Buying and Selling a Business: Practical Tax Considerations
by Roger Royse
The M&A market is back, if it were ever gone, at least in the $5 million to $25 million market. That may be viewed alternatively as either an indicator of an improving economy or a lack of confidence in getting to bigger valuations in the future. Whatever the reason, these are busy times for corporate lawyers, as well as tax lawyers.
This Article attempts to summarize and provide an overview of the tax issues involved in the structuring of a sale or acquisition of a company. The Article will address issues arising in tax-free reorganizations, taxable transactions, S corporations, and foreign corporations. The goal of this Article is to give the reader a framework for how to analyze, structure, and negotiate the tax provisions when a client wants to sell a company. This article will also summarize traditional and emerging tax techniques in M&A practice.
Taxable or Tax-Free Transactions.
The first question will almost always be whether the seller can avail itself of the tax-free provisions of the Code. “The bigger issue to be considered is the tax sensitivity of the buyers and sellers. As odd as that sounds at first, a seller may have substantial losses available to offset any gains, or the sale might be at a loss. The seller might be foreign or non-taxable in the US. Similarly, on the buy side, the business deal might totally overshadow any tax consequences. The size of the target might be inconsequential to the buyer, or the buyer simply might not care about getting extra tax basis. In those cases, there is not much for a tax lawyer to do but sit on the sidelines and watch for wholly avoidable taxes in the transaction. The vast majority of sale transactions, however, will require a determination of whether the deal can be structured to be wholly or partially tax-free.
Although the tax-free reorganization provisions are not elective, it is possible to change the economics and structure of a transaction to fit within the tax-free provisions if that provides the best result to the parties. Often, getting the business to fit within the tax-free provisions will greatly increase the complexity of the transaction, so a client’s desire to reduce taxes must be balanced against their tolerance for complexity. If the buyers and sellers are more sensitive to avoiding complexity than to tax concerns, and the reorganization will make the transaction complex, the analysis stops there. If tax is more of an issue than complexity, the use of the tax-free reorganization provisions must be considered. In order to determine whether the tax-free reorganization provisions are available, the lawyer must investigate the type of currency being given to the sellers in exchange for their stock or assets. That “currency” could be in the form of buyer stock, cash, compensation, debt or contingent and deferred payments. Of that currency, some portion may be in the form of buyer equity (i.e., stock in the buyer). The amount of equity in the deal will drive the rest of the initial analysis.
A seller must retain a sufficient equity stake in the acquirer in order for a transaction to be treated as a tax-free reorganization. That “stake” is commonly referred to as the “continuity of interest” requirement and according to Revenue Procedure 77-37, at least 50% of selling shareholder’s shares must be exchanged for buyer equity to meet the IRS safe harbor. Fifty percent is considered safe under the Revenue Procedure. Case law allows as little as 25% but most tax lawyers will not accept such a low amount as sufficient continuity for the transaction to be tax-free.
Traditionally, the IRS will rule favorably if there is at least 50% continuity (e.g. 50% of the consideration is buyer stock). Relatively recent developments in the law have been more tax friendly towards transactions with less than 50% equity. Under regulations, buyer stock is valued the day immediately before the signing of the definitive acquisition agreement. Thus, fluctuations in stock value between the day of signing and the day of closing are less of a concern than prior to the issuance of those regulations. Additionally, if a specified value is given (e.g. $100,000 worth of stock), that specified value will be used.
The IRS applies certain guidelines when determining the tax-free status of a transaction. The lawyer should discuss these factors with the CFO or CEO to make sure all of the requirements are fulfilled. The factors are described below.
The amount of “other property” in a tax-free merger is important because the shareholders in a tax-free merger recognize gain only to the extent of boot. “Boot” includes non-stock property and securities. Selling shareholders will not recognize taxable gain or pay tax on the value of stock received in a transaction. Instead; they will take a low “exchange” basis in the buyer stock received in the merger and recognize a gain when they eventually sell the buyer stock.
Type A – Statutory Merger. Mergers require compliance with a state merger statute. For this reason, they are often referred to as “statutory mergers.” The typical merger occurs when two companies combine but only one survives. Domestic companies can now merge under Code section 368 with foreign companies, subject to certain requirements described below.
There is no “substantially all” requirement in a merger. A “substantially all” requirement would prevent the target from making distributions prior to the merger. There is also no “voting stock” requirement in a merger, which means that an acquirer can exchange non-voting stock for target company stock in a tax-free merger, in addition to cash and other property subject to continuity requirements.
There must be a business purpose for the reorganization; a tax motivation alone will not suffice. As a practical matter, the business purpose requirement has not been much of a hurdle. However, the “economic substance” doctrine (which has now been codified into law) may subsume this requirement entirely.
Plan of Reorganization. The acquirer must have a written plan of reorganization which should describe the transaction. This is one requirement that can always easily be met.
Continuity of Business Enterprise (“COBE”). The acquirer should intend to continue the acquired business after the transaction. Under the regulations, this means that the transferee must either continue the target’s historic business or use a substantial portion of the target’s assets in a business.
