Taxable Acquisitions of Freestanding C Corporations

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					Acquisitions of Subsidiaries of
  Freestanding Companies
• Tax-free Subsidiary Sales
• Taxable Subsidiary Sales
  – Taxable asset sale
  – Taxable stock sale
  – Taxable stock sale with an IRC
    §338(h)(10) election
     Tax-free Subsidiary Sales
• The divesting parent exchanges the stock or assets
  of the subsidiary for the stock of the acquiring
  firm.
• No gain is recognized.
• The sold subsidiary’s NOLs remain with the
  subsidiary but are limited by §382.
• The acquirer takes a carryover basis in the
  subsidiary’s assets and stock.
• The divesting parent takes a substituted basis in
  the acquiring stock received equal to its basis in
  the sold subsidiary’s stock.
  Undesirable Aspects of Tax-
    free Subsidiary Sales
• The seller has not truly divested its holding
  in the sold subsidiary.
• The seller will hold a relatively illiquid
  block of the acquirer.
• The acquirer and the seller may both hold
  financial positions with a built-in gain after
  consummation of the transaction.*
     * If the FMV of the subsidiary is greater than the
       seller’s tax basis in the subsidiary’s stock.
             Given Information for
              Examples and Cases
Purchase Price                                      $10,000.00
Target's Tax Net Asset Basis*                        $2,000.00
Divesting Parent's Tax Basis in Target's Stock       $2,000.00
Corporate Tax Rate                                      35.00%
Discount Rate                                           10.00%
Amortization Period                                      10.00

  -The subsidiary is 100% owned by the parent.
  -Neither the subsidiary nor the divesting parent have NOLs.
  -The sold subsidary is liquidated by the parent after the sale.

*Historical cost of $2,000 with $0 of accumulated depreciation.
          Example: Tax-Free Subsidiary
        Stock Sale Under IRC §368(a)(1)(B)
Divesting Parent Shareholders:                            Acquirer Shareholders:
          No direct tax effect.                                No direct tax effect.

    Divesting Parent:                                              Acquirer:
 Receives $10,000 of acquirer          $10,000 of        Purchases the stock of the target
stock in return for the divested      acquirer stock      (subsidiary) for $10,000 of its
 subsidiary’s stock. Realizes a                           stock. Takes a carryover basis
   gain of $8,000. No gain is                               in the stock of the acquired
recognized. Takes a substituted         All of the        subsidiary ($2,000). Acquired
   basis in the acquirer stock      subsidiary’s stock   subsidiary becomes a subsidiary
       received ($2,000).                                  of the acquirer and its asset
                                                                 basis carries over.
               Sold Subsidiary:
The owners of the subsidiary corporation change.
The tax attributes of the subsidiary are limited but
  stay with the subsidiary. The tax basis of the
      subsidiary’s assets carryover ($2,000).
Example: Post-Acquisition
  Ownership Structure
                   Acquirer:
  Owns 100% of the sold subsidiary’s stock.
  Has a basis in the target’s stock of $2,000
  and a basis in the target’s assets of $2,000.



              Sold Subsidiary:
            Now a wholly owned
          subsidiary of the acquirer.
          Net asset basis is $2,000.
    Taxable Subsidiary Sales
• Taxable Asset Sale--the acquirer purchases
  the assets of the subsidiary (target)
  corporation (usually for cash) from the
  divesting parent.
• Taxable Stock Sale--the acquirer purchases
  the stock of the target corporation from the
  parent for cash.
• Taxable Stock Sale w/ an IRC §338(h)(10)
  election--completed as a stock sale but
  taxed like an asset sale.
         Taxable Asset Sales
• A gain or loss is recognized and computed
  as price less basis in subsidiary’s net assets.
• The portion of the gain that arises from
  recaptured depreciation is ordinary income;
  the difference between the purchase price
  and the historical cost of the assets is a
  capital gain.
• The sold subsidiary’s NOLs remain w/ the
  divesting parent, can offset a gain on sale,
  and are not limited by §382.
                                     Continued. . . .
Taxable Asset Sales. . .Continued
• Generally, the divesting parent corporation
  liquidates the sold subsidiary; no gain or
  loss is recognized on the liquidation under
  IRC §332.
• The acquirer steps-up to a basis in the
  subsidiary’s assets equal to the purchase
  price paid.
• There are tax benefits from additional
  depreciation and amortization deductions.
         Taxable Subsidiary Asset Sale
 Divesting Parent Shareholders:
            No direct tax effect.

