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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