No Net Value. The relatively recent recession has spawned a newer requirement in the areas of tax-free reorganizations. The “no net value” rule requires an exchange of net value. There must be equity in the deal. In other words, no net value can be exchanged at the owner level if debt exceeds the value of assets. Such a transaction would simply be a sale in exchange for debt, and would no longer be tax-free (but see below).
Type B – Stock for Stock. A Type B reorganization is a stock for stock exchange (solely for voting stock of the acquirer), in which the acquirer has “control” of the target immediately after the transaction. Despite appearing to be the easiest type of reorganization, a Type B reorganization is rarely the right approach. The problem with a Type B is that no boot is allowed. Theoretically, if there is even one dollar of non-stock consideration, the transaction is treated as a taxable sale. Although Type B reorganizations are not done very often, it is sometimes a way of converting a non-taxable sale to a taxable one, which could be desirable depending on the parties’ preferences.
Type C – Stock for Assets. In a Type C reorganization, the acquirer transfers stock and cash to the target in exchange for substantially all of its assets and then the target liquidates. A Type C reorganization may be preferred to a Type A reorganization for two reasons. First, an acquirer might not want all of the assets and liabilities of the target. A Type C reorganization allows the acquirer to be selective when purchasing the target’s assets and assuming its liabilities while allowing the seller to obtain tax-free treatment. Second, there may be regulatory issues that prohibit a statutory merger. This situation is rare but can occur in regulated industries such as banking.
A Type C reorganization implicates other issues that lawyers should be aware of. A type C reorganization is relatively restrictive since there must be a transfer of at least 90% of the fair market value of the target’s net assets and 70% of the target’s gross assets. An odd “hair trigger” boot relaxation rule provides that liabilities are not included in this net asset determination unless there is cash or other property passing from the acquirer to the target, in which case it is all considered.
Type D Divisive Reorganizations. A divisive Type D reorganization typically involves the transfer of assets to a corporation, the stock of which is then distributed to shareholders of the distributing company. A “spin off” is like a non-taxable dividend in that the stock of the transferee is distributed to shareholders pro rata. A “split off” is akin to a non-taxable redemption in that the transferee is distributed in exchange for some of the shareholders’ stock in the distributing company. Finally, a “split up” is similar to a non-taxable liquidation in that the distributing company’s businesses are dropped into companies that are distributed in complete liquidation of the distributing company.
Acquisitive Type D Reorganizations. An acquisitive Type D reorganization occurs when the shareholders of the transferor own 50% or more of the acquirer. Typically, an acquisitive Type D occurs when a corporation transfers assets to a controlled or related corporation in exchange for stock. The transaction might otherwise be a Type C reorganization except for the 90%/70% rule. However, 50% common ownership of the transferor and acquirer would allow this reorganization to be a Type D reorganization.
Liquidation/Reincorporation Doctrine. Closely related to the concept of a forced acquisitive Type D reorganization is the judicially created concept of ignoring a liquidation that is followed by an incorporation. A company’s shareholders might want to engage in such a scheme in order to trigger losses built into their stock while maintaining the benefit of the corporate form. Under step transaction principles however, if the liquidation followed by a reincorporation were collapsed into one transaction, the transaction would be recharacterized either as a non-event (i.e. the result is the same as the starting point) or a Type D reorganization. The success of the plan basically depends on there being no plan, and it is thus a risky strategy.
Triangular Mergers. Triangular or subsidiary mergers allow an acquirer to acquire a company in a tax-free reorganization while leaving liabilities at the subsidiary level, similar to a stock purchase in the taxable context. In a triangular merger, the acquirer will acquire the target in exchange for acquirer stock by merging it with or into a subsidiary, usually formed just for that purpose. When the smoke clears, the acquirer will own the stock of the subsidiary, which will own the business of the target.
Forward and Reverse Triangular Mergers. In a forward subsidiary merger, the target merges with and into the merger subsidiary. The subsidiary survives and the target ceases to exist. A good forward triangular merger requires the same factors that are normally required for a merger – continuity of proprietary interest, continuity of business enterprise, business purpose, net value, etc.
In a reverse merger, the target survives and the separate existence of the merger subsidiary ceases. In both cases, the merger consideration is stock of the parent/acquirer (if it were stock of the merger subsidiary, it would simply be a merger, not a triangular merger).
In a reverse merger, the assets and business of the target stay with the target and only ownership changes. In a forward merger, the business of the target is inherited by the subsidiary by operation of law. Sometimes that transfer by operation of law triggers anti-assignment clauses in contracts that would not be triggered by a reverse merger. In addition, the merger subsidiary will obtain a separate taxpayer identification number. For those and other non-tax reasons, targets and sellers of targets typically prefer a reverse merger to a forward merger.
Often times in a reverse triangular merger, companies will have shareholder debt. Sometimes shareholders loan money to a company but do not document the loans, do not charge interest, and do not follow other formalities. This debt is sometimes not repaid and is instead converted into stock of the borrower. The tax risk is that the debt will be treated by the IRS as a class of redeemable preferred stock. If so, and if that “deemed stock” is not exchanged for stock or securities of the acquirer, the transaction will fail to qualify as a reverse triangular merger because 80% of ALL classes of stock will not have been acquired for stock of the acquirer.