           Divesting Parent:
Receives $7,200 from the sold subsidiary in
liquidation. There is no tax associated with
     the liquidation under IRC § 332.                        Acquirer Shareholders:
                                                                    No direct tax effect.
$7,200         All of the subsidiary’s stock
                                                                           Acquirer:
           Sold Subsidiary:                                           Purchases the assets of
                                                  $10,000 cash        the target (subsidiary)
  Subsidiary receives $10,000 for all of its
  assets. Recognizes a gain of $8,000 and                            for $10,000 cash. Takes
incurs a tax liability of $2,800. After-tax, it                        a basis in the target’s
 has $7,200 that is distributed to the parent       All of the       assets equal to the price
         corporation in liquidation.              target’s assets         paid ($10,000).
              Tax Implications of a Taxable
                       Asset Sale
                             Given                                                                            Taxable Asset Sale
Purchase Price                                      $10,000.00      Purchase Price                                      $10,000.00
Target's Tax Net Asset Basis*                        $2,000.00
Divesting Parent's Tax Basis in Target's Stock       $2,000.00
                                                                    Tax Effect for Divesting Parent:
Corporate Tax Rate                                      35.00%
                                                                     Gain on Sale                                        $8,000.00
Discount Rate                                           10.00%
Amortization Period                                      10.00
                                                                     Cash Received                                      $10,000.00
  -The subsidiary is 100% owned by the parent.                       Tax on Gain                                          2,800.00
  -Neither the subsidiary nor the divesting parent have NOLs.        After-tax Cash                                      $7,200.00
  -The sold subsidary is liquidated by the parent after the sale.
                                                                    Acquirer Cost:
*Historical cost of $2,000 with $0 of accumulated depreciation.
                                                                     Purchase Price                                     $10,000.00
                                                                     Less: Incremental Tax Savings                        1,720.48
                                                                     Net After-tax Cost                                  $8,279.52

                                                                    Acquirer's Tax Basis in Target's:
                                                                     Stock                                                     n/a
                                                                     Net Assets                                         $10,000.00
                                                                     Step-up in the Tax Basis of T's Assets               8,000.00
 Taxable Subsidiary Stock Sale
   w/o a §338(h)(10) Election
• A capital gain is recognized and computed
  as price less basis in subsidiary’s stock.
• The sold subsidiary’s NOLs remain with the
  subsidiary but are limited by §382.
• The acquirer takes a carryover basis in the
  subsidiary’s assets.
• The acquirer takes a basis in the target’s
  (subsidiary’s) stock equal to the purchase
  price.
         Taxable Subsidiary Stock Sale
           w/o a §338(h)(10) election
Divesting Parent Shareholders:                           Acquirer Shareholders:
          No direct tax effect.                                No direct tax effect.

    Divesting Parent:
Receives $10,000 cash in return                                    Acquirer:
                                       $10,000 cash
  for the divested subsidiary’s                          Purchases the stock of the target
stock. Recognizes a capital gain                          (subsidiary) for $10,000 cash.
on the stock sale of $8,000 and                           Takes a carryover basis in the
 incurs a tax liability of $2800.       All of the           target’s assets ($2,000).
 After-tax, divesting parent has    subsidiary’s stock   Acquired subsidiary becomes a
             $7,200.                                        subsidiary of the acquirer.
               Sold Subsidiary:
The owners of the subsidiary corporation change.
The tax attributes of the subsidiary are limited but
  stay with the subsidiary. The tax basis of the
      subsidiary’s assets carryover ($2,000).
Post-Acquisition Ownership
        Structure
                   Acquirer:
  Owns 100% of the sold subsidiary’s stock.
  Has a basis in the target’s stock of $10,000
  and a basis in the target’s assets of $2,000.



