Election is Looming; Understanding how Former Vice President Biden’s Tax Plan may Impact M&A Markets as well as ESOPs – As Exit Alternatives

President Trump’s Tax Cuts and Jobs Act (TCJA) of 2017 was the largest overhaul to the Internal Revenue Code (IRC) in over 30 years. The current election is looming and there could be significant changes to the IRC if the Biden administration wins in November. If elected, Former Vice President Biden will likely propose an ambitious tax plan that could reverse many of the changes enacted into law with the TCJA. Biden’s goal is to raise over $3 billion¹ in tax revenue over the next decade to fund his other campaign promises.

It is important to remember that 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.

The remainder of this article focuses on the key changes in Biden’s tax plan that affect M&A activity, as follows²:

Major business tax changes ^{3, 4}

• Increase the corporate income tax rate from 21%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%; and
• Offers tax credits to small business for adopting workplace retirement savings plans.

Major individual and payroll tax changes^{5, 6}

• Restore the pre-TCJA top individual income tax rate of 39.6% for those with income over $400,000;
• Increase the tax rate on long-term capital gains and qualified dividends from 20.0% to 39.6% for individuals with income above $1 million;
• Phase out the qualified business income deduction under IRC Section 199A for filers with taxable income over $400,000; and
• Impose a new 12.4% Social Security tax on wages above $400,000 shared equally between the employee and employer.

Focal Point from above: “Increase the tax rate on long-term capital gains and qualified dividends from 20.0% to 39.6% for individuals with income above $1 million.”

Based on the above, there is clearly cause for alarm if a shareholder is contemplating an imminent sale transaction which would trigger a capital gains tax. However, a careful read of the initiative regarding capital gains tax includes some ambiguity pertaining to “earnings (taxable income) above $1 million.”

• Does the $1 million include or exclude the consideration of the capital gain itself?

• Marcum’s Michael D’Addio researched this and stresses, “There is no legislative language which defines the contours of the Biden proposal. Most commentators and practitioners I have discussed the capital gain proposal with interpret the $1 million threshold to include the capital gain itself (and probably would be Adjusted Gross Income). They interpret the term ‘earn’ to include investment income as well as earned income.” In other words:
  • To exclude all investment income (interest, dividends and capital gains) would make investment income more valuable than earned income.
  • To include certain unearned income (interest and dividends) towards the $1 million threshold but exclude capital gains would cause a shift in investments to growth assets versus income producing assets.

Either of the above options would seem to unfairly benefit the wealthy who would not have the immediate need for earnings which, on its face, does not seem like it would accomplish the intended goal of the tax reform, in that it would legislate into the IRC a rule that would disproportionately benefit the wealthy.

An additional question raised by the language is:

• Does the ordinary income rate apply only to the long-term capital gains which causes the income to exceed $1 million or to all of the long-term capital gains if income exceeds $1 million?

A consensus, based on industry analysis in the accounting industry, is that the ordinary income rate applies only to the long-term capital gains which causes the income to exceed $1 million. Clearly, however, these nuances must be discussed and contemplated.

D’Addio stressed that, as of October 2020, there is no real statutory text to examine and, as with most preliminary tax plans, professionals (tax attorneys and tax accountants) are digesting, analyzing and attempting to interpret what is essentially an outline of the proposed tax changes.

Impact on M&A Activity Due to these pending tax changes

The prospect of a tax increase is one factor that may be catalyzing some M&A activity in 2020. Capital IQ⁷ shows there were 44% more deals announced in the four-week period from September 12, 2020 to October 12, 2020, as compared to the four-week period from March 31, 2020 through April 30, 2020 (the month after most of the United States had gone through some sort of shut down related to the Coronavirus pandemic). The data reveals that M&A activity rose recently, with this activity most likely being dually fueled by (i) the optimism of reopening of the economy (once a successful vaccine is introduced as a response to the pandemic), and (ii) plausible future tax related concerns as business owners are seeking to exit before corporate and individual rates go up. If Biden does ultimately win the election, it is likely that will see a further uptick in deals in the remaining time in November/December 2020, motivated for tax reasons as they did in late 2012 when the Bush tax cuts were set to set to expire.⁸

Whether to accelerate capital gains into 2020, versus waiting until 2021 will become clearer after the election when we see which party controls the presidency and the chambers of Congress. Even if the Democrats gain control, it is not a guarantee that the increase in the capital gains rate will pass. Furthermore, it is unclear that a tax bill passed sometime during 2021 will be retroactive and cover sales occurring in 2021 prior to the change in law. However, Congress has made retroactive law changes previously.

