Impact of Proposed Tax Increases on Mergers and AcquisitionsPDF
Political leaders have made numerous proposals to increase tax rates and make other tax changes that are adverse to taxpayers. The most important are the Biden administration’s revenue proposals, which are often called the Green Book. Among the proposals is a large increase in capital gains tax rates.
It is likely any tax increases will be smaller than those proposed by the administration. Any tax legislation will require the approval of all Democratic senators and almost all Democratic representatives. Some Democrats have expressed concerns about the size of the capital gains and corporate tax increases. Although it is unclear what tax changes, if any, will be enacted, the administration’s proposed changes will have a significant impact on transactions this year and likely impact transactions in subsequent years.
PROPOSED TAX CHANGES IN THE ADMINISTRATION’S GREEN BOOK
- Capital Gains Taxed as Ordinary Income. The proposal would tax long-term capital gains and qualified dividend income at ordinary rates for taxpayers whose income exceeds $1 million. Although most other proposals would be effective after 2021, the increase in the capital gains rate is apparently proposed to apply to transactions occurring after April 28, 2021. Such an effective date would no doubt be much criticized and seems unlikely to be adopted.
- Transfers of Appreciated Property by Gift or Death Treated as Taxable Sales. The proposal would generally treat donors and decedents as recognizing gain on appreciated property transferred by gift or death. There would be a $1 million exclusion per donor or decedent. There would also be exclusions for transfers to charities and spouses. Transfers of property to and distributions of property from irrevocable trusts, partnerships and other entities classified as partnerships would be treated as taxable transactions. The tax on illiquid assets transferred at death could be paid over 15 years. Payment of tax attributable to family-owned businesses could be deferred until the business is sold or ceases to be operated by the family.
Such proposals would be a sweeping change in tax law. Imposing tax on contributions of appreciated property to partnerships and distributions from partnerships is especially surprising. Some Treasury officials have indicated the proposal is not intended to apply to routine partnership transactions.
- Taxing Gain as to Carried Interests as Ordinary Income. For taxpayers with income over $400,000 who own a profits interest in an investment partnership, the proposal would tax the service provider’s income at ordinary rates and subject it to self-employment taxes. The importance of such a change would largely depend on whether capital gains for high-income individuals are taxed as ordinary income, as described above.
- Increase in Top Individual Tax Rate. The highest tax rate for individuals would increase from 37% to 39.6%. Also, the highest bracket would begin at lower income levels than under current law.
- Expansion of Self-Employment and Net Investment Income Taxes. The proposal would subject all pass-through business income of taxpayers with at least $400,000 of adjusted gross income to either the net investment income tax (NIIT) or self-employment tax (SET). The NIIT base would include income and gain from businesses not otherwise subject to employment taxes. Shareholders of S corporations, limited partners and LLC members who materially participate in the business would be subject to SET on income above certain thresholds. The proposal would generally mean high-income individuals who are partners in partnerships to which they provide services could not avoid paying at least 3.8% tax in addition to normal income taxes.
- Limits on Like-Kind Exchanges. Under the proposal, a taxpayer could utilize Section 1031 like-kind exchanges to defer up to $500,000 of gain each year ($1 million for joint filers). The proposal would apply to transactions completed after 2021. Under that approach, the limit would apply where the relinquished property is sold in 2021 and the replacement property is acquired in 2022. Such an effective date would no doubt be strongly criticized. Moreover, because some Democrats in Congress have criticized the entire proposal, it seems unlikely to be enacted.
- Increase in Corporate Tax Rate. The proposal would increase the corporate tax rate from 21% to 28%. After some Democratic senators expressed concern about the size of the increase, the president indicated a somewhat lower rate (such as 25%) might be acceptable.
- Fifteen Percent Minimum Tax on Book Income. Corporations with worldwide book income in excess of $2 billion would be subject to a tax equal to 15% of worldwide pre-book income minus NOLs, foreign tax credits and certain other credits.
- Limit on Interest Deductions. Interest deductions of U.S. corporations that are part of a multinational group would have interest deductions limited to their proportional share of the group’s interest expense.
- International Tax Changes. Significant changes would be made to international provisions, including major changes to GILTI, the expansion of deduction disallowances under Section 265, the repeal of FDII, the expansion of the inversion rules and the replacement of BEAT.