              Sold Subsidiary:
            Now a wholly owned
          subsidiary of the acquirer.
          Net asset basis is $2,000.
Tax Implications of a Taxable Stock
  Sale w/o a §338(h)(10) Election
                                    Selected Given Information
                    Purchase Price                                      $10,000.00
                    Target's Tax Net Asset Basis                         $2,000.00
                    Divesting Parent's Tax Basis in Target's Stock       $2,000.00
                    Corporate Tax Rate                                      35.00%
                    Discount Rate                                           10.00%
                    Amortization Period                                      10.00

                                                                          Taxable Stock Sale w/o a
                                             Taxable Asset Sale            Sec. 338(h)(10) Election
 Purchase Price                                         $10,000.00                      $10,000.00

 Tax Effect for Divesting Parent:
  Gain on Sale                                              $8,000.00                    $8,000.00

   Cash Received                                           $10,000.00                   $10,000.00
   Tax on Gain                                               2,800.00                     2,800.00
   After-tax Cash                                           $7,200.00                    $7,200.00

 Acquirer Cost:
  Purchase Price                                           $10,000.00                   $10,000.00
  Less: Incremental Tax Savings                              1,720.48                         0.00
  Net After-tax Cost                                        $8,279.52                   $10,000.00

 Acquirer's Tax Basis in Target's:
  Stock                                                           n/a                   $10,000.00
  Net Assets                                               $10,000.00                     2,000.00
  Step-up in the Tax Basis of T's Assets                     8,000.00                         0.00
      Taxable Stock Sale w/ a
       §338(h)(10) Election
• §338(h)(10) allows for the potentially
  favorable tax treatment of an asset sale
  without incurring the non-tax costs of an
  asset sale.
• A subsidiary stock sale can be taxed as an
  asset sale under §338(h)(10) only if both the
  acquirer and the divesting parent jointly
  make the election.
     Taxable Stock Sale w/ a
      §338(h)(10) Election
• A gain is recognized and computed as price
  less basis in the subsidiary’s net assets.
• The portion of the gain that arises from
  recaptured depreciation is ordinary income;
  the difference between the purchase price
  and the historical cost of the assets is a
  capital gain.
• The sold subsidiary’s NOLs remain w/ the
  divesting parent, can offset a gain on sale,
  and are not limited by §382.
                                 Continued. . . .
     Taxable Stock Sale w/ a
§338(h)(10) Election. . . Continued
 • The acquirer steps-up to a basis in the
   subsidiary’s assets equal to the purchase
   price paid.
 • The acquirer takes a basis in the target’s
   (subsidiary’s) stock equal to the purchase
   price.
 • There are tax benefits from additional
   depreciation and amortization deductions.
         Taxable Subsidiary Stock Sale
           w/ a §338(h)(10) election
Divesting Parent Shareholders:                             Acquirer Shareholders:
          No direct tax effect.                                 No direct tax effect.

     Divesting Parent:
Receives $10,000 cash in return
                                                                     Acquirer:
 for the divested subsidiary’s         $10,000 cash
                                                               Purchases the stock of the
  stock. Recognizes a gain of
                                                                  target (subsidiary) for
  $8,000 (purchase price less
                                                                  $10,000 cash. Takes a
 subsidiary’s net asset basis).           All of the             stepped-up basis in the
 Divesting parent pays tax of        subsidiary’s stock          target’s assets ($10,000
  $2,800. After-tax, divesting
                                                                  basis; $8,000 step-up)
       parent has $7,200.
                                                                as a result of the deemed
                    Sold Subsidiary:                          asset sale under §338(h)(10).
 The owners of the subsidiary corporation change. The tax          Acquired subsidiary
attributes of the subsidiary remain with the divested parent. becomes a subsidiary of the
The tax basis of the subsidiary’s assets carryover ($2,000).             acquirer.
Post-Acquisition Ownership
        Structure
                   Acquirer:
  Owns 100% of the sold subsidiary’s stock.
  Has a basis in the target’s stock of $10,000
  and a basis in the target’s assets of $10,000.



