How will the 2013 income tax changes impact 2012 mergers and acquisitions?

Overview of tax rate changes

The end of 2012 will mark the second time the Bush tax-cuts are to expire.  If Congress and the President do nothing, the top individual income tax rates will increase from the current 35% to 39.6% and the capital gains rate will increase from 15% to 20%.  However, the largest increase will be on qualified dividend income; the rate will increase from 15% to 39.6%.

In addition to the expiring Bush tax cuts, the 2010 Health Care Bills added two new Medicare taxes starting in 2013.   A 3.8% "Medicare Tax" on "net investment income" would only apply to interest, dividends, annuities, royalties, rents, and capital gains. There is also a 0.9% Medicare tax on earned income.  Both of these Medicare taxes apply to taxpayer's whose income generally exceeds $200,000 or $250,000 depending on whether you file as a single taxpayer or file a joint return.

General tax strategies

Assuming that each of these tax rate increases take effect as scheduled, the following should be considered when structuring a transaction in 2012 and beyond.

  Defer income or accelerate deductions -  In tax planning, the general rule is to defer income to the next year and accelerate deduction to the current year.  Essentially pay taxes later.  However, with the increased tax rates, accelerating income to 2012 and deductions in 2013 may lower the overall tax burden of the transaction.

  Earn outs - Structuring a deal to include a higher potential sales price to the seller may involve the use of an earn outs.  Generally, an earn out is taxed as an installment sale and the related tax is not due until the seller has received funds.  Monies received from an earn out in 2013 on a deal closed before 2013 will be taxed at the prevailing tax rates at the time the funds are received.  Therefore, structuring an earn out that extends beyond 2012 may increase the tax burden to the seller for the higher capital gains rate and the 3.8% Medicare tax.  Consider having part of the earn out that may be due in early 2013, be paid on December 31, 2012.

  Owner financed installment obligations - Similar to the discussion on earn outs, a seller pays taxes on the gain associated with an installment sale when payments on an owner financed installment sale are received.  However, a seller can elect out of the installment sale and report all of the gain immediately.  Depending on the timing of the installment note, this may be a good option if the seller would have received the installment payments in early 2013.

  Post acquisition training - If a Seller has agreed to perform services post-acquisition  in order to provide an easier transition, the two parties have to agree how to structure the payment for services to be rendered.  Payments for services that extend into 2013 will he subject to the higher income tax rates and will also include the 0.9% Medicare tax.  Consider providing advance payment or minimize the purchase price allocation to training and consulting services.

With the increase in tax rates expected, professionals working in the M&A field should be prepared to hear Sellers demand a close date on or before December 31, 2012.  In addition, there will be deal structure nuances that will attempt to minimize the deferral of gains to 2013.