Why Tax Reform May Lift Middle Market M&A to New Heights in 2018!

It’s just possible the 2017 Tax Cuts and Jobs Act is poised to have an even greater impact than U.S. legislators initially envisioned. In addition to spurring job growth and driving wages higher, the new tax code has provisions that potentially will not only boost middle market investment, but also jump start deal making across the U.S. A guest article in the February 5, 2018 issue of Mergers & Acquisitions observes that:

“There is tremendous sentiment that M&A activity in the middle market will surpass 2017 levels this year. Both the size of deals and the quantity of those deals will likely be much higher as both sellers and acquirers look to take advantage of the act’s pro-growth provisions. It is important to realize all of the benefits and potential hurdles the act contains so that all parties will benefit...”

Here’s a detailed look at how some of the anticipated changes translate into positive benefits for middle market M&A in 2018.

Effects of Corporate Tax Rate Reduction and Corporate Alternative Minimum Tax Repeal

The Act reduces the corporate tax rate from 35 percent to a flat 21 percent and repeals the corporate alternative minimum tax. Both changes became effective after Dec. 31, 2017 and will increase the after-tax profitability of corporations.

According to the Mergers & Acquisitions article, “Corporations will be looking for making additional investments in the business which sets the stage for M&A activity. Corporations will seek better multiples by obtaining a return on investment, and with tax reductions, focusing on enhanced cash flow by acquiring middle market companies – especially those that require or produce accelerated tax benefits for qualified property.”

As defined by the Act, qualified property includes any tangible property with a depreciable life of 20 years or less. This includes computer software, machinery, land, property, and many other tangible assets. As the article explains:

“The act provides an immediate bonus deduction for 100 percent of the cost of these assets for through 2022. More importantly, the deduction is available for both new property and property acquired from a different taxpayer. In other words, property acquired through an acquisition now qualifies. Businesses looking to reduce their tax burden will find these provisions particularly attractive and will be inclined to use excess cash to make investments in middle market companies.”

Impact of Tax Rate Changes to Pass-Through Companies

“Pass-through corporate structures such as partnerships and LLCs make up 90 to 95 percent of the middle market and are a preferred structure for private equity deals because it alleviates ‘double taxation,’ and allows the flexibility of an exit,” notes the Mergers & Acquisitions article. However, “For those seeking to acquire a company, these favorable deductions could present challenges for targets that are non-qualifying businesses. Private equity sponsors will need to consider these challenges…”

One-Time Repatriation Tax on Accumulated Earnings Held Overseas Could Boost Investment in U.S.

The tax rate is 15.5 percent on earnings held in cash and eight percent on the remaining earnings and is paid over a period of years. Corporations will likely want to invest these funds to avoid additional future taxes. According to the article:

“This could set up a tremendous opportunity for the middle market because corporations may likely use their repatriated cash to acquire companies that complement their core business. Again, like the corporate rate reduction, the Act’s impact on freeing capital for investments will put the burden on acquirers to put that capital to work in the U.S. which may result in enhanced multiples.”

Clearly, for those with the skill to take advantage of these new opportunities, the 2017 Tax Cuts and Jobs Act is well positioned to have a positive impact on middle market M&A in the coming year and well beyond!