How Will Tax Reform Impact M&A?

Tax reform is nigh. It is one issue that rises above the partisan gridlock on Capitol Hill and the stakes are so high that even the prospect of change — which could occur this year — is altering the deal-making calculus.

Corporate tax rates, enshrined offsets, loopholes and capital gains are all on the table, potentially recasting the way global business is done. The proposed changes could have major consequences for all businesses, rippling throughout the U.S. — the world’s biggest M&A market — and abroad.

Certainly, tax reform will have its winners and losers. A lower corporate tax rate may disadvantage many middle market companies in favor of industry behemoths. The threat of heftier taxes could spur business owners to go to market while the getting is good.

Simplifying the byzantine tax code will be a complex undertaking. Existing proposals entail different approaches and priorities, but there are some areas of overlap as well. Here are some of the most salient reforms that affect every player in the M&A ecosystem, from middle market business owners to strategics (large corporations) to financial buyers, such as private equity investors.

Keeping Business at Home

The U.S. has the highest corporate tax rate in the developed world at 35%. Although many corporations effectively lower their burden through tax breaks and other reductions, the statutory rate is broadly considered too steep for businesses to compete against global rivals.

Lower corporate income tax (the president has proposed 28% and Republicans 25%) is not just designed to boost U.S. competitiveness, it is also key in preventing tax inversions, a much-maligned corporate maneuver aimed at sidestepping the 35% rate. The Treasury has already cracked down on the transactions, where a U.S. multinational becomes a subsidiary of a parent company in a low-tax jurisdiction, but a gentler federal tax will go a long way to keeping companies at home.

In addition to barring inversions, lawmakers have proposed a “tax holiday” so companies could repatriate stockpiles of foreign revenue at a much lower rate. This would be a one-off aimed at channeling vast sums back into the U.S. Potential long term fixes to the offshoring of money include a 19% tax on foreign profits rather than the 35% federal rate. A more radical solution would be for the U.S. to abandon the worldwide tax system altogether in favor of a territorial regime. This would mean that instead of paying U.S. tax on foreign income, less the amount of foreign tax already paid, U.S. businesses would only pay taxes in the country where the money was earned.

The proposals may range from the radical to the redundant, but are motivated by the same belief: a lower corporate tax burden will boost U.S. businesses, promote investment and combat foreign takeovers.

The Loophole Dilemma

It’s not all upside, however. In order to offset the lower overall tax rate, loopholes will be eliminated. Of course, part of what makes tax reform so tricky is the fact that livelihoods often rest on loopholes. One of the most prevalent deductions — accelerated depreciation — is squarely in the crosshairs. Accelerated depreciation allows businesses to write off the lost value of investments, i.e. machinery, equipment and real estate, as a tax deduction, only at a faster rate than the value actually declines. Businesses will have to rethink the pace and size of their investments if they cannot be quickly used to minimize taxes.

The Middle Market Takes the Burden

Much of the tax debate focuses on big business. They are the ones with massive incomes, global footprints and lobbying muscle. However, the middle market is equally affected by, if less embroiled in, an eventual overhaul. Indeed, reforms aimed at broadening the tax base — to counter the lower corporate rate alongside eliminated loopholes — could land heavily on small and mid-sized businesses.

How so? A large number of middle market businesses are closely held and structured as pass-through or flow-through companies, namely partnerships, S corporations or limited liability companies. These firms do not pay corporate income tax; instead business income flows through to owners to be taxed at the federal level at individual rates. For the meantime, at least. Reform could strip pass-throughs of this favorable treatment and make them more like C corporations, taxed at both the firm level and at the individual level. Factor in a loss of accelerated depreciation and other so-called tax preferences and the middle market risks bearing the brunt of a new tax paradigm.

Ideally, corporate tax reform would shield the middle market by reducing the marginal tax rates for the individuals through whom business income is taxed. Alternatively, the lower-tax thresholds for small corporations (15 percent on first $50,000 of income) could be expanded to accommodate a greater share of income.

Private Equity Squeeze

There are few hotter issues in the overall tax debate than carried interest. Carried interest is the share of profits received by investment fund managers, namely private equity GPs. The controversy rests on the fact that these profits are taxed as capital gains, at 20%, not as ordinary income. Reformers will almost certainly try to eliminate this tax break, claiming carried interest is compensation rather than a return on an investment. Less money for fund managers, others contend, will be a drag on private equity investment, affecting not only the PE set but also the middle market companies they typically acquire.

Beware Business Owners: Capital Gains

Lastly, a tax overhaul could include a hike in capital gains, raising the top rate from 23.8% to 28%. While this would potentially affect investors of every stripe, nobody would feel it more than the seller of a business. After crunching the numbers, many business owners would prefer to sell earlier than planned if it meant keeping five percent more of the payout.

Fuel For the M&A Spree?

So far 2015 has lived up to M&A forecasts. The first quarter represented the greatest M&A volume in eight years, and the U.S. market did particularly well, with roughly $415 billion in deals announced. In short, this year is on track to be a remarkable year for M&A, rivaling or exceeding pre-crisis highs. Tax reforms could well play into the bonanza, encouraging companies to hit the market before rates and write-offs undergo a dramatic shift.

While megadeals have dominated the headlines this year, the middle market is poised for an uptick as strategic buyers give way to private equity firms, flush with cash after a stretch of strong fundraising and successful exits. Especially with interest rate hikes on the horizon, the current access private equity has to favorable debt capital makes now an even better time to buy.

While the tax overhaul is surrounded by speculation, there are a few fundamental certainties. A lower corporate rate will necessitate fewer loopholes and a broader tax base. The changes could help fuel an M&A market that is already cooking, incentivizing buyers and sellers alike. For business owners in particular, 2015 may prove an irresistible marketplace.