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					     TAX ISSUES TO CONSIDER IN
     COMMON ACQUISITION SCENARIOS
Panelists: Scott D. Vaughn, Partner – Ernst & Young LLP
           Annette M. Ahlers, Corporate Tax Partner – Pepper Hamilton LLP
Moderator: Herb S. Ezrin, President – Potomac Business Group, Inc.

                             December 13, 2005
Taxable Acquisitions—
Stock vs. Asset
General Differences
Basic Structure


                          $
          Buyer                     Seller




          Target                    Target
        Corporation               Corporation


Buyer acquires the stock of Target Corporation for cash.
Taxable Stock Purchase:
Results to Buyer




• Buyer takes a purchase price basis in the stock
  of Target Corporation (“Target”).
• However, Target itself does NOT get a stepped-
  up basis in its assets. (The assets retain their
  historic tax basis.)
Taxable Stock Purchase:
Tax Attributes of Target



• The tax attributes (e.g., Net Operating Loss
  carryovers, tax credits, earnings & profits, etc.) of
  Target are generally retained by Target.
• Utilization of such attributes following the
  acquisition may, however, be limited under anti-
  loss trafficking rules:
        - See, for example, §§382, 383, 384, 269
        (use of NOL carryovers following ownership
        changes, etc.)
Taxable Stock Purchase:
Results to Seller


 • Individual Sellers
   - Generally, gain or loss determined based upon the
  difference between the proceeds received and the
  seller’s basis in the stock of Target sold.
  - Gain generally taxed at long-term capital gain rate
  (Federal =15%)
 • Consolidated Group Seller
   - Any gain is taxed at corporate rates.
  - Previously deferred group income or gains could
  become triggered.
  - In certain circumstances, losses may be
  disallowed or deferred.
Taxable Stock Purchase: Sample Transaction

                             $100
          Buyer                     Seller (S/Hs)

   Seeks to acquire Target                 Stock:
                                           FMV = $100
      Buyer Results:                       Basis = $0
      $100 stock basis
        $0 asset basis
                                       Target
                                     Corporation
                                           Assets:
                                           FMV = $100
                                           Basis = $0
 • Buyer acquires stock of Target.
 • What are the net after-tax proceeds to the Seller?
    Taxable Stock Purchase:
    Sample Transaction Results


• Seller (Target S/Hs)           Proceeds       $100
  receives $100 in               Basis          – 0
  consideration for its          Capital Gain = $100
  shares of Target stock.
• Seller recognizes $100 of      Capital Gain    $100
  capital gain and pays          Rate         (x 20%)
  roughly 20%, or $20, in        Tax           = $20
  federal and state taxes on
  the transaction.               Proceeds       $100
                                 Tax            - 20
• Seller is left with $80 at
                                 Net             $80
  the end of the day.
Taxable Stock Purchase:
Issues to Consider



• Since tax (and other) liabilities remain with Target
  after the purchase transaction, thorough tax due
  diligence on Target is recommended.
Taxable Stock Purchase:
Issues to Consider



• Advisable Purchase Agreement considerations.
   – The Buyer typically requires a full indemnity for taxes
     paid in prior years and that all required returns have
     been filed.
   – If there are significant issues with respect to certain
     tax filings or positions, an escrow can be established
     to hold back amounts until a matter is resolved (i.e.,
     the Target is undergoing a state sales and use tax
     audit which will be resolved in 12 months.)
   – Recently, Buyers have been requiring representations
     that no “listed or reportable” transactions have been
     entered into.
Taxable Asset Purchase



                                 Seller

                                      $   2
                                      Distribute
                                      Net After-Tax
                                      Proceeds
                     $
    Buyer        1 Sell Assets   Target
Taxable Asset Purchase:
Results to Buyer


• Buyer takes a purchase price basis in the assets
  acquired.

 - Purchase price usually can be amortized /
 depreciated for federal income tax purposes,
 resulting in future tax deductions (over the tax life
 of assets acquired) for the amount paid.
 - Goodwill and other intangibles generally have a
 15-year straight line life for tax purposes.
 Taxable Asset Purchase:
 Results to Seller/Target

• Seller recognizes gain/loss based upon the
  difference between the proceeds it received and the
  seller’s basis in the assets sold.
• Character of gain may be part ordinary and part
  capital.
• The tax attributes—e.g., NOLs—of Target (seller of
  assets) remain with Target.
• After corporate level tax is paid by Target, only net
  after-tax proceeds are available to be distributed to
  the shareholders of Target. The shareholders then
  generally recognize gain/loss based on the
  difference between the proceeds they receive and
  the shareholders’ basis in the Target stock that
  becomes cancelled.
 Taxable Asset Purchase: Sample Transaction


