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M&A Dealmakers Tackle COVID and Tax Policy Uncertainties

Posted on Nov. 3, 2020

Dealmakers are continuing to address complexities in structuring transactions amid the pandemic while considering how uncertainties in tax rates factor into the mix.

It’s been a tumultuous ride for the mergers and acquisitions market in 2020, with sharp declines in the early months of the coronavirus pandemic followed by signs of an upturn in the second quarter, albeit not in all sectors.

According to PitchBook Data Inc.’s third-quarter 2020 Northern American M&A Report, released October 21, overall M&A activity rebounded with quarter-over-quarter increases in the number and value of deals, representing the first gains since the fourth quarter of 2019.

M&A deal volume has “accelerated pretty significantly from the depths of the COVID crisis” in both the private equity and the corporate markets, and deals are getting done despite the challenges in valuing some target companies affected by the pandemic, Adam Benson of Alvarez & Marsal Taxand LLC told Tax Notes.

To address the uncertainties fueled by the possibility of substantial changes in tax policy, dealmakers are using mechanisms that have become more prominent in a pandemic-stricken world, such as earnouts and equity rollovers, according to M&A practitioners.

Democratic presidential candidate Joe Biden’s proposals that have gotten attention include taxing capital gains at ordinary rates for taxpayers with income over $1 million, increasing the corporate tax rate from 21 percent to 28 percent, and upending the regime for foreign-source income under the global intangible low-taxed income rules.

The uncertainties regarding corporate and capital gains tax rates are affecting deal terms and timing in some circumstances in private equity and corporate M&A markets.

Saul E. Rudo of Katten Muchin Rosenman LLP said any tax legislation will require rethinking on the sell side and the buy side as well as time for equilibrium to set in.

Rudo noted that the consensus seems to be that 2021 is “going to be a robust” year for M&A deals. If that growth occurs regardless of tax policy changes, buyers and sellers might turn to more earnouts, rollovers, and other vehicles to figure out how to bridge any gaps, he said.

Speeding Up, Slowing Down

According to a recent Deloitte survey of 1,000 executives at U.S. corporations and private equity investor firms, the anticipated effect of the election on “dealmakers’ willingness and ability to do deals is nearly split: 25 percent of respondents say uncertainty surrounding the election has slowed deal activity, and 23 percent say it has accelerated deal activity.”

Particularly for family-owned businesses, the potential doubling of the capital gains tax rate effectively is a motivating factor to get the deal done before the end of the year, Benson said. That’s true in private equity but also for corporate deals involving smaller, founder-led technology companies, he added.

For those individual sellers, “tax is very meaningful” and has led to some deals having covenants that say if the deal doesn’t close by year-end, the seller has the unilateral right to walk away, Benson said. That allows them to decide December 31 whether they want to proceed “even if there is regulatory delay or something else that is out of the buyer’s hands,” he added.

Also, investment bankers are truncating processes by pushing people hard to get to a valuation to close deals by that date, according to Benson. He said it wouldn’t be surprising if deals accelerated into the second half of this year result in a slowdown in M&A activity in the first quarter of 2021.

Similarly, Rudo said that in anticipation of a Biden administration — with a Congress that could effectuate his tax proposals — “there might be deals that are in the hopper that are moving forward . . . quickly [to] get done before year-end.”

Closely held business owners, however, generally assess how things might play out over the next five or 10 years. According to Rudo, they run the numbers, taking into account taxes they will pay and the annual returns from investing the after-tax proceeds from selling and comparing that to the post-tax dividends they will receive if they hold on to the business.

Under Biden’s proposed change in capital gains tax, for a seller with annual income above $1 million, the question is whether it makes sense to hold on to the business considering the 39.6 percent federal tax on the capital gain and the state taxes layered on top of that, which, for example, in California would be 13.3 percent, Rudo said.

So in some circumstances, the owners will opt to hold on to their businesses, according to Rudo.

Benson said his firm hasn’t seen that yet, noting that “in the swing of the pendulum, we’re currently [in] the acceleration” mode because most conversations with clients now are focused on a deal that they want to get done quickly.

But if there’s a change in administration and a potential change in law, “it wouldn’t surprise me at all to see a bit of a pullback — a wait-and-see approach to see where things come out,” Benson said.

Benson agreed, saying that for closely held family or founder-run businesses contemplating whether to sell or hold on to the business, “the math changes pretty materially without the lower capital gains rate.”

That could have a stifling affect on the number of assets that come to market, Benson added.

Triggering Gains

Year-end tax planning is common when there’s a potential change in administration, so business owners or private equity funds that can’t close deals by December 31 might consider transactions to trigger built-in gain, Benson said, adding that he expects to have many conversations about that.

If a business has been struggling and there’s uncertainty about its future, companies can create longer-term values from depressed assets while the rates are low, Benson said. He said they can accomplish that by executing “certain types of transactions to trigger whatever gain is inherent in that business or getting certain assets out of corporation solution or converting to an S corporation or a partnership.”

Those are taxable transactions that might be worth considering if corporate tax rates are expected to go up — essentially restructuring the business “into something that could be valuable long term if the business does recover,” Benson explained.

With the disruption in the market, there’s been more carveout transactions, which are generally done to restructure the company and focus on its core businesses, Benson said, adding that the anticipation of a higher corporate rate might be driving the increase in those deals.

