As law firms endeavor to survive in an increasingly competitive world, one strategy picking up steam is the law firm merger. 2018 was a banner year for mergers as firms moved at a rapid pace to complete more acquisitions than in years prior. Some advisors point to the challenges that small law firms are currently facing amidst all of the changes in traditional ways of practicing law, such as automation of many legal services and downward fee pressure as reasons for the uptick in M&A activity. Artificial intelligence, for example, is making an impact in law firms as this new technology is reducing the need for hundreds, or in some cases, thousands of hours that would otherwise be spent by young attorneys performing document review tasks.
Clients simply would prefer that this new technology perform such repetitive tasks as opposed to a team of attorneys doing things the old fashioned, and of course, more costly way. In this article, we recap law firm merger activity in 2018 and consider the economic outlook for law firm mergers for 2019.
2018 IN REVIEW
Law firms completed a record 106 mergers during 2018, according to Altman Weil, Inc. The 106 mergers represented an increase of five mergers from the previous year, and 33 mergers above the average of 73 transactions that have taken place over the prior ten year period. Some law firms merged to get a foothold into a new geographic area. Of the 106 mergers, 57 involved law firms acquiring practices located outside of their home state. Fourteen of such transactions consisted of acquisitions of firms situated outside of the United States. New York City, home to one the world’s most high profile financial services sector was the geographic market most targeted in 2018 with eight firms from the Big Apple being acquired last year.
Most of the firms acquired had between six to 20 partners. The largest merger of 2018 was the combination of Bryan Cave LLP and UK based Berwin Leighton Paisner, resulting in a combined law firm of over 1,600 attorneys. The two firms sought to obtain a competitive advantage in the global marketplace through the combination of each other’s resources, which resulted in an expanded presence and set of service offerings around the globe.
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. [1]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 December 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 percent to a range between 2.25 and 2.5 percent. 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. 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 December 31, 2017 to January 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 February 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.
[1] 3.2% in Q3.
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