                                           Individual
                                             Sellers
                                      Stock:
                                    FMV = $100       2    $___
                                    Basis = $0       Distribute
   • Buyer Result:                                   Net After-Tax
                                       Stock         Proceeds
   $100 Asset Basis                   Cancelled

                          1 $100
          Buyer                              Target
                           Assets
                                                 Assets:
                                                 FMV = $100
• Buyer acquires assets of Target.               Basis = $0
• What are the net after-tax proceeds
  to the Individual Sellers?
      Taxable Asset Purchase: Sample Transaction Results

                                                                 Target
•   Target receives $100 in consideration             Proceeds                 $100
    for its assets and recognizes a $100              Asset Basis              – 0
                                               Ordinary and/or Capital Gain = $100
    gain at the corporate level.                      Corporate Tax Rate    (x 40%)
•   Target pays roughly 40%, or $40, in           Tax                        = $40
    federal and state taxes on the
                                                     Proceeds                 $100
    transaction.                                      Corporate Tax           - 40
•   Target distributes the remaining $60 to        Net Cash Available to S/Hs $ 60
    its S/Hs (the Sellers) in a liquidation.
                                                              Sellers (S/Hs)
•   Sellers recognize a $60 capital gain on           Net Cash to S/Hs           $60
    the liquidation and pay roughly 20%, or           Stock Basis                 - 0
    $12 in federal and state taxes on the         Capital Gain                 = $60
                                                      Individual Tax Rate    (x 20%)
    transaction.                                  Tax                          = $12
•   Sellers are left with $48 at the end of
    the day.                                           Proceeds to S/Hs          $60
                                                       Individual Tax            - 12
                                                   Net Cash to Sellers           $48
Taxable Asset Purchase:
Issues to Consider


• Buyer of assets generally does not inherit any past
  income tax liabilities associated with the business
  acquired, such liabilities remaining behind with the
  Seller/Target.

 - As such, generally non-income tax due diligence—e.g.,
 sales/use tax, property tax, etc.—is primary focus of tax
 due diligence efforts.

• Buyer and Seller often have adverse interests in
  allocating the purchase price among the assets sold. Tax
  rules set forth a method for allocating purchase price
  among seven classes of assets.
Taxable Asset Purchase:
Issues to Consider


• Advisable Contract considerations.
   – Buyer and Seller may want to include a
     schedule in the purchase agreement which
     allocates purchase price among assets being
     acquired or at a minimum have review
     authority over the other parties’ information
     statement being filed with the tax return for
     the year in which the transaction occurs.
   – Buyer will still ask for general tax indemnities
     that all prior year tax returns have been filed
     and all taxes have been paid, including sales
     and use taxes.
Modeling: Buyers and Sellers Need to Compare and Contrast
the Tax and Other Consequences of Each Structure



• What if Target has NOLs to offset?

• Buyer may want to buy assets (because
  Buyer can generally depreciate the
  purchase cost).
• Corporate Seller, however, may not want to
  sell assets (because Seller is often subject
  to the corporate double tax).
        Elective Asset Acquisitions:

Taxable Acquisitions of S Corporations (or
of Certain Subsidiaries in Affiliated Groups)

          Section 338(h)(10) Elections
Elections to Treat Certain Stock Acquisitions as Asset Acquisitions




    • In certain circumstances, if 80% or more of the
      stock of an S corporation (or an 80%-owned
      corporate subsidiary of an affiliated group) is
      acquired in a taxable transaction, then an
      election can be made to treat a stock sale
      transaction as an asset sale transaction solely
      for tax purposes (a Section 338(h)(10) election).
    • BOTH Buyer and Seller must join in making the
      Section 338(h)(10) election.
§338(h)(10) Deemed Asset Purchase



                       Actual Sale of
                                          Corporate
            P          T Stock Ignored      S/Hs
                                                              2
                                                         Deemed
                         1                               Liquidation
                       Deemed Taxable                    of Old T for
                                                         Proceeds
                        Sale of Assets
          New                                  Old
           T                                    T
                          Proceeds


Fiction of an asset purchase by “New” Target; asset sale by “Old” Target
§338(h)(10) Election (Deemed Asset Purchase):
Benefits




• Buyer of stock takes purchase price basis in
  stock. Target obtains purchase price basis
  in its assets.
• Generally results in only one level of tax for
  Seller.
• Seller reports gain from asset sale but
  ignores stock sale.
 §338(h)(10) Election (Deemed Asset Purchase):
 Sample Transaction #1
Takes $100 basis
    in stock