               Sold Subsidiary:
             Now a wholly owned
           subsidiary of the acquirer.
           Net asset basis is $10,000.
    Tax Implication of a Taxable Stock
      Sale w/ a §338(h)(10) Election
                                          Selected Given Information
                        Purchase Price                                            $10,000.00
                        Target's Tax Net Asset Basis                               $2,000.00
                        Divesting Parent's Tax Basis in Target's Stock             $2,000.00
                        Corporate Tax Rate                                            35.00%
                        Discount Rate                                                 10.00%
                        Amortization Period                                            10.00
                                                                  Taxable Stock Sale w/o a      Taxable Stock Sale w/ a
                                          Taxable Asset Sale      Section 338(h)(10) Election   Sec. 338(h)(10) Election
Purchase Price                                       $10,000.00                   $10,000.00                 $10,000.00

Tax Effect for Divesting Parent:
 Gain on Sale                                         $8,000.00                    $8,000.00                  $8,000.00

  Cash Received                                      $10,000.00                  $10,000.00                  $10,000.00
  Tax on Gain                                          2,800.00                    2,800.00                    2,800.00
  After-tax Cash                                      $7,200.00                   $7,200.00                   $7,200.00

Acquirer Cost:
 Purchase Price                                      $10,000.00                  $10,000.00                  $10,000.00
 Less: Incremental Tax Savings                         1,720.48                        0.00                    1,720.48
 Net After-tax Cost                                   $8,279.52                  $10,000.00                   $8,279.52

Acquirer's Tax Basis in Target's:
 Stock                                                      n/a                  $10,000.00                  $10,000.00
 Net Assets                                          $10,000.00                    2,000.00                   10,000.00
 Step-up in the Tax Basis of T's Assets                8,000.00                        0.00                    8,000.00
Review of Various Subsidiary
    Sale Tax Structures
                                                               Tax Structure
                                                                       Taxable stock        Taxable stock
                                      Tax-free          Taxable        sale w/o a 338        sale w/ a 338
Factors influenced by stucture       stock sale        asset sale      (h)(10) election     (h)(10) election
What is acquired?                       Stock            Assets             Stock                Stock
Consideration used:                 Acquirer stock    Usually cash       Usually cash         Usually cash
Effect on the Divesting Parent:
  Gain or loss recognized:               No                 Yes                Yes                 Yes
  Gain computed as:                    No gain       Price less basis    Price less basis   Price less basis
                                     recognized       in subsidiary's     in subsidiary's    in subsidiary's
                                                        net assets            stock            net assets
  Character of gain:                     n/a         Ordinary income        Capital gain    Ordinary income
                                                     and capital gain                       and capital gain
  Sold Subsidiary's NOLs              Remain w/         Remain w/           Remain w/          Remain w/
                                    subsidiary but   divesting parent     subsidiary but    divesting parent
                                    limited by 382    and can offset      limited by 382     and can offset
                                                     gain on sale; not                      gain on sale; not
                                                      limited by 382                         limited by 382
Effect on the acquirer:
  Basis in subsidiary's assets:       Carryover         Step-up to          Carryover         Step-up to
                                                      purchase price                        purchase price
                                                           paid                                  paid
  Basis in subsidiary's stock:        Carryover            n/a           Purchase price     Purchase price
  Tax benefits from additional           No                Yes                No                 Yes
    depreciation and amortization
    deductions
           Tax Implications of Various
        Taxable Subsidiary Sale Structures
                                                  Susidiary Sale Structure                        Tax Benefit Split
                                            Taxable Stock         Taxable Stock        Mid-point Price
                                           Sale w/o a Sec.        Sale w/ a Sec.          w/ a Sec.            Incremental
                                          338(h)(10) Election   338(h)(10) Election   338(h)(10) Election       Difference
Purchase Price--Base Case                         $10,000.00
Acquirer Indifference Price                                             $12,191.86
Purchase Price--Tax Benefit Split                                                            $11,095.93

Tax Effect for Divesting Parent:
 Gain on Sale                                      $8,000.00            $10,191.86            $9,095.93

