Law Firm Mergers and the Economic Outlook for 2019

Law firm merger activity in major cities along the Mid-Atlantic was particularly vibrant with roughly 25% of last year's mergers were firms on the East Coast between the states of Maryland and New York.

M&A Outlook for 2019

The Economic Environment 

After approximately two years of steady growth in the stock market, 2018 was characterized by financial turbulence, particularly in the last three months of the year. For the year, the Dow dropped 5.6%, the S&P 500 fell 6.2% and the Nasdaq was down 4%.

Recently enacted tax cuts boosted the US economy, as GDP growth ratcheted up to 4.2% annualized in the second quarter of 2018 (3.2% in Q3). However, storm clouds lay over the horizon in some places outside of the country. In some areas, such as Europe, growth decelerated last year contributing to less harmonized growth globally.

Yet, despite current uncertainties that lay in the economy, certain factors, namely interest rates and regulatory policy, point to continued strong merger activity in 2019.

Interest Rates

On Dec. 19, 2018, the Board of Governors of the Federal Reserve System issued a press release on the state of the U.S. economy. Citing a low unemployment rate, relatively low inflation, and impressive economic growth, the Fed raised the primary borrowing rate by a modest 0.25% to a range between 2.25% and 2.5%. The fed also stated its intention to raise rates two times in 2019.

Taxes

2018 marks the first year the Tax Cuts & Jobs Act of 2017 (TCJA) was in effect. The TCJA brought several changes impacting law firms, which may impact the structure of a deal being contemplated. A brief overview of them is as follows.

Pass-Through Entities

For law firms structured as pass-through or disregarded entities (sole proprietorships, S corporations, partnerships and limited liability companies), the TCJA reduces several individual income tax rates, including the top rate from 39.6% to 37%. It also introduces a new 20% deduction under Section 199A of the Internal Revenue Code (IRC), applicable to qualifying taxpayers. (For more on Section 199A, see, "The Nitti Gritty on Section 199A Regulations," Withum.) The deduction is disallowed for pass-through earnings derived from the performance of services in the field of law above an income threshold.

Corporate Tax Rates

At the heart of the TCJA is the reduction of the top corporate tax rate from 35% to 21%. The new law eliminates the Personal Service Corporation (PSC) designation, allowing all incorporated law firms to pay tax at the flat rate of 21%.

Interest Deductions

The TCJA reduces the tax benefits of a law firm relying on debt. Generally, the new law limits the deduction for interest expense to 30% of a business's earnings. For tax years beginning after Dec. 31, 2017 to Jan. 1, 2022, earnings are computed without regard for depreciation, amortization and depletion. Any disallowed deduction can be carried over indefinitely. Law firms with less than $25 million in annual gross receipts are exempt from this limitation.

Other Tax/Regulatory Considerations

No changes were made to the Federal statutes governing mergers and acquisitions for corporations. Therefore, law firms organized as corporations (including PSCs and S Corporations) can still use IRC Sec. 368 for tax free reorganizations. On Feb. 1, 2019, the Treasury Department and Internal Revenue Service issued a revised version of the final regulations on the Section 199A pass-through deduction.

Lower tax rates should increase profits, providing law firms cash to acquire other practices. The issuance of the final regulations on the new section 199A deduction provides guidance and clarification on a complex area of the tax law affecting some lawyers. The TCJA imposed limitation on the deduction for interest could make acquisitions more costly for firms that use debt to buy other companies.

Conclusion

The Fed's interest rate moves and the newly enacted TCJA presage another strong year of law firm mergers. If your law firm is contemplating such a move, our experience has shown that an early involvement of your advisors in the development of an overall game plan for the merger is highly recommended. Assessing the cash flow concerns, business and risk issues, and tax issues up front is the most efficient way of dealing with such issues that will ultimately arise during a merger transaction. If you have any questions about the apparently inexorable wave of law firm mergers or would like to seek our assistance in a possible merger of your law firm, please contact Bill Sansone, Practice Leader of Withum's Law Firm Services Group or a member of Withum's transaction advisory services team.

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Marcus Dyer, Esq, CPA, is a tax manager in Withum's Law Firm Services Group.  He has extensive experience representing clients in commercial and tax disputes before state courts, Federal District Court and the United States Tax Court. He is an active member of Withum's Law Firms Services Group which has clients ranging in size from sole practitioners to multi-location regional practices.