TAX REFORM:

Implications for
M&A
May 1, 2018

Presenters:
Scott Whittaker
G. F. Gay Le Breton
Daniel Walter
Presenters

Scott T. Whittaker G. F. Gay Le Breton Daniel J. Walter

Stone Pigman Chaffe & Associates, Inc. Stone Pigman
Walther Wittmann, L.L.C. Walther Wittmann, L.L.C.
Member Managing Director Member
504.593.0836 504.524.1801 504.593.0826
[email protected] [email protected] [email protected]

2
Disclaimer
 The information contained in this presentation is not legal, business or tax
advice, and has been provided by the presenters and their firms solely for
educational purposes. None of the information or analyses presented are
intended to form the basis for any decision regarding any specific
transaction, and no specific recommendations are intended. Webinar
participants should not act upon this information without seeking
professional advice.
 Investment banking services offered through Chaffe Securities, Inc., Member
FINRA/SIPC.

3
Key Areas of the Presentation
 Overview of the Tax Cuts and Jobs Act on M&A Activity
 Corporate Tax Rate and Pass Through Changes
 Impact of Bonus Depreciation
 Interest Expense Limitations – Financing Considerations
 Affect of Tax Act on Company Value
 Impact on Valuation Approaches
 Increase in Cost of Capital
 Case Study

 Appendices – Bonus Materials

• Partnership Audit Guideline Changes
• Carried Interest Rule Changes
• How to Adjust Pre-2018 Precedent Transaction Data

4
Overview of the Effect of the Tax Act on M&A

CHANGE EFFECT EFFECT ON M&A

Mandatory Repatriation of Foreign Increase in cash available in US
Profits and new Global Tax Regime US targets more palatable

Reduced Corporate Rates and New Frees up cash for acquisitions

Passthrough Deduction Reduces tax burden

100% Bonus Depreciation Full expensing of the cost of certain assets

Interest Deductibility Limitation Changes the economics of financing

acquisitions

NOL Usage Limitation & Reduces value of tax assets

Amortization of R&E

Increased Carried Interest Holding Increases tax cost of early exit

Period

5
Corporate Changes
 Reduced Tax Rates for C Corps
• Prior Law – Highest marginal rate of 35% with phase out of graduated rates
• Current Law – Flat rate of 21%
 Dividend Rate on Distributions to C Corps
• If a C Corp owns another C Corp, dividends to parent taxed at the general C Corp rate
• Prior law provided a deduction for dividends received by the parent ranging from 70%-
100% (depending on the ownership %)
• Current law reduces the amount of the deduction to adjust for reduction in C corp rate
 Dividend Rate on Distributions to Individuals
• Unchanged – highest rate is still 20%
• 3.8% “Medicare” tax is still applicable
 Corporate Alternative Minimum Tax is eliminated
 Corporate Changes are Permanent

6
Pass-through Entities and QBI Deduction
 Highest individual tax rate is now 37%
 Deduction for individual taxpayers of up to 20% of Qualified Business Income
received from pass-through entities (i.e. partnership, S corp or sole proprietorship)
 Applicable for calendar tax years 2018 - 2025
 “Specified Services” Limitation
• QBI deduction does not apply to health, law, accounting, performing arts, consulting,
athletics, financial services and brokerage services
 Wage/Property Limitation on QBI Deduction
• 50% of W-2 wages paid by the business that are allocable to the taxpayer
• OR
 25% of W-2 wages paid by the business that are allocable to the taxpayer
 PLUS 2.5% of the unadjusted basis of qualified property
 Phase in of limitations
• If a taxpayer’s overall income is $157.5k ($315k for married) , the full 20% deduction is
allowed regardless of the limitations
• BUT if a taxpayer’s overall income is $207.5k ($415k for married) , the limitations will
apply in full

7
Tax Rate Comparison
Prior Law Current Law
Pass-Through Pass-Through
Corporation Pass-Through Corporation
w/deductibility w/o deductibility
Income $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Pass-through
N/A N/A N/A ($200,000) N/A
Deduction
Taxable Income $1,000,000 $1,000,000 $1,000,000 $800,000 $1,000,000