- Closing Sales Before the End of this Year. Notwithstanding the proposed retroactive effective date for the increase in capital gains rates, it is unlikely any increased rate will apply to sales this year. Owners who expect to sell assets soon should negotiate for the transaction to be completed this year.
- Avoiding Installment Notes, Escrows, Earn-Outs, Other Deferred Payments. Sellers should negotiate to avoid or minimize some of the sales proceeds being paid in future years. If higher rates are effective in years after 2021, sales proceeds received after this year will be subject to higher tax rates notwithstanding the sale’s occurring in 2021.
- Elect Out of the Installment Sale Method. If a seller is unable to negotiate a transaction in which all proceeds are received in 2021, it may be beneficial to elect out of the installment sale method (when it files its 2021 tax return) and be taxable in 2021 on amounts that are paid in future years. Such an election has several disadvantages, including the difficulty of estimating the current value of potential future payments and the possibility of having a capital loss in future years (which cannot be carried back to the year of the sale if the expected payments are not received).
- Do Not Use an Investment in a Qualified Opportunity Fund to Defer Gain that Will be Taxed at a Higher Rate in a Later Year. It may not be advantageous to use investments in qualified opportunity funds and similar structures to defer taxation for a number of years. Such a structure could result in the deferred gain being taxed at significantly higher rates. Qualified opportunity funds, however, offer significant tax advantages in addition to the deferral of tax.
- Trigger Taxable Gain this Year for Assets that are Expected to be Sold in the Next Year or Two. For publicly traded assets that are expected to be sold after the end of the year, the owner could sell this this year and acquire similar or essentially identical replacement assets. Although there are wash sale rules that limit an owner’s ability to recognize losses when buying and selling assets within a specified period, there is no similar limit to prevent the acceleration of gain. In the case of non-publicly traded assets, an owner may trigger taxable gain by engaging in transactions with affiliates that intentionally fail the requirements for tax-free treatment under, for example, Section 351 or 368.
- Accelerating Gain Previously Deferred Under an Installment Note. If a seller holds an installment note under which it will be taxable on payments over several years, it may be beneficial to cause all of the gain to be taxable this year. The holder could, for example, negotiate a significant change to the note that is treated as a termination for tax purposes or pledge the note as collateral for a loan, which may accelerate the gain previously deferred.
- Purchase Price Allocation. If in future years a seller is taxed on capital gains at the same rate as ordinary income, the seller may not be disadvantaged by a purchase price allocation that benefits the purchaser by allocating as much as reasonable to accounts receivable, inventory, equipment and the like to maximize the buyer’s deductions in the early years. A seller could use such favorable allocation as a basis for a higher sales price.
- Allocations to Noncompete Covenants. If in future years a seller is taxed on capital gains and ordinary income at the same rate, the seller may not be disadvantaged by a large allocation to a noncompete covenant. That would be especially advantageous to a buyer who acquires stock because the amount allocated to the noncompete should be amortizable over 15 years.
- Increased Value of NOLs. If corporate tax rates are increased, a corporate target’s NOLs, tax basis and other tax attributes will become more valuable. That should enable sellers to negotiate higher sales prices.
- Tax-Free Mergers and Other Combinations are More Attractive. If in future years capital gains are taxed at higher rates, tax-free mergers and joint ventures will become more attractive relative to taxable structures. Similarly, Section 1031 like-kind exchanges would become more beneficial to sellers of real property.
- Profits Interests are Less Advantageous. To the extent the holder of a profits or carried interest will be taxed at ordinary rates, the tax benefit of such interest is significantly reduced. That is especially the case because the company never receives a compensation deduction for the value of carried or profits interests provided to employees or other service providers.
- Choice of Entity. If corporate tax rates are increased significantly, the advantage of flow-through entities over C corporations will increase. If there are increased capital gains rates, the Section 1202 exclusion for gain from the sale of qualified small business stock (i.e., the stock of certain C corporations held for more than five years) will become more advantageous.
It is unfortunate taxpayers have to make guesses about potential tax changes in structuring transactions. Making informed guesses and appropriately adjusting transaction timing and structure can produce significant tax savings.