The tax consequences and risks set the stage for an odd dynamic when considering whether to do a deal as a reverse or a forward merger. The continuity requirements of a reverse merger are more stringent, as discussed below, requiring that 80% of all classes of stock of the target be acquired for stock of the acquirer. A forward triangular merger, however, is only subject to the general continuity requirement, so that an acquisition of 50% of the target stock for stock of the acquirer will suffice, and it is not necessary that 50% of every class of stock of the target be acquired for acquirer stock. Thus, it would seem that a forward merger is the safer bet since the requirements are easier to comply with.
A consequence of failing to qualify as a merger is that the tax incentives are reversed. A “busted” forward merger is treated as an asset sale followed by a liquidation, which results in two levels of tax – one on the deemed sale of the target’s assets and again on the deemed sale of the target’s stock in liquidation. A busted reverse merger, however, is treated as a stock sale with only one level of tax at the shareholder level.
Thus, the seller has a Sophie’s choice – either take a heightened risk that the transaction will fail the tax-free reorganization provisions but with a potential of one level of tax (as a reverse merger), or take a lower risk of failure with a higher potential penalty of two levels of tax (as a forward merger).
This is a tough choice since valuation issues can make the tax-free conclusion less than doubt-free. In addition, there may be concerns over what will be considered a class of stock for this purpose, so a reverse merger is rarely risk-free.
Fortunately, there is a solution that minimizes risk of failure and the penalty. Under a 2001 revenue ruling, a reverse merger followed by a forward merger into another merger subsidiary will be tested under the forward merger rules for continuity (50%). However, if it fails to be a good merger for some reason, it will be taxed as a failed reverse merger, i.e. as a stock sale. The IRS will consider the transaction as a forward merger, despite the first transitory step of merging a subsidiary into the target since at the end of the day, the target does not survive. However, if the transaction fails to qualify as a tax-free reorganization, the first merger is fully taxable (as a stock sale) and the second merger into a subsidiary is a non-taxable merger of two wholly owned subsidiaries. It gets even simpler, as many practitioners will form the second merger subsidiary as an LLC that is treated as a disregarded entity, so if the first merger is busted, the result is (as a tax matter) a tax-free liquidation of a corporate subsidiary when the target’s assets are transferred to the disregarded LLC. The revenue ruling has given taxpayers an easy insurance policy against these competing risks and penalties.
Net Value Rules. If the debt owed by a target company exceeds the fair market value of the target company’s assets, the sellers are not exchanging equity in that deal. They are simply selling assets for debt assumption
If there is a “no net value” issue, a potentially important case is Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942) (Alabama Asphalt). Alabama Asphalt supports the propositionthat the proprietary interest holders in an insolvent company are the long-term debt holders, and can be treated as equity holders for purposes of the reorganization provisions. Under Alabama Asphalt, we can have an exchange of stock and securities in an insolvent company and still have a good reorganization.
Section 382. Whenever there is a tax-free reorganization, tax attributes (such as basis, holding period, and character) will be inherited by the acquirer. One of these tax attributes is a target’s net operating loss (“NOL”) carryforwards. However, Code section 382 will generally limit the amount of income that can be offset by NOL carryforwards after a corporation has an ownership change. Generally, an “ownership change,” with respect to a target, occurs when there is an increase in stock ownership by one or more target shareholders of more than 50 percentage points within a 36-month period. After an ownership change, a company may use its NOL carryforwards only to the extent of the applicable federal rate multiplied by the value of the target company. The applicable federal rate is currently less than 1% so for planning purposes, we can assume that NOLs will effectively disappear in a transaction.
As noted, in a typical acquisition, the target will lose the benefit of its NOL carryforwards if there has been a “change in ownership.” There is another tier to this analysis, however. An acquirer will also want to know whether the company concluded financing transactions before it was sold, as many companies do. If so, it is possible that there has been an ownership change before the pending acquisition and the target did not have the full use of its NOLs. This would mean that the company’s tax returns are in error, and the acquirer may be taking a larger tax obligation than expected.
Non-Qualified Preferred Stock. Whenever there is preferred stock in a deal, a lawyer must determine whether that stock is Non-Qualified Preferred Stock. “Preferred Stock” (in the tax sense) is “limited and preferred as to dividends and does not participate in corporate growth to any significant extent.” Stock is Non-Qualified Preferred “if (i) the holder has the right to require the issuer or a related person to redeem or purchase the stock, (ii) the issuer or a related person is required to redeem or purchase such stock, (iii) the issuer or a related person has the right but not obligation to redeem or purchase the stock, and, as of the issue date, it is more likely than not that such right will be exercised, or (iv) the dividend rate on such stock varies in whole or in part with reference to interest rates, commodity prices, or similar indices.” Non-Qualified Preferred Stock is treated as boot and, in certain circumstances, does not count as “stock” for continuity purposes. The mere fact that the preferred stock can be converted to common stock does not mean that it participates in corporate growth to any significant extent for this purpose.