Tax Rate 35% 39.6% 21% 37% 37%

Tax on Entity Income ($350,000) ($396,000) ($210,000) ($296,000) ($370,000)
Entity Net Income $650,000 $604,000 $790,000 $704,000 $630,000

Distribution Tax Rate 20% N/A 20% N/A N/A

Tax on Distribution ($130,000) ($0) ($158,000) ($0) ($0)
Owner Net Income $520,000 $604,000 $632,000 $704,000 $630,000

Blended Tax Rate 48% 39.6% 36.8% 29.6% 37.0%

*Does not take into account the effect of state and local taxes.

8
Bonus Depreciation
 Bonus Depreciation – Current Law
• Applies to new qualified property
• 50% of cost may be recovered in the first year
 Bonus Depreciation – New Law
• Applies to new or used qualified property
• 100% of cost may be recovered in the first year (for property purchased prior to
January 1, 2023)
• Phased out over time:

Year 2018 - 2022 2023 2024 2025 2026

Percentage 100% 80% 60% 40% 20%

9
Bonus Depreciation
 “Qualified Property”
• Machinery and equipment – YES, think class life of 20 years or less
• Buildings and land – NO
• Qualified Improvement Property – NO, technical correction needed
 Generally defined as certain improvements to an interior portion of a building
 Interim strategy – cost segmentation study
• Intangible property – NO
 Goodwill, going concern, customer lists, IP, etc.

 Can Apply to a Portion of Company Acquisition Price Now That Used

Property is Eligible for Bonus Depreciation
• In a purchase of assets, Buyer may immediately expense portion of purchase price allocable
to Qualified Property
• Does not apply to a purchase of stock, unless parties agree to a 338(h)(10) election

10
Interest Deductibility Limitation
Under the Tax Act, interest expense deductions are limited for companies with average
annual revenues over $25 million.
 Deduction for business interest is limited to 30% of Adjusted Taxable Income (ATI) plus
business interest income plus motor vehicle floor plan financing interest
• Before 2022  ATI approximates EBIDA, excluding US federal income taxes
• 2022 and after  ATI approximates EBI, excluding US federal income taxes

 Given this limitation, a company can get a full current deduction of interest with:
30% Interest 30% Interest
EBIDA Deductibility EBI Deductibility
$7,750 $2,325 $6,250 $1,875
Debt to Interest Interest Debt to Interest Interest
EBIDA Total Debt Rate Expense EBI Total Debt Rate Expense
5.0x $38,750 6.0% $2,325 5.0x $31,250 6.0% $1,875
4.0x $31,000 7.5% $2,325 4.0x $25,000 7.5% $1,875
3.0x $23,250 10.0% $2,325 3.0x $18,750 10.0% $1,875

 Disallowed interest deductions are carried forward indefinitely

 Real estate businesses ( i.e. real property trades or businesses) may elect out of interest
expense limitations rules but then lose bonus depreciation. The election is permanent.

11
Timing of Certain Provisions of 2017 Act
… 2021 2022 2023 2024 2025 2026 2027
Depreciation /
Amortization Applicable 100% 80% 60% 40% 20%
Percentage*
AP Longer Production* 100% 80% 60% 40% 20%

5-Year Amortization (U.S.)

Research & Experimental Expensed
15-Year Amortization (Non-U.S.)

Interest Limitation 30% EBITDA 30% EBIT

NOLs arising prior to 12/31/17 - Old Law

NOL/Deductions NOLs arising after 12/31/17 - 2017 Act

Pass-Through Deduction In effect Expired

*Also applies to used property

(Property that was not used by the taxpayer any time prior to the acquisition)

12
Impact of Tax Changes on Value
Two factors of the Tax Act have an upward impact on business value
➢ Lower corporate tax rate – Means increased cash flow and typically higher value
➢ Accelerated depreciation – Greater tax shield today translates to higher value

