2021-03-08 Potential Tax Changes on the Horizon and the Impact on M&A

Introduction – 2020 was a tumultuous year for businesses and the global economy with the onset of COVID-19. Drastic changes have occurred in the way people go about their lives, entire industries have been upended, and the social and economic impacts of the pandemic linger on.

Despite some remaining economic uncertainty, the outlook for middle-market merger & acquisition (M&A) transactions is strong. The end of the U.S. election season suggests a more predictable economic atmosphere in the short and long term, leading to higher levels of investor confidence. The development of COVID-19 vaccines and logistical planning to expedite distribution have boosted expectations about future economic growth as well.

That being said, the potential effects of legislative changes, particularly corporate and individual tax hikes, may have a significant impact on those who are considering buying or selling a business or business assets. 

Major Take-Away

The Biden administration has indicated it will push for tax increases on high-income earners at some point during the next four years. While the exact parameters and timing of these proposals is still to be determined, owners thinking about the sale of their business in the next few years should consider expediting their timeline. Waiting to sell could mean having to potentially pay higher taxes if the proposals become law. Moreover, several current tax incentives for business owners are set to expire at the end of 2021. Each of these factors might propel M&A activity to even higher levels over the near-term.

Background

President Biden has pledged to seek action in 2021 on his campaign proposals to help quicken the pace of economic recovery. He is seeking to achieve this in part through a $1.9 trillion COVID-19 relief package. In addition, Biden’s “Build Back Better” plan draws on increased taxes from corporations and high-income individuals to help fund government spending and investment in transportation, manufacturing, green energy, and infrastructure. [1]

The Biden administration’s tax proposals would in effect rescind the major tax reductions enacted by the 2017 Tax Cuts and Jobs Act (TCJA) for high-income earners. Although any specific tax changes will have to be negotiated, legislative action before the end of 2021 appears more likely than it did prior to January. With Democrats in control of the Senate, they now have the option to use the budget reconciliation process to fast-track some of Biden’s proposals.

The course of the pandemic and debate over the projected size of the federal debt and budget deficits will play a role in the tax policy decision making process. Additionally, it’s important to evaluate which components of tax legislation may have bipartisan support.

Biden Administration’s Tax Proposals

President Biden has stated that he will not increase taxes on those with annual incomes less than $400,000. However, his administration has discussed potentially raising government revenue in several ways.

Key business tax proposals being considered (which are subject to ongoing negotiations and revision):

• Increasing the corporate income tax rate from 21% to 28%
• Requiring U.S. companies to pay a minimum 21% tax on foreign income and increasing the current minimum tax of profits earned by foreign subsidiaries of U.S. firms from 10% to 21%
• Requiring a 15% minimum book tax on companies with book incomes of more than $100 million but have not paid federal corporate income tax

Key individual tax proposals being considered (which are subject to ongoing negotiations and revision):

• Increasing the maximum federal income tax rate from the 37% to 39.6% (its previous level) for those earning over $400,000
• Taxing capital gains and dividends as ordinary income for individuals with income above $1 million
• Rolling back certain deductions and exemptions for those with incomes above $400,000

A booming stock market coupled with higher-income earners taking less of a hit from the pandemic could give President Biden the means to increase long-term capitals taxes of higher earners. Biden has proposed that individuals earning more than $1 million annually should be charged with a steeper capital gains tax on their long-term gains. [2]

In addition, the Biden administration has proposed extending the Social Security tax to higher-income levels, reducing the estate tax exemption by about 50%, and repealing the “step-up in basis” that allows descendants to pass investments to heirs tax-free. [3] Furthermore, the preferential treatment of carried interest, which is vital to private equity firms and hedge funds, could be impacted.

Another provision with particular importance includes the phase-out of qualified business income (QBI) deductions. Under current law, non-C-corporation taxpayers can deduct 20% of QBI from pass-through entities or qualified real estate trusts. [4] Biden has proposed phasing-out these QBI deductions for those earning above $400,000.

Expiration of Certain TCJA Provisions

It’s also important to highlight some current tax rules set to expire in the coming years. While most of the TCJA’s provisions will sunset by 2025, several are scheduled to do so much earlier. This includes:

• Immediate deduction of R&D expenses replaced by five-year amortization
• Phasing down of bonus depreciation

There will be new rules in 2022 requiring the capitalization of research expenditures. Through 2021, business owners can take an immediate deduction for research and development (R&D) expenses. However, starting in 2022 these costs can no longer be deducted immediately. Rather, R&D expenses will have to be paid off and then deducted over a five-year period (2022-2026). With this in mind, business owners may have an incentive to accelerate R&D expenses into 2021 before the provision expires.

Another provision that will begin to phase down is bonus depreciation. Bonus depreciation allows businesses to deduct a percentage of the cost of assets the year they acquire them, rather than depreciating them over a period of years. Under the TCJA, certain businesses can write off 100% of the cost of eligible purchases and property. However, that 100% will begin to decrease after 2022 to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% thereafter. [5]

The ability to deduct 100% of a large asset’s cost in the year of acquisition can generate significant tax savings. Businesses in the market to make significant fixed asset purchases in the next few years may want to take advantage of this provision before bonus depreciation beings to decline.

With the prospect of tax changes coming as soon as year-end, it is wise for business owners to start planning now to make sure they are well-positioned to achieve their long-term goals.

Other Factors Impacting the M&A Climate

M&A activity strongly recovered during the second half of 2020, a trajectory that is likely to continue throughout 2021. This recovery was due to several factors including the re-emergence of paused deals, pent-up demand from private equity (PE) due to significant amounts of cash reserves (i.e. dry powder), urgency of sellers to close before year-end, and some distressed opportunities arising because of the pandemic. [6]

Companies in the business services and technology sectors have experienced particularly high growth rates. For example, there has been a remarkable increase in demand for remote working and learning technologies and cybersecurity services. The relevance of these industries and many others coupled with their performance despite the pandemic has caught the attention of many investors. To this effect, a significant return in deal flow was observed in the third and fourth quarter of 2020.

Corporate and private investors have capital available and will pursue deals to build scale and expand scope. Targets will come from a growing pool of sellers, including companies that suffered during the pandemic, select business owners looking to exit, and businesses looking to sell non-core segments with higher valuations holding up. [7] Strategic buyers are seeking growth by acquiring market share, expanding into adjacent areas, or investing in innovative technologies that will help streamline processes.