August 7, 2020 •Eitan Milstein
Please Note: this article was published prior to the completion of the 2020 US Election Cycle.
November’s electoral outcome is far from certain, but a change in the White House – combined with ongoing fallout from the Covid-19 pandemic – may have a profound effect on the M&A landscape.
The federal deficit has risen sharply during the Trump administration. Coronavirus-related spending has further accelerated that trend. Corrective actions – via entitlement cuts, tax increases, or both – are anticipated. Former Vice President Joe Biden’s tax plan represents a significant departure from current federal rates and thresholds
The Biden Plan imposes new burdens on individual business owners and their companies:
Corporate Income: rate increases from 21% to 28%, plus the alternative minimum tax (AMT) is reinstated
Payroll: additional bracket for earnings above $400,000, taxed at 12.4% and split evenly by employers and employees
Individual Income: top marginal rate increases from 37% to 39.6%
Qualified Business Income Deduction (for partnerships & S-Corps): phased out for taxable income above $400,000
Long-Term Capital Gains: rate nearly doubles from 20% to 39.6% on income above $1 million, matching the top ordinary income tax rate
What could this mean for owners of private businesses?
Those who simply seek to maintain the status quo will experience notable reductions in free cash flow and in take-home earnings. Meanwhile, owners with near-term M&A ambitions may think twice, as their businesses will most likely garner lower offers from potential acquirers.
Why? Institutional financing for M&A deals will decline, due to companies’ decreased cash flow and thus their ability to amortize debt. This will lower purchase multiples and overall valuations. Furthermore, most sellers’ net proceeds will be subject to capital gains tax rates equivalent to ordinary income rates (39.6%)
Owners seeking pre-inauguration exits may encounter stiff headwinds.
The inherent uncertainties of the Coronavirus epidemic have added new constraints to the M&A process. Companies attempting third-party sales can expect extra impediments including:
- Lower close rates and “on-time” transactions
- Flexible language regarding final purchase prices
- Increased claw-back, earn-out, and roll-over equity provisions
- Tighter reps and warranties
Does this leave owners between a rock and a hard place?
Not necessarily. The outcome of the 2020 Presidential Election is still up in the air. Even in the event of a Biden victory, there is no guarantee his tax plan will be enacted in its present form.
But with the ongoing threats of both Coronavirus and the widening federal deficit, it would be wise to consider tax mitigation strategies and/or M&A alternatives.
An ESOP may represent a meaningful and sensible alternative.
Employee stock ownership plans are already desirable transactions among owners seeking fair-market value for their shares, liquidity, tax-advantages, and continued roles with their businesses. In a higher tax environment, the benefits of an ESOP become even more meaningful due to three unique features:
- Selling shareholders can defer and potentially eliminate capital gains taxes (via 1042 rollovers)
- Companies earn income tax deductions equivalent to the sale price
- Those companies can become permanently tax-free entities, as 100% employee-owned S-Corp
Employee stock ownership plans do not preclude companies from making future transactions, including third-party sales, ESOP expansions, and plan terminations. For business owners, that may be the most reassuring benefit of all. In times of uncertainty, flexibility – without sacrificing upside – is critical.
The future is unwritten. Public health and electoral outcomes are hard to predict. As a result, the M&A waters may remain choppy for quite some time. It might be the right time for owners of privately-held companies to chart a new course.