Organizations with the desire to grow and expand should ignore the many opportunities presented with mergers. However, for these transactions to create value for the company, tax implication of mergers must be managed from the beginning. Understanding those implications will help streamline merger discussion.
Top Tax Implications during a Merger
The tax implication of correctly structuring the merger process can have a direct impact on the economics of the transaction for both organizations. Therefore, there are eight primary tax issues related to a merger. These include:
- Accrued liabilities
- Financing structure
- Legal status
- Ordinary versus capital gain
- Sales taxes
- Post- transaction filing
- Tax attribute carryovers
- Transaction costs
A large amount of time should be spent investigating whether the other party has unrecorded assets with a potential for loss carryback, unclaimed tax credits and additional assets that are not displayed on their balance sheet. It is critical to record all pre-acquisition liabilities prior to the merger transaction.
One of the most important initial questions before a merger is how it will be financed. Utilizing a higher amount of common stock will allow for a tax-free reorganization. However, if the purchaser is foreign, debt financing often requires the domestic party to withhold taxes on all payments. This also occurs during multi-state mergers.
Another critical consideration is what type of organization is each of the merging companies: S Corp, LLC or Partnership. The tax basis will depend on that answer. The change in tax structure can be evaluated in IRC Section 338(g) for a partnership and S Corp.
Ordinary versus Capital Gain
If the assets of each merging company include depreciated assets, inventory and ordinary income assets then regular tax rates will be applied to all net gains including prior depreciation. However, any sale of partnership assets can generate ordinary gain with regards to “hot assets”.
Sales tax costs are initially overlooked during most proceedings until the final moment. These taxes are applied to gross allocations for specific asset types such as equipment, software, vehicles, etc. These taxes typically increase the cost of any assets. Therefore, it is critical to determine which party will bear the costs of the transfer and sales taxes.
Following the transaction the new company must use the previous tax elections. Also, annual conformity with each previous company’s fiscal year-end is required and short-period returns may also be required. Therefore, it is critical for both parties to include the responsibility for pre- and post-merger taxes such as income, payroll and property in addition to the allocation of associated liabilities.
Tax Attribute Carryovers
Another critical consideration is whether the other party has tax attributes like a high tax basis in operating assets or tax credit carryovers. If they do, a tax-free reorganization can be an attractive option. However, IRC Section 382 could limit the overall value of the net operating loss with state limits being more restrictive.
Since the entire merger process will generate a significant amount of legal, accounting and other transaction costs, the company can reduce reportable capital gains. Many costs related to pre- and post-mergers are deductible under general operating costs for the specified period.
With the global economy at a low point, mergers have significantly increased in recent years. Leveraged transactions consent to major deals throughout the private equity market. Therefore, tax-efficient mergers are critical to the return-on-investment (ROI) for private equity holders.
The entire merger procedure involves the coordination of many different processes within a limited timeline. During this procedure there is little flexibility with regards to bidding and implementation deadlines. The timeline is kept short to hold management attention. In most instances, time is lost due to the organization of the deal team. Since there is such a small amount of time, merger structuring, modeling tax in the business forecast and state and local tax due diligence should be immediately addressed.