Another technique for C corporations, similar to what’s done in estate planning, is freezing assets at their current valuation, Benson said. If the corporation wants to become a partnership, generally that conversion triggers all the built-in gain that would be taxed at the corporate level with distributions taxed at the shareholder level, he explained.

It that’s not palatable, a corporation with a value of $100 million, for example, could “freeze the amount of the business that′s in corporate solution” and restructure so that future business growth is in partnership form, Benson suggested. That has tax implications, but it may be beneficial to do that now at lower rates, with depressed values and the potential for higher rates in the future, he said.

Mitigating Valuation Pressures

Uncertainties stemming from the effects of the pandemic and potential tax policy changes under a new administration present valuation challenges, which have spurred an increase in alternative deal structures that could be traps for the unwary.

Rudo said that amid the pandemic, M&A practitioners have wrestled with valuation disparities and concerns, such as sellers affected by COVID-19 thinking their business will do well in the next couple of years, while buyers are less certain and looking for proof or assurance of that value.

In deals involving closely held businesses, buyers seeking to keep seller management in place have required equity rollovers in excess of 20 percent, which generally trigger the section 197 anti-churning rules, Benson said.

Section 197(f)(9) was designed to prevent the amortization of intangible assets in some transactions unless the transfers result in a significant change in ownership or use.

If a buyer and seller are deemed related, the basis step-up that’s generated on an acquisition transaction of intangibles, such as goodwill, is no longer amortizable, Benson explained.

But it’s often “a sneaky issue that gets missed a lot, and there are just foot faults for people to fall into it,” Benson said. As equity rollovers increase along with other equity incentives, coupled with the attribution rules, “you can trip over 20 percent and it surprises people,” he added.

With the increases in rollover percentages, the ability to amortize the basis step-up of goodwill and some other intangible assets over 15 years could be at risk without appropriate structuring around the anti-churning rule, Benson said.

For example, if 25 percent of the ownership in an S corporation will be rolled over, the deal can be restructured such that the buyer is purchasing an interest in a partnership rather than the assets, Benson said. That’s because buying an interest in a partnership can generate a partner-level attribute rather than a step-up in the assets themselves, which generally isn’t subject to the anti-churning rules, he added.

Rudo said with a potentially higher capital gains rate under a Biden administration, closely held businesses might want to roll over more equity into the buying entity to keep their income below $1 million, Rudo said.

So instead of a tax-deferred rollover of 10 to 20 percent, they want to roll over 30 or 40 percent, hoping for lower rates after 2024 or returns on their pretax rollover amount that exceed what they would get after paying taxes on a complete sale of their business, Rudo explained.

Equity rollovers aren’t new mechanisms in M&A deals, “but the stakes just become higher as the rollovers get bigger . . . and it gets harder to structure around some of these issues,” Benson said.

Building in Flexibility

With the possibility of higher taxes on capital gains, some buyers might be less enamored with rollovers — wanting to roll over less equity or doing them tax free to trigger the gains in 2020, Benson said.

“So there can be a bit of a push and pull” because the buyer usually focuses on the dollar amount of the rollover and cares less about whether it’s tax deferred, Benson said.

That process requires negotiation and consideration of building in flexibility such that if there’s a tax-deferred equity rollover and it appears the rates will increase, there’s a mechanism in the deal documents and transaction structure that could trigger those gains to take advantage of the 2020 tax rates, Benson said.

“That’s been a topic of a lot of conversations,” Benson said, adding that people are using, for example, the installment sale rules to defer gains that can be later triggered upon receipt of cash, which can be reinvested in the business.

Or transactions with an equity rollover could include an option to make a retroactive check-the-box election that would trigger gain, Benson said. That allows the sellers to wait and see what happens through the end of the year, he noted.

Timing Considerations

What to expect after the election is a hot topic given the magnitude and iterative nature of possible changes, Todd Castagno of Morgan Stanley said October 26 during a webinar hosted by CPA Academy.

In looking at Biden’s proposals, it’s important to think not only about the corporate rate increase itself but how it interacts with the other elements, such as the changes in the GILTI regime, Castagno advised. And “it’s not only what to expect but [also] when to expect it that I think is challenging,” he said.

Rudo pointed out that rate increases like those that may happen under a Biden administration generally aren’t retroactive from the date of enactment but are effective on the date or shortly after. But if Biden and Congress want an effective date of January 1, “I would think [they] would start saying in the middle [or] . . . end of November” that’s what they intend to do, he said.

Further, the continued need for a stimulus package stemming from the effects of the pandemic that taxpayers have been waiting for likely affects Biden’s ability to effectuate tax increases, Castagno said, adding that that’s likely to be the first piece of legislation needed.

“Timing matters a lot — hopefully we’ll have a robust recovery, but if we don’t, I think the attitude and climate for tax increases may influence what can actually get legislated,” Castagno said.

And it’s not just looking at the tax items Biden is proposing, but also the adjacent policies he may pursue, such as infrastructure and green energy. Castagno said those policies could create complexity and affect timing of tax proposals. And if it’s infrastructure, that’s a challenging piece of legislation in its own right, making it unclear whether it’s possible in 2021 or more likely the following year, he added.

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