Potential M&A Structure to Hedge against the “unknown” of the Biden Capital Gains Tax

Per D’Addio, a strategy to consider is that if a taxable sale transaction is currently contemplated and the question involves whether the gain should be reported in 2020 and 2021, one option could be to sell the property on an installment gain basis. The transaction could be completed in 2020 with payment of all or a portion of the sales proceeds in 2021. This will permit the seller the option of reporting the gain, assuming a taxable stock (vs. asset) sale on the installment basis in 2021 (if there are no unfavorable tax changes) or to make an election out of installment sale treatment and include the gain in 2020.⁹

How does the Biden Capital Gains Tax proposal impact ESOPs as an alternative to M&A?

This focus on the capital gains tax rate brings about a good reminder of one of the key benefits to selling shareholders in ESOP transactions. As a C Corporation, a selling shareholder can elect to defer or possibly eliminate all capital gains tax in a qualified ESOP transaction. This is accomplished by making a Section1042 election¹⁰ for the sale of their equity to the ESOP in an ESOP transaction. With capital gains tax rates possibly reaching 39.6 %, the avoidance (or deferral) of the capital gains tax is a substantial tax benefit and warrants careful consideration by any shareholder looking to monetize and sell all or even a portion of their stake in their company. The avoidance of the capital gains tax under Section 1042 assumes that the Biden tax plan¹¹ is not successful in legislating the elimination of the step-up in cost basis at death (for property transferred to heirs), as the step-up in basis is the key in eliminating the capital gains.

Additionally, when a C Corporation is owned by an ESOP (either partially or full owned), there is a significant tax benefit to the company after an ESOP transaction. In paying down any ESOP-transaction related loan, an additional tax incentive for ESOPs is that the company can deduct both the principal and interest (in lieu of just interest) related to loan payments. In essence, this translates into the entire transaction purchase price being tax-deductible for the Company.

Summary

The prospect of a capital gains tax increase, coupled with positive signs of a post-pandemic rebound of the economy, may continue to catalyze M&A activity as we near the November 2020 election and will certainly incentivize sellers should Biden prevail. Business owners are indeed contemplating an exit before corporate and individual rates potentially go up with the proposed Biden tax plan. It is important to understand that there are nuances in the current proposed language that require careful interpretation. Further, decisions are currently being made based merely on speculation that there will indeed be a change in administration – and, even if there is a change, it is unknown whether the proposed tax law would pass – in whole, or in part. Structuring a deal with flexible tax reporting options is worth strong consideration. Finally, regardless of these anticipated changes, if structured correctly, this potential change in tax law is a great reminder that an ESOP can sidestep this entire issue by making a Section 1042 election and either deferring or eliminating the capital gains tax, entirely.

Sources | Notes

1. https://taxfoundation.org/joe-biden-tax-plan-2020/
2. Note that the full scope of the Biden tax plan is beyond the scope of this article.
3. https://files.taxfoundation.org/20200928134201/Details-and-Analysis-of-Democratic-Presidential-Nominee-Joe-Bidens-Tax-Proposals-September-2020-Update.pdf
4. The below list is not a complete list of the proposed individual income tax changes under the Biden tax plan.
5. https://files.taxfoundation.org/20200928134201/Details-and-Analysis-of-Democratic-Presidential-Nominee-Joe-Bidens-Tax-Proposals-September-2020-Update.pdf
6. The below list is not a complete list of the proposed individual income tax changes under the Biden tax plan.
7. Capital IQ database is a financial database that records all merger and acquisition activity in the United States. Research performed on October 13, 2020.
8. President George W. Bush lowered the top capital gains rate from 20% to 15% in 2003 under the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) that was set to expire on December 31, 2012. President Obama signed the American Taxpayer Relief Act of 2012 providing for a maximum capital gains rate of 20% (plus a net investment income tax of 3.8% applicable for certain transactions).
9. All costs associated with this type of transaction should be evaluated, including an interest charge on the deferred gain where an installment sale obligation exceeds $5 million.
10. Under IRC Section 1042, eligible shareholders can defer capital gains tax on eligible stock sold to an ESOP if the proceeds of the sale are reinvested in qualified replacement property (“QRP”). Taxes will be deferred until the taxpayer disposes of the QRP. If structured properly, the taxpayer can avoid paying all capital gains taxes. Section 1042 is similar to the real estate provision IRC 1031 and life insurance IRC Section 1035.
11. Assuming Biden is elected and assuming that both houses of Congress have a Democratic majority that would be necessary to pass such tax reform legislation.