Verit View-February 2018
Tax Cuts and Jobs Act: Opportunities for Middle Market
Verit Advisors’ view is that the Tax Cuts and Jobs Act alters the tax landscape and creates a unique opportunity for companies to examine both corporate strategy and structure in light of stakeholder objectives. The cut in the corporate tax rate in particular is a cornerstone of the new law. To the extent that the cut in the corporate tax rate increases free cash flow, companies may bolster growth initiatives with new capital expenditures, acquisitions, or organic expansion. In addition, the cut in the personal tax rates may increase disposable income and therefore consumer spending.
While it is too early to tell the overall effects the new tax law will have on the corporate landscape, Verit believes that the following are worth examining as a part of a strategic review.
- C-Corp. vs. S-Corp (or LLC): Due to fact that corporate tax rates decrease to 21% and personal tax rates remain relatively unchanged, there may be some benefits to converting from an S-Corp to a C-Corp. The benefit of a C-Corp vs. S-Corp will vary from company to company. Verit recommends thorough tax analysis on both the personal and corporate level. This needs to weighed very thoughtfully in an ESOP context. With the S-Corp owners being eligible, in some circumstances, to deduct 20% of their income, the tax benefits of S-Corp vs. C-Corp ESOPs merit detailed comparative analytics. In addition, the new S-Corp provision would decrease the amount of distributions made to the ESOP.
- New Sources of Capital: With the corporate tax rate decrease to 21% and the potential 20% flow through tax deduction, companies may find that they have access to additional capital. The increase in available cash flow available to service debt payments, in addition to the unprecedented amounts of capital from an ever-growing number of sources (private equity sponsors, institutional investors, family offices, banks, non-banks, international), capital is readily available in today’s market. Theoretically, this could help companies fund additional growth strategies that were previously out of reach.
- Increased M&A Activity: According to Pitchbook, U.S. private equity middle-market activity remained strong through Q3 2017 with $233 billion across 1,652 deals, a 13.0% increase and 1.5% decrease, respectively, from the same period in 2016. While deal count has decreased slightly, mid-market M&A EBITDA multiples have risen to their highest levels on record, 10.7x through Q3 2017. In addition, industry tracker Preqin estimates the global private equity industry raised $453 billion in 2017, surpassing the previous landmark of $414 billion set in 2007, leaving $1 trillion to invest into companies. The new tax law promises to continue to fuel an active M&A environment. With a 15.5% repatriation rate for cash profits held offshore and 8.0% for non-cash, investors are poised to invest in companies in the United States. Flush capital markets and the positive momentum from repatriation promise to continue fueling the strong middle market M&A environment. Is now the time to sell?
- Interest Deductibility: Previously, net business interest (business interest expenses minus business interest income) was entirely deductible. The new tax law limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for the next four years. Beginning in 2022, the limit decreases to 30% of EBIT. For leveraged companies and newly leveraged ESOPs, this will decrease deductible expenses and increase taxable income. It is important to note that debt incurred prior to the new law is not grandfathered. In addition, this provision only applies to companies with gross receipts greater than $25 million. For ESOP companies, the interest deductibility becomes an important component in analyzing S-Corp vs. C-Corp.
Verit Advisors’ view is that while there is still some uncertainty as to the effects of the Tax Cuts and Jobs Act, companies should proactively analyze their operating and capital strategies for opportunities to drive growth in shareholder value
As always, it is Verit’s vision to bring a fresh approach and customized solutions to advise private business owners on ownership transition.