Downward pressure on value is less significant: interest expense deduction cap for highly
leveraged companies; net operating loss deduction limitation; repatriation tax; R&D amortization
reduction; and decreased value of tax assets resulting from lower tax rates
Incremental cash flow may not translate into free cash flow and increased company value. There
are many potential uses of cash, such as increased employee compensation, increased capital
investment, lower debt due to interest limitations and increased dividends

Some Valuation Benchmarks will change

➢ PE ratios probably stay near the same – there will just be higher earnings to capitalize. If tax
reform increases growth (or expected growth), then PE ratios should increase
➢ EBITDA multiples should increase for companies with US profit – companies will keep a
greater percentage of EBITDA, so each dollar of EBITDA is more valuable.
➢ Recalibrate rules of thumb – e.g. a 7.0x EBITDA industry might now be 9.0x EBITDA industry

13
 Impact on Valuation Approaches
Market Approach – Guideline Company Method
➢ Tax changes are already reflected in public company stock prices and resulting multiples
➢ For the next year, forward multiples may be a better indicator of value post-Tax Reform
because TTM figures will include pre-Tax Reform data
Market Approach – Precedent Transaction Method
➢ Historical EBITDA, EBIT multiples prior to date of enactment may not reflect the 2017 Act
➢ It may take years to accumulate a statistically significant sample of M&A transactions dating
after the 2017 Act to assess the impact on multiples
➢ Value adjustment may be necessary when using pre-2018 multiples
Cost Approach – Adjusted Book Value
➢ Estimated taxes on the difference between appraised value and tax basis of assets will need
to be adjusted

14
Impact on Valuation Approaches

Income Approach – Discounted Cash Flow Analysis

➢ Higher after-tax cash flows may be somewhat offset by slight increases in cost of capital

➢ Many provisions of the Act are set to expire over 5 to 10 years. Consider extending
forecast horizon in a DCF through 2026 (until the temporary provisions have expired)
➢ Terminal year calculation should be based on normalized cash flows, reflecting those
provisions that are permanent in nature
➢ Interest Expense limitation complicates model. Need to test each year.
➢ In valuing a pass through entity, need to be mindful of whether the 20% QBI deduction
applies and the expiration of in 2025 of both the QBI deduction and the lower individual
tax rate

➢ Uncertainty around tax rate inputs and assumptions may cause a heavier weight on
guideline company method

15
Impact on Cost of Capital
Changes in the Tax Act will likely increase a firm’s weighted average cost of
capital. WACC is a function of the cost of equity, the cost of debt and their
proportionate share of the capital structure.
Cost of Equity
 Components of cost of equity include the risk-free rate, a market risk factor (beta), an equity
risk premium from the public markets, and a company-specific risk premium
 Historical data used to estimate beta does not incorporate the impact of the tax rate changes
 The risk-free rate and equity premiums are not expected to change because of the Tax Act

Cost of Debt
 The Tax Act increases the after-tax cost of debt because of the lower tax shield provided by
interest expense resulting from a lower corporate tax rate, and limits on interest deductibility.
 Even though the after-tax cost of debt is higher, lower taxes enhances the ability of borrowers
to service debt. Fixed charge ratios should improve.

16
Weighted Average Cost of Capital
Weighted Average Cost of Capital 2016 2018
(1)Equity Rate 10.0% 10.0%

(2)Debt Rate 5.0% 5.0%

(3)Tax Deduction @ 39% & 29% -2.0% -1.5%
(4)Tax Affected Debt Rate 3.1% 3.6%

(5)Capital Structure - Debt 23.1% 20.5%

(6)Capital Structure - Equity 76.9% 79.5%

(7)WACC 8.4% 8.7%

While this example does not include any adjustment to the cost of equity, some
change would be expected in beta related to financing risk. The increase in beta will be
greater for those companies with higher leverage.

