How a M&A Deal structure can have implications in Tax Considerations for buyer and seller?

Mergers and Acquisitions are carried out as a growth strategy to increase revenues or eliminate competitor threats.Although in many cases more focus is spent on how the target company can complement the acquirer in their future growth, the important point that is generally overlooked at the initial stages is the tax consequences on the buyer and seller due to the consummation of the deal.
In the M&A the purchase price is determined and paid by the buyer based on the value that the buyer thinks the seller can provide.The seller has to pay tax to the state on the capital gains.

There are generally two ways a transaction is structured in an acquisition:

• Asset Sale
• Stock sale

Here we are only focusing on the structure of the transaction and not how the consideration is paid.The consideration that is paid by the buyer can be by cash, debt or equity.
The scope of this article is restricted to M&A where the seller is a Corporation or C Type Corp.There are minor changes when the target company is a Partnership or Limited Liability Company (LLC) which is beyond the scope of this article.

Structuring the Deal as a Stock Sale

• When the buyer looks to acquire the seller through acquiring 100% of its equity, then it comes under a stock sale.Here the transaction is happening between the buyer and target shareholders and not between the buyer and target company.
• This means that the buyer is not looking to buy the assets and liabilities of the target company but only transfer of ownership from seller to buyer.In this case the shareholders transfer their ownership to buyer.This includes preferred stock, common stock and Class A stocks with different voting rights.
• If the buyer uses cash as payment structure then tax has to be paid on capital gain that the seller shareholders gets from redemption of its stocks.Depending on the duration the shareholders have held the stock, they have to pay a short term or long term capital gain tax.Generally when the stock is held for more than 1 year then it is long term capital gain tax which is at more favorable rate.
• If it is an equity swap between the buyer and seller, then the seller shareholders receive the buyer equity and they need to hold this for more than 1 year to avoid any tax liabilities.

Stock sale are favorable to the seller than to the buyer

• When the buyer acquires the seller through the stock sale then he inherits both the asset and liabilities of the target company.
• There shall be no change in the values of asset and liabilities of the target on this transaction. Hence the buyer needs to continue the same depreciation/amortization accounting followed by the seller on the assets acquired by it.Hence there cannot be any tax savings achieved by the buyer due to incremental depreciation/amortization
• Since the buyer also inherits the tax liabilities of the seller, proper representations and indemnification provision needs to be drafted in the SPA agreement to protect the buyer from unforeseen tax liabilities.
• The buyer will continue to use the same tax attributes of the target.In case the target company has Net Operating Losses(NOL), then the buyer can use these losses in their taxable income and also carryforwards in future.Other tax attributes like input tax credits, tax credit carryforwards and R&D amortized costs can be used by the buyer on its taxable income and also carry forward.
• Generally there is a limitation to these tax carryover and it cannot be done forever for an acquisition. Section 382 of IRS clearly states that there would be a limitation on the buyer to carry forward the losses to a maximum of 20 years.In addition Section 382 also limits the loss amount that can be used as a carry forward by the buyer in future.In addition if the target company has raised funding through its equity which results in a change in ownership prior to the acquisition then section 382 limitation is also applied.

Structuring the Transaction as an Asset Sale

• This transaction is between the target and the buyer.This means the buyer is acquiring the assets of the target company. The buyer may decide to acquire all the assets or can cherry pick the assets that he wish to acquire.In this transaction, the buyer inherits only those liabilities related to the assets he acquire.In this way, the buyer can insulate himself from other unforeseen liabilities.
• If the buyer looks to acquire 100% of the assets from the target then this means that the target is liquidated and no longer cease to exist.The buyer pays the price to the target and any capital gain that the target gets is then distributed to its shareholders.

Asset sale is not preferred by the seller than buyer

• In the asset sale there will be a double taxation.The target company has to pay the corporate tax on the capital gain from the sale of its asset.Post that when the proceeds are distributed to target shareholders as dividend payments then the shareholders need to pay an income tax on the same.
• When the buyer acquires the assets, then there will be a step up in the price of the assets which will generally be the Purchase price.
• The accounting and tax standards differ on the way how assets are valued.The buyer shall depreciate the assets through Straight line method of accounting but as per IRS tax accounting, the assets needs to be depreciated through Accelerated method.Hence the accounting profit and taxable profits differ and the buyer needs to provision the same in its balance sheet.
• When the buyer purchases the assets from seller, then assets values are adjusted from book value to fair market value.Any additional amount paid after this would be treated as Goodwill by the buyer in the balance sheet.The buyer can amortize the Goodwill as an expense for 15 years.If the income generated from the asset is less than the expense recorded then the buyer shall impair or even write off the asset.The buyer cannot claim any additional tax deductions on Goodwill as IRS does not recognize this.The only exception is when the buyer write off the asset completely and the target company ceases to have any business operations.

Conclusion

• As we see Stock sale is preferred by the Seller to avoid double taxation and the Asset sale is preferred by the buyer to avoid any unforeseen tax liabilities.
• If the buyer controls more than 40% target with stock as considerations then the transaction is treated as reorganization by the IRS and is tax free.
• The buyer has an option to convert the stock sale to asset sale by using election 338 of IRS.
• To ensure both buyers and sellers are benefited on the deal, they have to devise a deal structure which compensates the affected party.For instance if the buyer thinks that it can achieve tax savings through an Asset transaction by incremental depreciation then it can negotiate with seller by adjusting its purchase price to avoid any tax liabilities incurred by seller.