Give Small Businesses The Tax Breaks On Mergers

In the corporate mating game, large companies have the cards stacked in their favor. Taxpayers and small businesses end up footing the bill.

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Since 1953, when I entered the merger business, I estimate there have been at least 50,000 corporate acquisitions and mergers in this country. Most were cases of huge companies taking over small ones. The majority of the companies acquired by the giants were weakened, damaged, or destroyed.

What often happens in these acquisitions was described by William Norris, a founder and chairman of Control Data Corp., when he and I testified before the U.S. Senate antitrust subcommittee in 1978:

"Immediately after a takeover, an innovation-stifling process sets in. The aggressor blankets the other with bureaucracy, layer upon layer . . .. Proposals for new products languish . . . . This process is compounded by employee trauma, because the more creative employees resign first. The result is the dispersal of the entrepreneurial team, the major job-creating resource of the company."

For several decades the giants have been picking off the best emerging companies by acquiring them. In the process, we have lost a generation of our most promising companies -- and cut off many of the growth companies of the next generation as well.

In a changing world, there are many reasons why businesses should be sold or merged. But when acquisitions occur, the nation would clearly be better served if the buyer were another small or medium-sized company. In the corporate mating game, however, large companies have the advantage. Bigness begets bigness, while taxpayers and small businesses pay the bill.

Who stacked the deck for the big companies? Unwittingly, Congress did. The giants' voracious appetites for growing companies -- and in recent years for other giant firms -- are whetted by three tax breaks: (1) the tax-free exchange of stock; (2) the deductibility of interest on the huge loans that float these deals; and (3) the use of retained earnings to help finance the acquisitions.

Let's look at the first situation. The average seller of a business wants a generous tax-free exchange of stock. He "rolls over" the investment in his present company for the marketable stock of another company. The bigger the partner, the better: A blue-chip stock gives the seller ready liquidity.He can turn the stock into cash -- without paying a capital gains tax -- by borrowing from a bank, using the stock as collateral.

Small or medium-sized acquirers are usually privately held or their stock is not actively traded. Therefore, in practice, they can't benefit from a tax-free exchange. As a consequence, small company owners who want ready cash find their assets "locked in," unless they are willing to merge with a larger company.

Now consider the giants' second advantage. Unlike small and mediumsized companies, they have no difficulty borrowing to finance acquisitions -- on preferred terms. In the past four years most of the hostile takeovers have been for cash, at least in part. It's ironic that small business is starved for capital at the very time the giants are spending billions on takeovers -- often just to use up surplus credit. What makes these deals doubly attractive to the buyers is that, since the interest is deductible, about half of an acquisition's carrying charges are borne by the U.S. Treasury.

Legislators have been diligent in curtailing interest deductions for small business. For example, the Tax Reform Act of 1969 restricts interest-deductibility of debentures as a means of buying another company. Only "poor" companies that can't readily obtain the necessary cash need resort to paying with debentures; the deductibility restriction doesn't apply to borrowed cash. And although huge corporations may deduct interest payments without limit, woe betide an individual who borrows to make investments and tries to deduct more than $10,000 annually.

As for the third advantage, the incentive to retain earnings to finance acquisitions is created because shareholders' dividends are taxed at ordinary income rates. If a corporation reinvests its earnings, the increased value of its stock is taxed only at the lower capital gains rate -- and then only when the shareholder sells. So corporations are encouraged to keep and reinvest profits rather than pay big dividends.Consequently investment money usually stays locked up in big corporations -- many of which can think of nothing better to do with the cash than buy other corporations.

How can we end this discrimination against small companies? First of all, we should not entirely do away with the tax-free exchange. In 30 years I have seen thousands of transactions in which legitimate and proper ends were served by tax-free mergers. This option was written into the law in recognition that businesses, in a dynamic capitalist economy, must have the flexibility to meet changing conditions.

This privilege was structured primarily to benefit the small and growing business, but it has functioned contrary to the lawmakers' intent. We need to restore the original purpose of this legislation by limiting the privilege to companies below a certain size -- say, $200 million in assets.

Second, when a borrower is above this size, we should removed the tax exemption on funds borrowed for the acquisitions.

Here's a solution to the third inequity. Giving management an incentive to retain earnings within the company would be fine if management invested the funds in new, productive assets instead of buying up other firms. Why not limit the tax breaks for big companies to corporate earnings actually reinvested in equipment, research, or production? Otherwise, earnings would immediately be taxed as income to shareholders -- without the capital gains break.

We should similarly encourage investors to take their holdings in large corporations and reinvest them in small business. Huge pools of capital lie dormant in stocks and properties that were acquired long ago at a fraction of today's prices. Holders often "sit tight" with them to avoid paying capital gains taxes. Investors should be permitted instead to sell and invest the proceeds in small business, deferring the capital gains tax until the small business investment is sold.

The mammoths have benefited from government largesse totaling countless billions of dollars during recent decades. If we remove the tax incentives that for so long have fueled their mergers, the activity will shift to small and medium-sized companies. That is the sector where mergers are needed to keep our capitalism dynamic. The industrial future of America lies with the nimbler businesses. Mergers among these smaller organizations are often the best way to hasten the growth of new creative entities.