17
Case Study
 A manufacturing company is for sale. The company is taxed as an S corp, and has the
following assets:
Asset Tax Basis FMV Gain
Land 50,000 50,000 0
Building 100,000 200,000 100,000
Machinery 0 500,000 500,000
Patent 50,000 200,000 150,000
Total 200,000 950,000 750,000

 A C corp buyer is interested in buying the company. For regulatory reasons the buyer wants
to purchase stock. The parties negotiate a price of $1,000,000 for the sale of all of the
company’s stock, which represents $50,000 of goodwill.
 After the price is negotiated, the buyer realizes it will receive a better after-tax result if it
purchases assets.
 The parties go back to the negotiating table and agree to make a 338(h)(10) election.
 Will the seller agree to the same purchase price of $1,000,000?

18
Case Study #1 - Stock Sale
How much tax will Seller pay in a stock sale?
Seller

Sale Price $1,000,000

Stock Basis ($200,000)
Gain $800,000
Cap Gain on sale (20%) ($160,000)
Seller’s After Tax Proceeds $840,000

Does Buyer receive a tax benefit from the stock purchase?

Buyer
Receives a basis in the stock of $1,000,000, which cannot be
used until the stock is sold.

19
Case Study #1 - Asset Sale
How much additional tax will Seller pay in an asset sale?
Purch Price Tax
Basis Gain Seller’s Tax
Allocation Rate
Land $50,000 $50,000 0 20% 0
Machinery $500,000 0 $500,000 37% $185,000
Building $200,000 $100,000 $100,000 25% $25,000
Patent and Goodwill $250,000 $50,000 $200,000 20% $40,000
Total $1,000,000 $200,000 $800,000 $250,000
Tax on Stock Sale ($160,000)
Additional Tax $90,000
Gross Up $22,500
Amount Needed to Equalize After-Tax Proceeds $112,500

For Seller to be indifferent between a stock sale and an asset sale, the
purchase price must be increased to $1,112,500.

20
Case Study #1 - Asset Sale
What is Buyer’s economic benefit from changing from stock sale to asset sale?
Purch
Basis Tax PV of Basis
Price Basis
Step-Up Life Step-Up
Allocation

Land $50,000 $50,000 0 N/A 0

Machinery $500,000 0 $500,000 0 $105,000
Building $200,000 $100,000 $100,000 39 $9,000
Patent and Goodwill $250,000 $50,000 $200,000 15 $29,000
Total $1,000,000 $200,000 $800,000 $143,000
BUT if Buyer must pay Seller to accept an asset sale ($112,500)
Buyer’s net benefit from the asset sale is: $30,500
Which as a percentage of the basis step-up value is: 21%

21
Case Study #2 – High Intangible Property
 A software company is for sale. The company is taxed as an S corp, and has the following
assets:
Asset Tax Basis FMV Gain
Land 50,000 50,000 0
Building 100,000 200,000 100,000
FF&E 0 100,000 100,000
IP 50,000 600,000 550,000
Total 200,000 950,000 750,000

 A C corp buyer is interested in buying the company. For regulatory reasons the buyer wants
to purchase stock. The parties negotiate a price of $1,000,000 for the sale of all of the
company’s stock, which represents $50,000 of goodwill.
 After the price is negotiated, the buyer realizes it will receive a better after-tax result if it
purchases assets.
 The parties go back to the negotiating table and agree to make a 338(h)(10) election.
 Will the seller agree to the same purchase price of $1,000,000?

22
Case Study #2 – Asset Sale
How much additional tax will Seller pay in an asset sale?
Purch Price Tax
Basis Gain Seller’s Tax
Allocation Rate
Land $50,000 $50,000 0 20% 0
FF&E $100,000 0 $100,000 37% $37,000
Building $200,000 $100,000 $100,000 25% $25,000
IP and Goodwill $650,000 $50,000 $600,000 20% $120,000
Total $1,000,000 $200,000 $800,000 $182,000
Tax on Stock Sale ($160,000)
Additional Tax $22,000
Gross Up $5,500
Amount Needed to Equalize After-Tax Proceeds $27,500

For Seller to be indifferent between a stock sale and an asset sale, the
purchase price must be increased to $1,027,500.