Exchange of Securities. The exchange for securities for stock or securities in a reorganization may be tax-free. Long term debt is typically considered a “security” for this purpose in the tax context while short term debt is generally not. Cancellation of debt (“COD”) income is possible even in a tax-free exchange of securities for securities. For example, if a bond holder exchanges a $1,000 bond of the target for a $900 bond of the acquirer, there can be $100 of COD income outside of the reorganization provisions.
Dividend Equivalency Test. When the transferring shareholder receives stock and cash in a merger, it would seem logical that the cash would be taxed at capital gains rates. However, this is not always the case. To determine the proper characterization of the cash proceeds (ordinary or capital), the lawyer must apply a dividend equivalency test. For example, if a person owns 100% of a corporation and only some of his stock is redeemed, that redemption would be taxed as a dividend under Code section 302 because the stockholder would still own 100% of the stock of the company after the redemption. Code section 302 provides three alternative tests for determining dividend equivalence: (i) the percentage of outstanding shares owned after the redemption is less than 80% of the percentage of the outstanding shares owned immediately before; (ii) the distribution is not essentially equivalent to a dividend; (iii) the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder.
The dividend equivalency analysis in a merger views the transaction in two steps: (i) as though the shareholders exchanged all of their target stock for acquirer stock and then (ii) immediately after the transaction, as though some of the acquirer stock were redeemed for cash. If the reduction in ownership in the second step is meaningful, then it is a redemption and not equivalent to a dividend.
Escrows. Escrow agreements can be tax significant. Normally, the target stockholders are treated as the owners of the escrowed stock. However, there are times when the target shareholders do not have the right to vote or receive dividends with respect to the stock. Under these circumstances, the target stockholders should not be treated as owners of the escrowed acquirer stock. This treatment is significant in non-taxable transactions because of the continuity test. In addition, interest does not accrue if the target shareholders are treated as owning the escrowed stock at closing. Although escrow agreements do not usually contain tax language, it is advisable to specify the intended tax consequences (and agree on reporting) in the escrow agreement to ensure there will not be an unexpected result.
Earn-Outs. Sometimes stock will issue after close under an earn-out or other contingency tied to performance or some other metric. Fortunately, earn-out stock is not generally treated as boot even though it is not issued at closing, since it is not cash or other property. If the stock is not treated as owned by the target shareholders until issuance, however, some portion of the stock should be recharacterized as taxable interest to adjust for time value.
The Use of LLCs. LLCs are often a preferred form of business entity because of their relative flexibility. An acquirer concerned about unknown target liabilities might form a single member LLC and have the LLC merge with the target, with the LLC surviving. At one time, the tax treatment of such a merger was uncertain because a merger was required to strictly comply with state law merger statutes. However, that uncertainty has been ameliorated by state law interspecies merger statutes. In addition, tax law has evolved along with state law changes. If all of the assets and liabilities of the target corporation are transferred to the LLC in the merger, and the LLC is treated as a “disregarded entity” (as single member LLCs are absent an election otherwise), those assets will be treated as being acquired by the acquirer in exchange for acquirer stock in a transaction that meets the definition of a Type A statutory merger. Conversely, there cannot be a merger of an LLC into a corporation under Code section 368 because the target is not a corporation. However, the transaction could be non-taxable under other provisions of the Code (such as section 351 if its requirements are met).
LLC Techniques. LLC techniques are used in a variety of circumstances. Two typical situations where these LLC techniques are utilized are as follows:
Scenario 1- The acquirer is unsure as to whether or not it wishes to complete the acquisition of all of the target stock. The acquirer decides instead to acquire a portion of the target’s stock currently with a call option on the remainder of the shares tied to certain metrics. The target shareholders might also have a put option on the shares at a certain price. The transaction is not a section 368 merger and does not satisfy the requirements of any other type of acquisition under section 368.
Scenario 2- The acquirer cannot engage in a merger for some reason, but wants to acquire 100% of the target shares. One of the advantages of a merger or acquisition is that the merger can generally be authorized by more than 50% of the shares as a matter of state law. Outside the merger context, in a purchase of shares, the acquirer must contract with all of the target’s shareholders. The share purchase strategy might not work well if there is a shareholder who does not want to sell.
Solution- Merge the target with an LLC. The solution to both of the problems above is to merge the target company with a subsidiary of an LLC, with the target becoming a wholly owned corporate subsidiary of the LLC. If at the end of the transaction the LLC owns the assets of the target corporation, the merger will be treated as a taxable liquidation of the corporation. If however, the LLC owns the stock of the target, the transaction will not result in a taxable liquidation. After the merger, the former shareholders of the target will own interests in the LLC. The LLC will own 100% of the target and will be able to do whatever deal is necessary with the acquirer under the terms of its operating agreement. It is worth mentioning that the section 704(c) allocations can become somewhat involved if the target has various classes of stock with varying holding periods and basis.
