If Joe Biden prevails in the presidential election this November, there could be another major shift in policy that M&A and private equity practitioners should consider in their tax planning.
Key insights
- Biden’s plan would make a variety of changes to the TCJA. Most proposed changes are not likely unless both houses of Congress have a Democratic majority.
- There are several proposed changes to business tax in Biden’s tax plan that could impact cash flow for businesses and private equity sponsors.
- There also could be an impact for private equity sponsors’ carried interests in Biden’s tax plan.
- The potential change in tax landscape could lead to an increase in M&A activity in the coming year.
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The unprecedented events surrounding the COVID-19 pandemic have overshadowed many of the usual talking points we hear during a presidential election year, including those around tax policy. While the Treasury and IRS continue to implement the Tax Cuts and Jobs Act (TCJA) of 2017, which was the largest overhaul to the Internal Revenue Code in over 30 years, the possibility of another change could seem overwhelming. Former Vice President Joe Biden has unveiled an ambitious tax plan which he would pursue if elected. Investors, business owners, and practitioners should consider the possibility of tax law changes when evaluating transactions in the near future.
What we know about Biden’s tax plan
Biden’s plan as currently crafted would eliminate key parts of the TCJA, leave some intact, and significantly modify others. According to the Tax Foundation, the plan could shrink the economy by roughly 1.5% but would raise more than $3 trillion in revenue over the next decade. Here are some key points of the presumptive Democratic candidate’s plan:
Major business tax changes
- Increase the corporate income tax rate to 28%
- Create a corporate minimum tax on book income for corporations with profits of $100 million or more
- Increase the tax rate on global intangible low-tax income (GILTI) from 10.5% to 21%
Major individual and payroll tax changes
- Restore the pre-TCJA top individual income tax rate of 39.6% for incomes over $400,000
- Increase the rate on long-term capital gains and qualified dividends from 20.0% to 39.6% on income above $1 million
- Phase out the qualified business income deduction under Section 199A for filers with taxable income over $400,000
- Impose a new 12.4% Social Security tax on wages above $400,000 to be shared equally between the employee and employer
Source: Tax Foundation
None of these proposals are likely unless both houses of Congress have a Democratic majority, but with 35 Senate seats and all 435 House seats up for election this year, a Democratic Congress is a possibility. If you’re considering selling or investing in a business in the near-term, consider the potential impacts of Biden’s tax policy.
Potential impact on transactions
Cash flow considerations
Biden’s proposed business tax changes would reduce cash flow for many C corporations. The impact could be even more pronounced if the TCJA’s interest expense limitation remains unchanged. If you’re considering a transaction involving a C corporation, you may want to use a discounted cash flow model to analyze the impact of these changes. These changes would also have an impact on the after-tax cost of debt and equity, which could influence the structure of deal financing.
The proposed payroll tax increase for earners with wages over $400,000 should factor into the cash flow analysis, since the employer would shoulder 50% of the liability. The current Social Security wage base is $137,700 per employee and the new 12.4% tax kicks in for wages over $400,000. This will create a so-called “donut hole” where wages between the general Social Security wage base (i.e., the current $137,700) and $400,000 will not be taxed. For companies with numerous high earners, this additional tax could significantly affect cash flow.
A phaseout of the Section 199A deduction would also negatively impact cash flow and could directly impact private equity sponsors with pass-through entities that are eligible for the deduction in their funds. The Section 199A deduction flows up to the fund sponsors and is available as a deduction on their personal returns. A phaseout of the deduction would increase the sponsors’ tax liability and presumably increase the amount of tax distributions required from portfolio companies.
The higher effective tax rate at the corporate level and corresponding decrease to cash flows may negatively impact company valuations. This will be important within private equity where cash flow can be a critical metric in valuing transactions, financial modeling, and benchmarking investor distributions.
Impact on carried interests
Private equity sponsors should also consider how Biden’s tax plan would affect their carried interests. The TCJA recharacterized gains from the sale of property held three years or fewer as short-term gain with respect to “applicable partnership interests,” which covers carried interests. As a result, sponsors generally must hold their interests at least three years to achieve preferential long-term capital gains treatment. Likewise, the partnership generally needs to hold the property sold for at least three years for the sponsors to qualify for capital gains rates.
While Biden’s proposed tax changes to do not directly comment on eliminating the capital gains treatment on carried or profits interests, his proposed increase to the long-term capital gain rate for those earning more than $1 million effectively does just that. Therefore, we may see private equity sponsors revising their investment models, which could have broader implications on valuations for both buyers and sellers.
Potential uptick in transactions?
The prospect of a tax increase, however, might catalyze M&A activity as business owners seek to exit before corporate and individual rates go up. For owners of pass-through entities, the proposal to increase the capital gains rate to 39.6% on income over $1 million will be a major factor in considering whether or when to sell their business.
Assume a sole S corporation owner sells 100% of the company’s stock and has $5 million of long-term capital gain resulting from the sale. If that stock was sold today at the current capital gains rate of 20%, the seller would pay $1 million in tax on the sale. That same sale under Biden’s plan would trigger $1.98 million in tax. With nearly an additional $1 million in tax resulting under Biden’s plan, business owners may be highly motivated to exit before such a rate increase.
How we can help
It’s difficult to predict what the tax landscape may look like in the foreseeable future, and the possibility of a major change in policy should the presidency and Congress change hands can seem daunting considering that the drastic changes brought about by the TCJA are still being navigated, not to mention the many challenges the US is currently facing.
A Biden win and a Democratic Congress will likely result in corporate and individual taxes going up, even though they might not be exactly as currently proposed. As such, buyers and sellers contemplating transactions in the coming months, should consider the implications of Biden’s plan as currently outlined.
Contact the CLA team to discuss how these issues may affect your business and investment decisions.