  Cash Received                                  $10,000.00             $12,191.86           $11,095.93
  Tax on Gain                                      2,800.00               3,567.15             3,183.58
  After-tax Cash                                  $7,200.00              $8,624.71            $7,912.35              $712.35

Acquirer Cost:
 Purchase Price                                  $10,000.00             $12,191.86           $11,095.93
 Less: Incremental Tax Savings                         0.00               2,191.86             1,956.16
 Net After-tax Cost                              $10,000.00             $10,000.00            $9,139.77              $860.23

Acquirer's Tax Basis in Target's:
 Stock                                             $5,000.00            $12,191.86           $11,095.93
 Net Assets                                         2,000.00             12,191.86            11,095.93
 Step-up in the Tax Basis of T's Assets                 0.00             10,191.86             9,095.93
Indifference Price Equation
The seller is indifferent if:

    PRICE338h10 - tc(PRICE338h10 - ASSET) =
       PRICENO338h10 - tc(PRICENO338h10 -STOCK)
where
•   PRICE338h10 is the price when an election is made
•   PRICENO338h10 is the price if the election is not made
•   ASSET is the seller’s basis in the net asset
•   STOCK is the seller’s basis in the sold subsidiary’s stock
•   tc is the corporate tax rate
    Minimum Price Equation
The minimum price demanded by the seller to
make the §338(h)(10) election is:
    PRICE338h10 =
       PRICENO338h10 + [tc/(1 - tc)](STOCK - ASSET)
where
•   PRICE338h10 is the price when an election is made
•   PRICENO338h10 is the price if the election is not made
•   ASSET is the seller’s basis in the net asset
•   STOCK is the seller’s basis in the sold subsidiary’s stock
•   tc is the corporate tax rate
  Maximum Price Equation
The maximum price that the acquiring firm
will pay in a §338(h)(10) transaction is:
  ACQPRICE338h10 = PRICENO338h10 + tc*
    PVANN*[(ACQUPRICE338h10 - ASSET)/N]
where
• ACQPRICE338h10 is the maximum purchase price the acquiring
  firm is willing to pay in a §338(h)(10) transaction
• PRICENO338h10 is the price if the election is not made
• ASSET is the seller’s basis in the net asset
• tc is the corporate tax rate
• N is the average useful life of the acquired subsidiary’s assets
• PVANN is the present value of an annuity
A §338(h)(10) election will be made in
a subsidiary sale when
 ACQPRICE338h10 - PRICE338h10 > 0

   or, put another way, when
 [tc/(1/FACTOR) - tc][PRICENO338h10 - ASSET] -
 [tc/(1 - tc)][STOCK - ASSET] > 0

   where
    • FACTOR is PVANN/N
    • The other variables are as previously defined
 Factors Determining a Parent’s Basis
in a Subsidiary’s Stock and Net Assets

• The parent’s tax basis in the stock and net
  assets will be equal if the subsidiary was
  internally generated.
• When the sold subsidiary was previously
  acquired by the divesting parent, the
  parent’s tax basis in the subsidiary’s stock
  and assets is determined by the tax structure
  used to acquire the target.
  Subsidiary Sales vs. Sales of
 Freestanding C Corporations
• With subsidiary sales, the seller is a
  corporation--not an individual shareholder
  or a group of various sorts of shareholders
• Subsidiary sales often result in a step-up in
  the tax basis of the target’s assets; in
  acquisitions of freestanding C corporations,
  the target’s assets usually carry over.
Conditions When a §338(h)(10)
     Election is Optimal
• When the target subsidiary’s stock basis =
  asset basis and purchase price > net asset
  basis.
• Also, when the tax basis of the target’s
  assets > the tax basis of the target’s stock.
Conditions When a §338(h)(10)
   Election is Sub-optimal
• When the divesting parent’s tax basis in the
  sold subsidiary’s stock substantially
  exceeds the net tax basis of the subsidiary’s
  assets.
• This situation is likely to arise if the
  divested subsidiary was previously acquired
  in a taxable stock acquisition.

				
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