Foreign and international tax transactions can be particularly complex. There are many “gotchas” that make these transactions difficult to manage, including the following:
Outbound Transactions (foreign acquirer and domestic target). In an outbound transaction, a foreign company acquires a domestic target. This transaction can be done on a tax-deferred or tax-free basis if there is compliance with numerous requirements. Generally, tax-free treatment is allowed ONLY if all of the following requirements are met:
- 50% or less of vote and value of transferee foreign corporation is received by U.S. target shareholders;
- 50% or less of vote and value of transferee foreign corporation is owned by U.S. persons who are either officers or directors of U.S. target or who are 5% target shareholders;
- A Gain Recognition Agreement (“GRA”) is entered into by the 5% U.S. transferee shareholders. A 5% U.S. transferee shareholder is a person that owns at least 5% of either the total voting power or the total value of the stock of the transferee corporation immediately after the proposed stock transfer;
- The foreign transferee corporation or any qualified subsidiary must have been engaged in an active trade or business outside the U.S. for the entire 36-month period immediately before the transfer;
- Neither the transferors nor acquirer intend to substantially dispose of or discontinue such trade or business; and
- The fair market value of the assets of the transferee corporation must be at least equal to the fair market value of the U.S. target. Assets acquired for the principal purpose of satisfying the substantiality test will not be included for this calculation or respected by the IRS.
The target’s accountant plays a vital role in these transactions and should be heavily involved. There are numerous reporting requirements with which the failure to comply could result in taxation of an otherwise non-taxable transaction.
Code Section 367(b) Inbound Transactions (domestic acquirer and foreign target).. In a section 367(b) inbound transaction, a domestic company acquires a foreign target. Generally, this acquisition can be done on a tax-free basis. However, the acquisition of a “controlled foreign corporation” (CFC) might trigger ordinary income to the target’s US shareholders. A CFC is a foreign corporation in which more than 50% of the entity is owned by U.S. shareholders, who each owns at least10% of the stock of the corporation. Code section 1248 recharacterizes a U.S. shareholder’s gain on the sale of CFC stock as ordinary to the extent of the earnings that are attributable to that U.S. shareholder.
Inversions. Under prior law, the classic inversion transaction involved a U.S. company forming a foreign company (possibly in a tax haven) and then engaging in a stock for stock exchange. At the conclusion of the transaction, the U.S. target shareholders would own shares of a foreign company, which would own the U.S. target. Moreover, the outbound stock transfer would be taxable, usually because of the failure to satisfy the requirement to have an active trade or business for at least 36 months and more than 50% ownership. However, the transferring company or its shareholders might have NOLs or sufficient tax basis to minimize the tax impact of the migration. As a result, tax was often avoided in the inversion, and the target would have successfully migrated to a foreign jurisdiction at low or no tax cost.
Eventually, Congress caught on to this strategy and passed new laws to govern outbound inversions. See Code Section 7874. Under current law, if the U.S. target shareholders own more than 60% of the foreign acquirer with no substantial foreign operations, the U.S. company is not permitted to use its NOLs to offset the gains on the transaction. Consequently, the domestic transferor will pay a tax on the exit that it previously would have avoided. If the U.S. target shareholders own more than 80% of the foreign acquirer after the inversion, the foreign acquirer will be taxed as a U.S. corporation. Consequently, the company will achieve no tax efficiencies by undertaking the migration. Also, adding insult to injury, the IRS imposes an excise tax on certain stock based compensation in an inversion. These rules have largely shut down the inversion strategy although there are still some ways to accomplish those goals. Code section 7874 contains an exception for companies with “substantial business activities” in the foreign jurisdiction, under which a facts and circumstances test compares the activities of a company in the foreign jurisdiction with activities of the company globally.
Subpart F Inclusions. As noted above, in the case of a CFC, U.S. persons are taxed on a portion of the CFC’s Subpart F income. The CFC rules are important to consider when negotiating and drafting documents because the inclusions are determined at the end of the year, and then allocated to each day in the year, including pre-close days. If there is a sale of a company in the middle of the year, then there will be a different set of shareholders at the beginning of the year than at the end of the year. This is significant because what happens after close is going to affect the inclusions for all U.S. shareholders during the year. This is a rare circumstance in which the acquirer can take actions after the close that will affect the seller’s pre-close taxes. In this situation, target company counsel should obtain covenants and indemnities relating to post-close actions that bear on pre-close taxes.
Joint Venture Structures. Joint venture structures are common in the international context. A transfer of property by a U.S. person to a foreign corporation will generally be taxable. Under Code section 367, if intangible property is transferred in a non-recognition transaction, the transferor will recognize income commensurate with the intangible property (and that income will be U.S. source income). Alternatively, if intangible property is sold in a transaction, gain is fully recognized. In either case, there is a tax cost in transferring intangible property to foreign corporations.
