Paul L. Caron

Friday, February 24, 2023

Weekly SSRN Tax Article Review And Roundup: Speck Reviews Do Corporate Taxes Impede Mergers?

This week, Sloan Speck (Colorado; Google Scholar) reviews a new work by Erin Henry (Arkansas; Google Scholar), Jennifer Luchs-Nuñez (Colorado State; Google Scholar) & Steven Utke (Connecticut; Google Scholar), Do Corporate Taxes Impede Merger and Acquisition Activity? Evidence from Private Corporations (Feb. 9, 2023)


The intuition that business income taxes affect the rate and volume of merger and acquisition activity has a certain theoretical—and anecdotal—appeal. The empirical challenges to validating this intuition are, however, legion. M&A implicates myriad tax benefits and detriments, firms’ abilities to monetize these tax benefits varies, and study design and data collection present significant hurdles. In a recent paper, Erin Henry, Jennifer Luchs-Nuñez, and Steven Utke employ an innovative natural experiment and proprietary IRS data to address taxes’ role in M&A involving closely held corporations. The authors show that entity-level tax cuts operate principally at the intensive margin, leading buyers to pay moderately lower prices for targets and their assets. Consistent with other research, the authors find little aggregate effect at the extensive margin—on the overall number of acquisitions.

But, at a more granular level, the authors identify surprising distinctions between temporary and permanent tax cuts: the former may drive increased acquisition activity, while the latter may decrease such activity, at least in the short term.

In constructing their study, Henry, Luchs-Nuñez, and Utke leverage temporary and permanent legislative changes to the § 1374 built-in gains tax applicable to tax-deferred acquisitions of C corporation property by S corporations. Before 2009, the built-in gains tax applied for a ten-year recognition period following a triggering event, such as an S election by an existing C corporation. Between 2009 and 2014, Congress enacted four temporary reductions in the recognition period’s length. In effect, these laws eliminated the built-in gains tax for S corporations in the latter portion of the recognition period—a time-limited tax break for a specific subset of S corporations subject to § 1374. Henry, Luchs-Nuñez, and Utke use tax filings to compare M&A activity for this treatment group with similar activity in the control group of S corporations still subject to the full built-in gains tax. The authors perform similar comparisons when Congress made a five-year recognition period permanent in the PATH Act of 2015.

As Henry, Luchs-Nuñez, and Utke note, Congress shortened the § 1374 recognition period (ostensibly) to lower tax-related barriers to dealmaking. Whether framed in terms of incentives, economic stimulus, or efficiency, Congress aimed to encourage more transactions, rather than simply affecting the price and terms of deals that would occur absent tax considerations. The authors find significant evidence of secondary price effects without much overall support for increased acquisition activity. Compounding these findings are the authors’ extraordinarily valuable estimates of the changes’ real budgetary costs: $2.45 billion during their eight-year study period, which is more than double the ex ante score produced by the Joint Committee on Taxation for the same years. In monkeying around with the esoteric built-in gains tax, Congress paid a lot to get a little—a classic hallmark of a special interest bargain with limited public benefit.

The authors add welcome nuance to this pernicious legislative story by separately analyzing Congress’s five legislative interventions—four temporary, and one permanent. One of these temporary interventions, in the Small Business Jobs Act of 2010, reduced the recognition period to five years for transactions in 2011. With respect to this legislative change (and no others), taxpayers really responded, and the pace of acquisition activity quickened. The authors appropriately attribute taxpayers’ response to intertemporal shifting of prospective transactions into the tax-favored period. On the other hand, when Congress made the five-year recognition period permanent in 2015, the rate of acquisition activity subsequently slowed. Again, the authors interpret this phenomenon as possible intertemporal shifting, this time from the current period to future periods with equivalent tax treatment. By crafting tax relief as temporary or permanent, Congress can cause taxpayers to accelerate or defer prospective transactions. This tool is potentially powerful and certainly worth exploring as a policy instrument.

The statutory designation of “temporary” or “permanent” is, of course, a largely nominal exercise. Congress has the authority to repeal or renew any law at any time, and scheduled sunsets establish legislative agendas as much as they threaten actual expiration. For low-salience provisions, lawmakers have the option of logrolling with must-pass bills. To attain the intertemporal effects described by Henry, Luchs-Nuñez, and Utke, taxpayers themselves must believe in the impermanence or durability of the relevant provision. Enacted months after the Great Recession’s market bottom, the Small Business Jobs Act may have hit these perceptions perfectly. Then, when Congress renewed relief (retroactively) in 2012 and 2014, taxpayers may not have experienced these laws as exogenous shocks; for future years, permanence (or additional renewals) may have represented dominant outcomes. Titrating legislation to these private social perceptions is a daunting task—and one that limits these strategies’ utility for policymakers.

In addition, other factors complicate the intertemporal effects found by Henry, Luchs-Nuñez, and Utke. Because § 1374 involves a multiyear recognition period, temporary tax relief generally affects only a discrete group of taxpayers: S corporations that previously acquired C corporation assets in tax-deferred transactions. (The authors’ identification and use of this group is particularly elegant.) By contrast, truly permanent tax changes also affect S corporations that plan to acquire C corporation assets, as well as corporate taxpayers that are simply searching for a legal way to avoid General Utilities repeal. In this way, permanent rules encourage more front-end planning—and possibly more or different M&A activity over the long run. Although outside of the scope of the authors’ study, a better understanding of these longer-term dynamics would augment the authors’ acute observations about temporary and permanent legislation.

Finally, the myriad legislative changes to § 1374 affected not only S corporations but also regulated investment companies and real estate investment trusts. (These industries also experienced an administrative kerfuffle when Treasury initially—and temporarily—declined to apply the PATH Act’s five-year recognition period to RICs and REITs.) The authors acknowledge that some S corporations may not respond as sensitively to the tax consequences of M&A. These entities’ owners may be unsophisticated, or may lack bargaining power, or may find the tax costs small relative to their potential gains in a transaction. As a result, S corporations may not respond as readily to congressional tax incentives oriented towards M&A. REITs, in particular, tend towards the opposite end of this spectrum—highly sophisticated market players with exquisite tax-sensitivity. It would be interesting to apply the authors’ methodology to REITs with respect to the same changes in law.

Overall, Henry, Luchs-Nuñez, and Utke provide an meaningful contribution to a substantial literature on taxation’s effects on M&A activity. Furthermore, the authors’ work complements and enhances other studies of the Great Recession such as Choi, Curtis, and Hayashi’s 2019 article on § 382 and the banking industry. Researchers in law, accounting, and economics, as well as policymakers, should find the authors’ paper important and timely.

Here’s the rest of this week’s SSRN Tax Roundup:

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