23
Case Study #2 – Asset Sale
What is Buyer’s economic benefit from changing from stock sale to asset sale?
Purch
Basis Tax PV of Basis
Price Basis
Step-Up Life Step-Up
Allocation

Land $50,000 $50,000 0 N/A 0

FF&E $100,000 0 $100,000 0 $21,000
Building $200,000 $100,000 $100,000 39 $9,000
IP and Goodwill $650,000 $50,000 $600,000 15 $87,000
Total $1,000,000 $200,000 $800,000 $117,000
BUT if Buyer must pay Seller to accept an asset sale ($27,500)
Buyer’s net benefit from the asset sale is: $89,500
Which as a percentage of the basis step-up value is: 77%

24
 Comparison of Case Studies
#1 - High #2 - High #1 – Prior #2 – Prior
Machinery Intangibles Law Law
Purchase Price (Stock Sale) $1,000,000 $1,000,000 $1,000,000 $1,000,000
Seller’s Additional Tax +
$112,500 $27,500 $129,000 $31,000
Gross Up
Adjusted Purchase Price $1,112,500 $1,027,500 $1,129,000 $1,031,000

PV of Buyer Tax Benefit $143,000 $117,000 $208,000 $195,000

Additional Purchase Price ($112,500) ($27,500) ($129,000) ($31,000)
Net Benefit to Buyer $30,500 $89,500 $79,000 $164,000
Percentage of Added
21% 77% 38% 84%
Value Retained by Buyer

 Buyer’s “cost” of an asset sale depends on allocation of purchase price among assets
 Current tax law lowers Buyer’s “cost” of an asset sale, BUT also lowers added value

25
26
Partnership Audit Changes
 New partnership audit rules in effect for tax years ending in 2018 and later
 The partnership must designate a “Partnership Representative” for each year when
it files its return
• The designation is only effective for that tax year
 The Partnership Representative has sole authority to act on behalf of the
partnership in an audit, and can bind the partners with respect to settlements
• The partners have NO right under the code to participate in the audit process or receive
notices from the IRS
• To protect the partners, the LLC Agreement should at minimum impose information
reporting requirements on the Partnership Representative
 Certain small partnerships may elect to opt out of the new audit rules
• Must have less than 100 partners all of whom are individuals, C or S corps or estates
 After the audit is complete, the partnership has 45 days to elect to “push out” the tax
liabilities to the partners from the prior year
 If the push out election is not made, the partnership must pay the tax

27
Partnership Audit Rules
How Does the IRS Collect Tax?

Tax
Liability

Audit
Here

28
Partnership Audit Rules
How Does the IRS Collect Tax?

Audit Tax
Here Liability

29
Carried Interest Rule Changes
 Holding period for long term capital gains increase from one year to three
years.
 Applies to profits interest or service interests. Does not apply to capital
interests.
 Applies to an applicable trade or business, which is defined as any activity
that consists of:
 Raising or returning capital AND
 Investing in (or disposing of) “specified assets” OR
 Developing “specified assets”
 Specified assets are
 Securities
 Commodities
 Real estate for rental or investment
 Cash and cash equivalents
 Derivative and options contracts
 An interest in a partnership to the extent of the partnership’s proportionate interest in specified
assets

30
 How to Adjust Pre-2018 Precedent
Transaction Data
Target 2018
2016 Transaction Company Subject Company Valuation
(1) Enterprise Value $ 65,000 (14) EBITDA $ 7,750
(2) Debt 15,000) (15) Depreciation Expense (1,500)
(16) Interest Expense 900
(3) Equity Value 50,000
(17) Pretax Income 7,150
(18) Taxes @ 29% (2,074)
(4) EBITDA 7,750
(19) Net Income $ 5,077
(5) Depreciation Expense (1,500)
(6) Interest Expense 900 EBITDA Multiple Approach
(7) Pretax Income 7,150 (20) EBITDA $ 7,750
(8) Taxes @ 39% (2,789) (21) 2016 EV / EBITDA Multiple 8.4
(9) Net Income $ 4,362 (22) Enterprise Value 65,000
(23) Debt (15,000)
(10) 2016 EV / EBITDA Multiple 8.4 (24) Equity Value $ 50,000
(11) 2016 Price to Net Income Multiple 11.5
Net Income Multiple Approach
(12) 2016 Tax Rate 39.0% (25) Net Income $ 5,077
(13) 2018 Tax Rate 29.0% (26) 2016 Price to Net Income Multiple 11.5
(27) Equity Value $ 58,197

