After the Tax Cuts and Jobs Act (TCJA) of 2017, the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020, and several new regulations, we once again find ourselves on the path of tax reconfiguration arising from President Joe Biden’s agenda. Biden’s tax plans, as they currently stand, are quite comprehensive, with several new provisions to go with the reversal or undoing of the tax code adjustments enacted a few short years ago.
Whenever there are expected changes to the tax code, uncertainty enters the markets and creates challenges for both investors and those involved in merger and acquisition (M&A) discussions. The uncertainty makes forecasting return on investment even more critical; however, it becomes extremely difficult unless you possess a crystal ball. Regardless of which aspects of the administration’s tax plan get passed and which ones fall by the wayside, there are two things that are most likely to occur: tax rates are going up and certain deductions will be going away. These changes will impact both businesses as well as the owners of those businesses. Thus, there could be a near-term acceleration of dealmaking in an effort to avoid an erosion of after-tax proceeds to investors.
One of the most significant changes being proposed is an increase to corporate tax rates from 21% to 28%. This is not a modest increase, but, if there is a bright side, tax rates will still be below the pre-TCJA maximum rate of 35%. The hike will undoubtedly put a strain on corporate earnings, further decreasing the value of target corporations and decreasing cash flow available to corporations who may be seeking a future acquisition. Furthermore, Biden intends to reinstate a corporate minimum tax (which was repealed by the TCJA) on corporations with global book income of $100 million or more. The tax is aimed at larger corporations, but it will likely be a factor in determining the value of those corporations due to the potential erosion of projected earnings.
Capital Gains Tax Rate
Similar to the corporate tax rate increase, individuals may see the top ordinary income tax rate restored to its pre-TCJA level of 39.6% (currently 37%). For investors, the tax rate on capital gains could see a huge spike from 20% to 39.6% for individuals earning over $1 million. Therefore, an investor’s tax bill could nearly double on any capital gains realized from the sale of their business, a deviation from the decades-old policy of granting favorable tax treatment for capital gains. This is all before considering the impact of state and local taxes and the net investment income tax. It not only affects individual investors but also will significantly impact private equity firms. Private equity firms, which often use debt to leverage acquisitions, are still reeling from the TCJA-enacted Section 163(j) interest expense disallowance rules. They will be dealt another blow as their profits are generally taxed at capital gains rates.
Qualified Business Income Deduction
The TCJA enacted Section 199A in an effort to level the playing field for small-business owners (other than C corporations) with a deduction of up to 20% on qualifying business income. The 20% deduction – a response to the corresponding reduction of the corporate tax rate – essentially lowered the effective tax rate on pass-through income from S corporations, partnerships, LLCs, and sole proprietorships to 29.6% (or 37% individual ordinary rate multiplied by 80%). Biden has proposed eliminating the Section 199A deduction for those making more than $400,000. For small-business owners of pass-through entities looking to sell the assets of their business, this could create a sizable gain within the business that would ultimately flow through to the owners. If the 20% deduction is removed for taxpayers exceeding the $400,000 cap, the tax on the sale of that business could increase significantly, forcing owners to increase the selling price to receive the same after-tax proceeds.
Business owners who may be considering retirement or selling their business must understand what the future looks like from a tax perspective. Businesses on both sides of the negotiating table already are taking measures to model out the proposed changes to determine their impact from a potential sale or acquisition. Many experts think that even if some of these proposed tax changes become law many businesses will see a decline in stock value; however, it is too early to conclude how much due to a lack of details related to the proposals. The businesses that benefited the most from certain aspects of the TCJA and other recent regulations would likely see the biggest decrease in value if those benefits were scaled back. Taxpayers must consider how the current administration’s tax plans would impact ongoing M&A discussions and decide whether or not to accelerate those discussions to close the deal before proposed changes become a reality – or at least factor the potential impacts into their negotiations.
James P. Swanick, CPA, is managing director in Global Tax Management Inc.’s Wayne office and a member of the
Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
Michael J. Tighe, CPA, is managing director with Global Tax Management Inc. and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at email@example.com.