                                     $100
               Buyer                                 Seller (S/Hs)
                                      Stock
                                 (ignore for tax
                                    purposes)       Stock:       “$100”
                                                    FMV = $100   Deemed
  Takes $100 basis
                                                    Basis = $0   Liquidation
      in assets
                                    Deemed
                                  Taxable Sale
               “New”                of Assets                S
               Target                                   Corporation
                                    “$100”
                                                           Assets:
 • Buyer acquires stock of S Corp.                         FMV = $100
 • Assume all assets generate capital gain.                Basis = $0
 • What are the net after-tax proceeds to Seller?
    §338(h)(10) Election (Deemed Asset Purchase):
    Sample Transaction #1 Results


• Seller (S/Hs) receives $100 for its S.
  Corp. stock but ignores the stock               S Corporation
  sale for tax purposes.                    Deemed Proceeds       $100
• For tax purposes, S Corp. is              Asset Basis           - 0
  deemed to receive the $100 for its       Capital Gain         = $100
  assets. S Corp. recognizes $100 in
  capital gain from the deemed asset               Seller (S/Hs)
  sale.                                     Capital Gain Reported $100
                                            Rate                 (x20%)
• The capital gain is passed-thru to
                                           Tax                    = $20
  Seller, who reports the gain and
  pays roughly 20%, or $20, in federal
                                            Proceeds              $100
  and state taxes on the transaction.
                                            Tax                  - 20
• Seller is left with $80 at the end of    Net                   = $80
  the day.
 §338(h)(10) Election (Deemed Asset Purchase):
 Sample Transaction #2
Takes $100 basis
    in stock

                                     $100
               Buyer                                 Seller (S/Hs)
                                      Stock
                                 (ignore for tax
                                    purposes)       Stock:       “$100”
                                                    FMV = $100   Deemed
  Takes $100 basis
                                                    Basis = $0   Liquidation
      in assets
                                    Deemed
                                  Taxable Sale
               “New”                of Assets                S
               Target                                   Corporation
                                    “$100”
                                                           Assets:
 • Assume 50% of assets generate capital gain,             FMV = $100
    and 50% generate ordinary income.                      Basis = $0
 • What are the net after-tax proceeds to Seller?
    §338(h)(10) Election (Deemed Asset Purchase):
    Sample Transaction #2 Results


                                                S Corporation
• Seller (S/Hs) receives $100 for its S   Deemed Proceeds       $100
  Corp. stock but ignores the stock       Asset Basis           - 0
  sale for tax purposes.                  Gain                = $100
• For tax purposes, S Corp. is            Allocation: Capital Gain = $50
  deemed to receive the $100 for its             Ordinary Income = $50
  assets. S Corp. thus recognizes
  $50 in capital gain and $50 in                  Seller (S/Hs)
  ordinary income.                        Capital Gain Reported    $50
                                          Rate                  (x20%)
• The capital gain and ordinary           Capital Gains Tax      = $10
  income are both passed-thru to
  Seller. Seller pays tax of roughly       Ordinary Income Reported $50
  20%, or $10, on the $50 capital          Rate                  (x40%)
                                          Tax on Ordinary Income = $20
  gain, and pays roughly 40%, or $20,
  on the $50 of ordinary income.            Proceeds               $100
• Seller is left with $70 at the end of     Tax                   - 30
  the day.                                Net                     = $70
 §338(h)(10) Election (Deemed Asset Purchase):
 Issues to Consider



• For S Corporation targets, tax due diligence is critical to
  establish the validity of the S Corporation’s status as
  such. This is critical for two reasons:
       (1) if S Corporation status was not maintained, then
       the corporation would have been subject to
       corporate level tax as if it were a “C” corporation and
       thus there could be tax exposure in the Target, and
       (2) the Buyer will not obtain the expected step-up in
       the basis of the Target’s assets if the Target was not
       an “S” corporation (and thus ineligible for the Section
       338(h)(10) election).
§338(h)(10) Election (Deemed Asset Purchase):
Issues to Consider



• Contract Points.
   – Parties specifically state in the agreement that the
     transaction is intended to be treated as a 338(h)(10)
     transaction.
   – Buyer may ask for additional representation that
     target has always been an S Corporation for fiscal
     income tax purposes.
   – General indemnities on filing returns and paying
     taxes.
§338(h)(10) Election (Deemed Asset Purchase):
Additional Tax Issues for S Corporations Including Those that were
Former C Corporations


• Application of Built-in Gain Tax (§1374)
• Other potential entity-level taxes
  -application of LIFO recapture tax
  -passive investment income tax
• State taxes at the entity and shareholder levels
• Character of gain on asset sale—ordinary vs.
  capital
• Modeling is crucial to understanding potential for
  Gross-up
Tax-Free Transactions




• In certain circumstances the Seller can dispose of
  the Target Corporation in a tax-deferred manner
  including by merging the target into an Acquiring
  corporation for stock of the Acquiring corporation or
  by exchanging the stock of Target solely for stock of
  Acquirer.
       -There are a number of different permutations
  and tax rules that govern when such transactions
  are tax-free.

				
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