom in acquisitions.

The new tax act includes a one-time repatriation tax for accumulated overseas earnings. This 15.5% tax on cash earnings and 8% of the remaining earnings can be paid over a period of years. This can create a significant middle market opportunity because corporations may use the repatriated cash to acquire companies that offer meaningful synergies. Much like the corporate rate reduction, the act puts the burden on acquirers to put capital to work in the U.S. That may mean larger multiples.

We don’t yet know how things will shake out, and businesses should proceed with caution. Acquirers must think not only about the present, but also about how future legislation may affect their acquisition. It’s important to get tax advice from experienced professionals, and to devise agreements that spell out tax liabilities and that protect all parties’ interests.

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