Typically, the use of a pass-through entity (i.e. an LLC treated as a partnership for tax purposes) as the transferee is a more tax efficient vehicle than a corporation. The U.S. transferor can avoid the recognition of gain on the transfer of intangible assets to the LLC and the super royalty provisions do not apply when dealing with an LLC. There are some additional areas to be aware of when dealing with joint ventures. If the LLC is taxed as a corporation, the transfer is taxable and the property should be sold for fair market value to manage the amount of gain recognition. If the transferee is a partnership for tax purposes, the disguised sale rules must be considered, especially if cash contributions to the LLC are distributed to the U.S. company. Planning is important in this area because a disguised sale will often put the U.S. company in a worse position than an actual sale. The disguised sales rules assume that a portion of all assets are sold in the deemed sale whereas in an actual sale, the company may be able to designate which (high basis) assets are sold and which (low basis) assets are contributed.
Treatment of Other Certain Transactions.
Installment Method Issues. Many transactions provide for deferred or contingent payments. Deferred payment sales are typically subject to the installment method reporting unless the seller affirmatively elects out. Under the installment method, a portion of each payment received by the seller is allocated to taxable profit and a portion to basis recovery. The percentage of each payment that is taxable income is based on a ratio of the gross profit in the transaction to the total contract price. Interest on the obligation is included in the taxpayer’s gross income according to their accounting method.
There are three traps that one can fall into with the installment method.
With certain types of sellers, like S corporations, a tax-free distribution can be made to the extent of basis in the pre-transaction planning stage. This allows cash to come out of the company tax-free to the extent of the shareholder’s basis in his stock. After reducing the basis to zero, the profit percentage will then be 100%, but the first dollars out (via distribution) can be recovered tax-free by using this technique. Hence, the lawyer should always consider advising the S corporation target to make pre-transaction distributions to the extent of basis before entering into an installment sale transaction.
If the taxpayer holds installment obligations at the end of a tax year of more than five million dollars, he must pay an interest charge on a portion of the tax liability that is deferred for the year. This rule applies for each selling shareholder, so a selling shareholder is sometimes advised to gift shares to a spouse to reduce the amount of installment obligations each would own. Often, a taxpayer might elect out of installment treatment and recognize as income the value of the installment obligation rather than taking the interest charge. This approach however requires recognition of income on amounts that might not be collected, in which case the taxpayer may end up with a (non-deductible) capital loss on the back end.
The third trap when dealing with the installment method has to do with basis allocation. As noted above, the first step is to determine the gross profit percentage and the portion of each payment that is taxable and the portion that is basis recovery. In the case of an earn-out or contingent payment, however, it is uncertain whether the client will collect on those amounts so the determination of a gross profit percentage relies on certain assumptions. First, the regulations require a taxpayer to assume that the maximum amount possible will be paid (i.e. all of the earn-out targets will be achieved) in determining the gross profit percentage. If there is no maximum amount, the regulations assume there is a basis recovery over the maximum term of the earn-out. If there is neither a maximum amount nor maximum term, the regulations assume that the basis will be recovered ratably over 15 years, and the payments in excess of ratable basis recovery are taxed as income.
Intuitively, it would seem that the taxpayer should recover his basis first and then pick up income when and to the extent that the payments exceed basis. This is referred to as “open transaction treatment” and applies only in rare and extraordinary circumstances. If circumstances exist which justify an open transaction treatment, the question of whether the parties have a sale or a partnership for tax purposes might be implicated. If it is a partnership, a different tax regime applies.
The seller should also keep in mind that there is always an interest element when there is a deferred payment. In other words, part of the payments will be taxed as ordinary income. Fortunately, the applicable federal rate is currently very low.
Code Section 338. There may be good corporate law reasons for preferring a stock transaction over an asset sale. The buyer, however, may want the stepped-up fair market value basis of an asset sale. Section 338 allows the parties to elect to treat a stock sale as sale of assets for tax purposes. The buyer would then take a fair market value basis in assets subject to depreciation and amortization, such as goodwill. Under Code section 197, all such intangible assets would be amortized over 15 years.
There are two types of 338 elections – 338(g), in which the sale gain is recognized post close and imposed on the company while it is in the buyer’s group, and 338(h)(10), in which an asset sale and liquidation is deemed to occur immediately prior to close and the gain is included in the seller’s tax returns.
The disadvantage of a Section 338(g) election, of course, is that it triggers a taxable gain at the corporate level on the deemed asset sale. This is advisable when the present value of the buyer’s future tax savings from tax-deductible depreciation and amortization expenses exceed the current tax cost of the step-up. Additionally, a stock sale accompanied by a 338 election is still considered a stock sale for corporate law purposes, so the buyer inherits all of the target’s liabilities.
While triggering gain on a deemed assets sale is generally to be avoided, there are two circumstances in which an acceleration of gain may be desired. If the target is a foreign corporation and not subject to U.S. tax, there is no tax cost to the election. Nevertheless, the acquirer will have an opportunity to use that stepped-up fair market value basis at some point in the future. The second situation in which a 338 election is preferred is when the target company has sufficient NOLs to soak up the gain on the deemed asset sale. Thus, despite the conventional wisdom that the 338(g) election is inadvisable because it accelerates gain in actuality, more analysis is required not only of the status of the buyer but also a present value analysis of the tax cost and benefits of additional basis amortized over 15 years.
