The Impact of Pending Tax Reform On Selling Your Business

  • By: Patrick J. Nolan

    Updated May 5, 2017 based on the April 26, 2017 White House Tax Reform Memo

    On April 26, the White House presented their “2017 Tax Reform for Economic Growth and American Jobs.” According to the one-page document that was provided to reporters, these changes would provide for “the biggest individual and business tax cut in American history.”

    Many of the structural changes to the tax code which were envisioned in the Ways and Means Committee blueprint, previously reported on below, are absent from the White House proposal released last week. This is good news for business owners who are looking to potentially sell their business in the coming 12-24 months, as a few of the structural changes previously proposed would likely have a negative near-term impact on M&A dynamics. Notably, there is no mention in the White House proposal for disallowance of deductibility of interest which would have disrupted the private equity world.

    There is no mention of a destination tax system, which would have disrupted businesses heavily reliant on foreign imports for their supply chain. Essentially, the White House has maintained the tax cuts envisioned in the Ways and Means Committee proposal while disregarding the specific structural changes that would help pay for the tax cuts. The White House plan is largely relying on enhanced economic growth due to the tax cuts to help balance the budget.

    Should such a plan make its way to law, it will greatly enhance the after-tax value of a business. The lower corporate tax rate means the cash flow projections for companies will increase. Given cash flow is the key component of a valuation, the higher future cash flow will translate into higher company valuations. Couple that with the reduced tax rates associated with a business sale, with individual and corporate ordinary income tax rates going down and the 3.8% Obamacare tax being eliminated, it’s feasible certain business owners will achieve a 10% tax savings purely as a result of the reduced tax rates.

    Finally, the elimination of the death tax is a huge consideration for most of our business owner clients, eliminating a large tax related to generational transfers. The combination of these effects could translate into an additional $5M-$10M of after tax proceeds on what would be a $50M company under today’s law.

    Following is a breakdown of the current vs. proposed components of the tax reform, along with the originally proposed components from the House Ways and Means Committee:

    Tax Reform FactorCurrentWays and Means Committee ProposedWhite House Proposed
    (April 26)
    Individual Income TaxHighest rate 39%, six tax bracketsHighest rate 33%, three tax brackets35%, three tax brackets
    Corporate Income TaxHighest rate 39%Highest rate 20%Highest rate 15%
    Long Term Capital Gains TaxHighest rate 20%Highest rate 16.5%Not addressed
    Estate Tax40% maximum rate in excess of $5.49MNo estate taxesNo estate taxes
    All this said, we are dealing with hypotheticals until House, Senate and White House can come to an agreement on a tax reform that satisfies all parties. While there is optimism this could be accomplished in 2017, there will surely be give and take before a final plan is placed into law.
    Original January 24, 2017 Post

    The White House and Congress are expected to make significant changes to US tax code in 2017. Anticipated tax law changes often impact business owners’ sale decisions. The anticipated 2011 tax rate increases created a surge in M&A activity in the fourth quarter of 2010. Owners exited their businesses prior to December 31, 2010 in fear of a hike in income and capital gain tax rates. In 2012 owners accelerated their previously planned exits in late 2012 to avoid a 3.8% investment income tax implemented in 2013 related to the Affordable Care Act.

    November’s election results compelled owners to act in the opposite direction from 2008-2009 and 2010-2011. Many owners with a sale scheduled to close in the fourth quarter of 2016 delayed sale until January 2017 anticipating more favorable tax rates in 2017. Tax reforms will likely impact how sale proceeds are taxed and what activities and transactions are taxable.

    The reform platform being promoted by the Ways and Means Committee will have implications for select operating businesses and private equity groups using debt to capitalize their acquisitions. If approved, the plan would create a lower corporate tax, lower individual income taxes and capital gains tax rates and remove estate and generation skipping taxes. It also provides for direct expensing of capital equipment purchases by businesses instead of capitalization and depreciation.

    Following is a breakdown of the current vs. proposed components of the tax reform:

    Tax Reform FactorCurrentWays and Means Committee Proposed
    Individual Income TaxHighest rate 39%, six tax bracketsHighest rate 33%, three tax brackets
    Corporate Income TaxHighest rate 39%Highest rate 20%
    Long Term Capital Gains TaxHighest rate 20%Highest rate 16.5%
    Estate Tax40% maximum rate in excess of $5.49MNo estate taxes
    The reform aspects should have a favorable after-tax impact on corporations and the owners of middle market businesses, but it is premature to jump to conclusions without considering how Congress plans to balance the tax revenue drop. In order to avoid the filibuster process, the proposal would have to fall under the term “reconciliation,” meaning that any cuts to projected tax revenue would be offset by a combination of additional tax income or spending cuts.

    Two of the proposed components to achieve reconciliation are quite controversial, and will impact many middle market business owners considering exit. They are as follows:

    #1: The disallowance of the deductibility of business interest expense.

    Under the proposal interest paid to lenders by companies will no longer reduce taxable income. Today’s M&A market is driven by private equity groups utilizing debt, typically equal to or greater than 50% of the entire capital structure, to fund acquisitions. The elimination of interest deductibility may shift the playbook for private equity, including the industry’s ability to finance deals and push valuations.

    #2: A shift to a destination-basis tax system.

    Under this proposal, products and services will be taxed in the country in which they are sold or consumed. A competitive advantage will be obtained for companies producing products domestically that are consumed in the U.S. over anything produced internationally and imported to the U.S. Similarly, those companies importing their products, or significant product components, will face an increased tax that will impact their ability to compete domestically.

    This proposed change is problematic for companies with an international supply chain and significant U.S. sales. However, this could benefit companies producing domestically or competing against companies producing internationally. Leaders in the consumer products and industrial component parts industries are paying particular attention to this reform due to their import based business models.

    The timing and likelihood of tax reform is unpredictable, but many political insiders feel the tax reform referenced here has a good chance of moving through the House to the Senate, possible as early as March 2017. President Trump has indicated loosely that he is not a huge fan of the Ways and Means Committee proposal, meaning significant progress on tax reform could be further down the road.

    During periods of fiscal policy uncertainty, we advise our clients to continue to build value in their businesses, stay informed of pending macro changes that could impact their sale proceeds and take advantage of the robust M&A environment while it is here.

    For a confidential conversation about your specific business plans in today’s M&A environment, don’t hesitate to contact us.