31
 How to Adjust Pre-2018 Precedent
Transaction Data
2018 Tax Law
Incorrect Correct Value
2016 Transaction Target Company (10) Equity Value Adjustment Valuation Valuation Increase
(1) Enterprise Value $ 65,000 (11) EBITDA $ 7,750 $ 7,750
(2) EBITDA 7,750 (12) 2016 EBITDA Multiple 8.4 8.4
(3) 2016 EBITDA Multiple 8.4 (13) Enterprise Value 65,000 65,000
(14) Debt (15,000) (15,000)
(4) 2016 Tax Rate 39.0% (15) Equity Value 50,000 50,000
(5) 2018 Tax Rate 29.0% (16) Equity Value Adjustment 1.000 1.164
(17) Adjusted Equity Value $ 50,000 $ 58,197 16.4%
(6) Equity Value Adjustment 1.164 (18) Debt 15,000 15,000
(7) Enterprise Value Adjustment 1.126 (19) Enterprise Value $ 65,000 $ 73,197 12.6%
(8) Equity Value Adjustment
(20) Enterprise Value Adjustment
(1 - 2018 Tax Rate)
(21) Enterprise Value $ 65,000 $ 65,000
(1 - 2016 Tax Rate)
(22) Enterprise Value Adjustment - 1.126
(9) Enterprise Value Adjustment (23) Adjusted Enterprise Value $ 65,000 $ 73,197 12.6%
(24) Debt (15,000) (15,000)
(1 - 2018 Tax Rate) Equity (25) Adjusted Equity Value $ 50,000 $ 58,197 16.4%
1+
[ (1 - 2016 Tax Rate
-1
] x
Enterprise Value

32
Presenters

Scott T. Whittaker
Stone Pigman
Walther Wittmann, L.L.C.
Member
504.593.0836
[email protected]

Mr. Whittaker represents clients in a wide variety of transactions, including buying,

selling and merging companies; private placements of securities; venture capital and
private equity transactions; joint ventures; roll-ups, spin-offs and split-ups; and all
phases of real estate acquisitions, development and financing. Mr. Whittaker is a
member of the Management Committee at Stone Pigman, where he also leads the
firm’s Merger’s and Acquisitions practice. He is currently Chair of the M&A
Committee of the Business Law Section of the American Bar Association, and has
been named by Best Lawyers as “Lawyer of the Year” in New Orleans, in the fields of
Mergers and Acquisitions, Venture Capital Law and Corporate Law.

33
Presenters

G. F. Gay Le Breton
Chaffe & Associates, Inc.
Managing Director
504.524.1801
[email protected]

Ms. Le Breton heads the Mergers & Acquisitions group of Chaffe &
Associates, Inc., with emphasis in services to privately held companies.
She has more than 30 years experience in the structuring and negotiation
of transactions, the valuation of for small- and mid-sized companies, and
the development and execution of competitive processes for the sale or
purchase of businesses. Ms. Le Breton is also President of Chaffe
Securities, Inc., the firm’s broker dealer subsidiary.

34
Presenters

Daniel J. Walter
Stone Pigman
Walther Wittmann, L.L.C.
Member
504.593.0826
[email protected]

Mr. Walter represents clients primarily in the areas of partnership and

corporate tax, federal and state tax credits and incentives, real estate and
corporate transactions, executive compensation and general corporate
matters. He is a Tax Law Specialist, certified by the Louisiana Board of Legal
Specialization. Prior to commencing his legal career, he worked as a pension
actuary for a major human resources consulting firm and owned and
operated a music venue in New Orleans.

35