Most 338 elections are of the (h)(10) variety. The 338(h)(10) election is like a 338(g) election except that the sale is treated as occurring immediately before close. The deemed sale gain is included in the tax returns of the selling shareholder or the selling consolidated group.
The 338(h)(10) election applies to S corporations (since 1997) and hardly ever does a sale of S Corporation stock occur without an (h)(10) election. There are some concepts to keep in mind with this type of transaction. Some taxes are imposed at the S corporation level, such as state income taxes in a state (e.g., California) that imposes a corporate level tax on S corporations. If the S corporation has “built in gain” assets from a time in which it was a C corporation, the gain on those assets would be triggered. The biggest difference, however, is that there may be a character difference if the 338(h)(10) election is made. In an asset sale, assuming the stock being sold is a capital asset, the character of the gain will be capital gain. In a 338(h)(10), the character of the gain as ordinary or capital depends on the type of asset being deemed sold.
The 338(h)(10) election requires a joint election (by buyer and all sellers) because the gain is picked up on the selling shareholders’ returns. This is significant since as a corporate matter, a majority of the selling shareholders can force a merger of the target whereas it only takes one non-electing seller shareholder to stop a 338(h)(10) election. In that case, the company may consider restructuring as a taxable forward merger or an asset sale to obtain a similar tax result without the elections.
Recurring problems. Section 338(h)(10) sets forth clear rules. However, they are sometimes counter-intuitive and there are traps. One potential trap involves the treatment of the distribution of installment obligations. When the deal consideration consists of both cash and installment obligations, IRS regulations discourage the payment of cash at close. The cash should either be distributed before close or paid sometime after close. If the cash is distributed at close, the regulations have the effect of accelerating gain on the installment obligation. Some commentators believe that this is an easy problem to plan around (defer the receipt of the cash until after close) but it is an issue that is often not addressed. See 1.338(h)(10)-1(e) Example 10 for a dramatic example of this rule at play.
Another trap involves a purchase of stock in a target with low inside basis when no 338(h)(10) election is made. At some point after close and after integrating the new company into the acquirer’s group, the acquirer may decide to liquidate the subsidiary to minimize administrative expenses. In the liquidation, the target’s basis carries over to the parent. In other words, the parent loses its basis in the target stock and instead takes the target’s basis in its assets. Some old rulings under prior law from the 1970s conclude that the parent’s basis in the stock is preserved, but the case law in which those rulings were based was repealed by statute in 1986. The conclusion is that if the acquirer desires a stepped-up cost basis in the target’s assets, it must make a 338(h)(10) election.
Purchase Price Allocations. The allocation of consideration is important since allocations to ordinary income assets such as receivables and inventory will be taxable at ordinary income rates (but more quickly deductible by the buyer) while allocations to goodwill may be taxable at capital gains rates to the seller (but amortizable over 15 years by the buyer). Under the old “Danielson” rule, the parties could simply agree on how the purchase price would be allocated in the agreement. Sometimes the allocation provisions were heavily negotiated. Under this rule, the IRS would generally respect the purchase price allocation agreed to by the parties at arm’s length unless it determined that the allocation was inappropriate.
Current practice is driven more by accounting considerations than tax. For accounting purposes, assets will be booked at fair market value on the closing date (not always the signing date). This usually will not be determined until after close. Thus, modern practice is to covenant to agree on an allocation at some later date, which is tied to the accounting valuation. Also, the accounting rules require a valuation of goodwill that may differ from the tax determination. As a result, there are now likely to be deferred tax assets and an immediate impairment charge as a result of an acquisition. Thus, there are good reasons for having allocation agreement language in the acquisition documents.
Special Considerations for Venture Backed Companies. Founders of venture backed companies are often asked to “unvest” their shares as a condition to financing. In other words, the founder must agree to return some portion of his or her shares to the company at a low or no cost if his employment with the company is terminated. This same concept of “unvesting” a founder’s shares is present in the merger and acquisition context because if the founder terminates service with the company post-close, it will greatly affect the value of the acquirer’s investment.
The question in the first scenario for the founder is whether the founder must file an 83(b) election. Under Code section 83(b), the value of property received for services is taxable when received or, in the case of property that is subject to a substantial risk of forfeiture (i.e. unvested), the value is taxable when and as the restrictions lapse unless the owner files an election under Code section 83(b) to treat the property as vested on the initial grant date. Because the value of the grant date is usually less than the value of the lapse date, a founder will file the election on the receipt of unvested stock. If the stock is initially vested and restrictions are applied later, there is a question regarding whether the election is required. Fortunately, IRS Revenue rulings answer that question. Under Rev. Rul. 2007-49, an 83(b) election is not required when formerly vested stock becomes unvested. However, the 83(b) election must be filed if unvested stock is exchanged for vested stock. The rules are a bit counter-intuitive since the receipt of unvested stock in a merger seems analogous to unvesting previously vested stock, but the rules differ in those situations and the consequences can be severe. The recipient would not be treated as the owner of the stock until it vests and it would be valued at that time, possibly taxed at ordinary income rates as compensation.
