By Colin O’Donnell
M&A Director
Mergers and acquisitions (M&A) offer companies a growth strategy to scale, increase market share, and access new technologies, but require a firm handle on tax strategy and planning. Tax laws have undergone significant changes in recent years, with more expected in 2023, impacting M&A transactions.
The Inflation Reduction Act of 2022 and the Consolidations Appropriations Act of 2021 are two key tax law changes that will affect middle market M&A deals in 2023. These changes modify the tax treatment of carried interest, capital gains, and limitations on net operating losses, among others. The timing, structure, cost, and tax implications of M&A transactions may be affected by these changes.
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Overview of the 2023 Tax Law Changes
Below is an overview of the 2023 tax law changes with information on the consolidated appropriations Act, an increase in the corporate tax rate, changes to NOL deduction, and other impacts the new law will have.
The Consolidated Appropriations Act (2021)
One change to keep on the radar involves The Consolidated Appropriations Act, 2021 (CAA), enacted in December 2020, which included several tax provisions that will take effect in 2023. Here are some of the key tax law changes that will impact lower middle market M&A transactions:
- Increase in the Corporate Tax Rate
The Tax Cuts and Jobs Act (TCJA) in 2017 lowered the corporate tax rate from 35% to 21%. However, the CAA will increase the corporate tax rate to 26.5% for taxable years beginning in 2023. This increase in will impact the after-tax cash flows of lower middle market companies and may impact their valuation in M&A transactions.
- Changes to the Net Operating Loss (NOL) Deduction
The NOL deduction underwent significant changes under the TCJA, including an 80% limitation on the deduction and the removal of NOL carrybacks. The CAA introduced additional changes, such as the indefinite carryforward of NOLs arising after December 31, 2022. These changes will affect the tax planning strategies of lower-middle market companies engaged in M&A transactions.
- Changes to the Section 163(j) Limitation
The CAA made changes to Section 163(j) of the Internal Revenue Code that will affect lower middle market companies. Beginning in 2022, the Section 163(j) limitation will be based on adjusted taxable income (ATI) rather than earnings before interest, taxes, depreciation, and amortization (EBITDA). This change will have an impact on the tax planning strategies for M&A transactions in these companies.
- Changes to the Section 1061 Carried Interest Rules
Section 1061 of the Internal Revenue Code provides rules for taxing carried interest, with changes made by the TCJA. The CAA has further changes that will impact lower middle market companies, including an increased holding period for long-term capital gains treatment from three years to five years, affecting the tax planning strategies of M&A transactions.
Inflation Reduction Act (2022)
The Inflation Reduction Act of 2022 will significantly impact top-tier M&A transactions, but mid-market deals can also benefit from the changes. Modifications to capital gains tax rates, carried interest tax treatment, and net operating loss rules are included in the Act. Mid-market companies can leverage these changes to reduce their tax burden and improve their M&A transactions’ financial performance.
Capital Gains Changes
The Inflation Reduction Act of 2022 increased the top rate to 25% for taxpayers with incomes over $400,000. This change can benefit mid-market M&A deals as it may incentivize high-net-worth individuals to invest in mid-market companies to take advantage of lower capital gains tax rates. This way, mid-market M&A companies can potentially attract more investors and secure better financing deals.
Adjustments to the Tax Treatment of Carried Interest
The Inflation Reduction Act of 2022 now requires a five-year holding period for carried interest to qualify for long-term capital gains treatment, encouraging investors to stay longer in middle-market companies. This promotes stability, enabling companies to focus on long-term growth strategies rather than short-term gains. Investors seeking longer-term investment opportunities with potentially lower tax burdens may find mid-market M&A deals more appealing.
Net Operating Loss (NOL) Rules
The Inflation Reduction Act of 2022 restricts the carrying forward of NOLs to offset future taxable income while expanding the ability to carry back NOLs to prior tax years. This change can benefit mid-market M&As by increasing the value of a target company with significant NOL carrybacks, potentially making it a more attractive acquisition candidate.
Impact on Lower Middle Market M&A Transactions
The 2023 tax law changes will impact lower middle market M&A transactions in several ways. Here are some of the key considerations:
Valuation
The increase in the corporate tax rate may impact the after-tax cash flows of lower middle market companies, which could impact their valuation in M&A transactions. Buyers and sellers will need to carefully consider the impact of the higher corporate tax rate on the valuation of the company.
Tax Planning Strategies
The changes to the NOL deduction, Section 163(j) limitation, and Section 1061 carried interest rules will impact the tax planning strategies of lower middle market companies involved in M&A transactions. Companies will need to carefully consider the impact of these changes on their tax planning strategies and adjust their strategies accordingly.
Deal Structuring
The 2023 tax law changes can affect M&A transaction structures. Buyers and sellers need to consider their strategies based on the changes’ tax implications. For instance, the Inflation Reduction Act may increase the appeal of target companies with NOL carrybacks, while the Consolidations Appropriations Act may provide tax benefits for certain capital investments in mid-market M&A deals.
Due Diligence
The changes to the tax laws will impact the due diligence process in M&A transactions. Buyers and sellers will need to carefully review the tax implications of the transaction and ensure that the transaction is structured in a tax-efficient manner. Additionally, buyers will need to carefully review the target company’s tax history and potential tax liabilities.
The 2023 tax law changes will significantly impact lower middle market M&A deals, and companies must adjust their strategies accordingly. Gertsburg Licata’s Tax Planning Practice Group guides buyers and sellers through the 2023 tax law changes and helps structure their M&A deals in a tax-efficient manner.
Contact an experienced Cleveland tax planning attorney at Gertburg Licata today.
Gertsburg Licata understands business expansion inside and out. Call us at (216) 573-6000 or complete our contact form to schedule a consultation with one of our M&A professionals.
Colin O’Donnell is Director of Mergers & Acquisitions for Gertsburg Licata Acquisitions. He can be reached at [email protected] or (216) 573-6000 x 8100.
