How Potential Tax Policy Changes May Impact Sellers in M&A Transactions

May 4, 2021

Cedric C. Fortemps, CFA, Co-Head of Downstream Energy & Convenience Retail Investment Banking and Michael J. Tucker, CFA, Senior Analyst
Downstream Energy & Convenience Retail Investment Banking Group

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Since the middle of last summer, anyone that spends a part of their day watching CNBC or reading the Wall Street Journal has seen interviews or articles covering the fact that there would likely be an increase in tax rates if Joe Biden were elected President. This topic has received nearly as much media attention as insights from Dr. Fauci or Dr. Gottlieb on the spread of COVID-19 and best practices on how to avoid being exposed to it. Now that President Biden has taken his oath of office, the only questions that seem to remain are how much tax rates are likely to go up and how significantly individuals and businesses will be impacted.

One of, if not the primary goal most clients have when they engage Matrix to sell their business, is to maximize net proceeds from the transaction. Unfortunately, as of today, we do not have the exact answers as to how materially the changes to the tax laws will impact taxes on transactions, but we have spent the last few months educating existing and potential clients on the impact to net proceeds that could result from higher tax rates in 2022, when taxes are likely to increase.

Potential Changes to Tax Laws
The Internal Revenue Code, or Title 26 of the United States Code, is the body of laws that codifies all federal tax laws and currently consists of over 6,550 pages. For the sake of brevity, we will focus on the key changes being considered by the Biden Administration that would most materially impact the amount of taxes payable on the sales of assets or stock. The table below lists certain tax provisions and the current tax laws that apply to those provisions. In the right-hand column, the table describes the potential changes being considered by the Biden Administration and Congress. The last three tax provisions in the table (i.e. like-kind exchanges, social security taxes and step-up in basis) won’t necessarily impact taxes on transactions, but they are likely of interest to many business owners, so they are included as well.

With the Democrats’ slim voting majority in the House of Representatives (222-213) and even narrower majority in the Senate (50-50, with majority only through Vice President Harris’ tie-breaking vote), the path to significant changes in the tax laws is likely not an easy one. However, with a potential passage through reconciliation or other means, including a negotiated bi-partisan agreement, experts believe it is likely some modifications to the current tax code will get passed.

The timing on the voting and passage of a bill to change the tax laws is somewhat uncertain at this time, but experts believe that any bill passed in 2021 would not change tax laws retroactively and that the changes would not go into effect until January 1, 2022.

Analysis of the Potential Impact to a Seller’s Net Proceeds
In the table below, we compare a pass-through entity (e.g. LLC, S-Corporation, partnership, etc.) owner’s net proceeds from a sale of his/her convenience store chain company’s assets. The scenario assumes that the selling company is an S-Corporation and is debt-free. The purchase price for the assets is $120 million. In both Case 1 and Case 2, we assume that the highest marginal income tax rate for individuals will increase from 37.0% to 39.6% in 2022. Case 1 assumes that the long-term capital gains tax rate increases from the current rate of 20.0% to 25.0%, while Case 2 assumes that this rate increases to the highest marginal income tax rate for individuals, which is assumed to be 39.6%. This potential material increase to the long-term capital gains tax rate for households making more than $1 million per year was part of President Biden’s tax proposal announced in late April. However, this part of the plan will likely face significant resistance from House and Senate Republicans, and potentially the more moderate members of the Democratic party as well.

As the table [1] above shows in Case 2, if individual income tax rates and long-term capital gains tax rates increase to 39.6% in 2022, a seller’s net proceeds could be materially impacted, with the seller potentially realizing 16.3% or approximately $14.8 million in less net proceeds in our example from a sale in 2022 versus 2021 [2]. As Case 1 shows, assuming a more modest increase to long-term capital gains tax rates, the impact is smaller, with the seller realizing 4.3% or approximately $4.0 million, less in net proceeds, which could very well be a best-case scenario if tax legislation does get passed. It should be noted that the full weight of the impact will vary for each seller based on the seller’s tax basis and the purchase price allocation agreed to. This is one of the many reasons that a potential seller should work closely with their tax and M&A advisors to fully understand the likely net proceeds from a sale, as well as to strategically negotiate the sale structure and allocation with the buyer.

[1] Each scenario assumes that the shareholder(s) are active in the business; otherwise, shareholders could be required to pay an additional 3.8% tax on capital gains income due to the Medicare Tax on investment income.

[2] Comparisons of potential taxes owed from a transaction in 2021 versus 2022 assumes that changes to tax laws go into effect on January 1, 2022 and are not made retroactive to any portion of 2021.

The potential increase in tax rates could also impact multiples that strategic buyers and financial buyers are willing to pay for acquisitions in the future, but since President Biden has made his plans quite public, it is very likely that some future increase in tax rates is already being factored into the prices being paid. However, if buyers were to pay lower multiples due to the increase in tax rates, that would also decrease net seller proceeds.

Conclusion
There is no doubt that the uncertainty surrounding the potential changes to the tax laws is creating angst for some owners and board members. The fact that today’s tax policies are likely to be more favorable than at any time in the foreseeable future and combined with the strong current M&A market has accelerated some owners’ decisions to sell their business. Just how beneficial a sale in 2021 will end up being versus a sale in 2022 from a taxable proceeds perspective won’t be known until later this year.

However, given the amount of time required to properly market a business and negotiate a purchase agreement that protects the seller in a sale, owners that want to try to take advantage of the current market and tax laws should not wait to contact experienced M&A and tax advisors. These professionals can help business owners better understand the impact these factors could have on a potential sale of their business.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with additional offices in Baltimore, MD and Chicago, IL. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, not-for-profit and publicly traded companies. Services include company sales, recapitalizations, capital raises of debt & equity, municipal advisory, corporate carve outs, special situations, management buyouts, corporate valuations and fairness opinions. Matrix serves clients in a wide range of industries, including automotive aftermarket, building products, business services, consumer products, convenience retail, downstream energy, healthcare and industrial products.