Options. Three things can happen with options in a transaction. First, the options can be assumed. The acquirer can give target option holders stock in the acquirer by substituting parent stock for target stock, subject to the same terms and conditions as the target options, including the “spread” (i.e. difference between the aggregate exercise price and value as of close). Secondly, the acquirer can substitute acquirer options for target options, which would be subject to the terms and conditions of the acquirer’s plan instead of the target’s plan. Finally, the options can be “cashed out,” meaning that the optionee receives cash in exchange for all of its rights under the option agreement. If the option is a Non-Qualified Stock Option (“NSO”), the “cash out” payment will be treated as a bonus, determined as if the optionee exercised the option and sold the option stock in the transaction. Since it is a compensatory bonus, the entire cash out payment will be treated as ordinary income, not capital gain.
Incentive Stock Options (“ISO”) are treated much differently than NSOs. If an optionee exercises an ISO immediately before the transaction and then sells their ISO stock in the transaction, the optionee would have a “disqualifying disposition” because he has not held the ISO stock for one year from issuance and two years from the option grant date. The optionee would be taxable at ordinary income rates on the amount received (net of exercise price); however, he would not be subject to payroll taxes such as FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act). However, if the ISO is instead cashed out, the cash out payment would be a compensatory bonus which would be subject to FICA and FUTA taxes. This is a subtle but potentially important difference and a great example of form over substance in tax law.
Who gets the deduction? When bonuses are paid at close or options are cashed out by the acquirer, there is some flexibility as to whether the deduction for the bonus payment is deductible by the target pre-close or the buyer post-close. An employer deducts the payment of bonuses based on their method of accounting. Under the cash method, the deduction generally arises when the employer has “paid” the employee. See Regs. §1.461-1(a)(1). Under the accrual method, the deduction arises when the employer’s obligation to make the property transfer becomes fixed, the property’s value is determinable and economic performance occurs. See Regs. §§1.461-1(a)(2) and -4(d)(2)(iii)(B). As a practical matter, this is an item that can be negotiated and scripted.
Code Section 409A. Section 409A imposes taxes and penalties on certain plans of deferred compensation that do not meet strict requirements for deferral elections, forms and timing of distributions, and other requirements. A deferral of compensation occurs whenever the service provider (employee) has a legally binding right during a taxable year to compensation that will be paid to such person in a later year. Treasury Regulation Section 1.409A-1(b). The consequences of violating 409A are that amounts which were to be deferred are subject to immediate taxation; an additional 20% penalty applies to such amounts and penalty interest applies.
In a merger and acquisition context, the issue often arises in connection with carve-out plans. Sometimes in a venture backed company, the preferred stock preferences take the entire purchase price in the deal. To incentivize common stockholders and employees to do the deal, the parties might agree to carve out a portion of the proceeds for management. Such carve-out plans are subject to section 409A. One approach to dealing with section 409A issues is to provide that all benefits under the plan are unvested. Under this scenario, if the service provider leaves employment, he would no longer participate in the carve-out plan. His interest would be wholly unvested. This is the most common way to take the plan out of a section 409A classification. Under Reg. 1.409A-3(i)(5)(iv), payments of compensation in this context may be treated as paid at a designated date or pursuant to a schedule that complies with section 409A if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally pursuant to the change in control event.
Golden Parachute Rules. Code section 280G imposes a 20% excise tax on excess payments to certain disqualified individuals upon a change of control. The excise tax must be paid if the parachute payment exceeds a certain amount (three times five year average annual compensation). In addition, the company that makes the payment loses the deduction for the compensatory payment and would have a withholding obligation for the excise tax, so the company also has an incentive not to make parachute payments.
Because the term “payment” is broadly defined, many transactions involve payments that are contingent on a change of control. In addition to severance and bonuses, acceleration of benefits (such as vesting) may result in parachute payments. Fortunately there is an exception available to corporations that could elect to be S corporations (without regard to whether there are nonresident alien shareholders) and small business corporations that are not publicly traded. A parachute payment also does not include any payment with respect to a non-publicly traded small business corporation if 75% disinterested shareholder approval is obtained. That approval must actually determine the right to the payment, meaning that the payee’s right to the payment must be conditioned on receiving approval. Burying this consent in an approval of the transaction will probably not satisfy the statute. In addition, the exception requires adequate disclosure of all material facts which probably requires a determination of the value of the parachute payment at or near the time of the payment (and not at some earlier “pre-wired” date). This valuation process requires a present value calculation of the payment, the value of the vested stock (in the case of accelerated vesting), and the value of accelerated vesting.
In the current environment of M&A activity, lawyers must be aware of the basic tax considerations and stakes in the typical M&A or sale of a business transaction. Hopefully this Article has provided an outline of traditional and current tax planning issues that arise in the typical transaction, the various means of structuring the form of their transactions to optimize after tax results, and issues to be aware of.
Internal Revenue Code of 1986, as amended.For additional information on buying and selling a business, contact Roger Royse.Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in
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For more information on this topic, contact Roger Royse