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TAX ISSUES TO CONSIDER IN COMMON ACQUISITION SCENARIOS

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.

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TAX ISSUES TO CONSIDER IN COMMON ACQUISITION SCENARIOS

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  1. TAX ISSUES TO CONSIDER INCOMMON 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

  2. Taxable Acquisitions—Stock vs. Asset General Differences

  3. Basic Structure Buyer $ Seller Target Corporation Target Corporation Buyer acquires the stock of Target Corporation for cash.

  4. 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.)

  5. 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.)

  6. 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.

  7. Taxable Stock Purchase: Sample Transaction Buyer Seller (S/Hs) $100 Seeks to acquire Target Stock: FMV = $100 Basis = $0 Buyer Results: $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?

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

  9. 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.

  10. 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.

  11. Taxable Asset Purchase Seller $ 2 Distribute Net After-Tax Proceeds $ Buyer Target Sell Assets 1

  12. 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.

  13. 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.

  14. Taxable Asset Purchase: Sample Transaction Individual Sellers Stock: FMV = $100 Basis = $0 $___ 2 • Buyer Result: $100 Asset Basis Distribute Net After-Tax Proceeds Stock Cancelled 1 $100 Buyer Target Assets Assets: FMV = $100 Basis = $0 • Buyer acquires assets of Target. • What are the net after-tax proceeds to the Individual Sellers?

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

  16. 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.

  17. 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.

  18. 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).

  19. Elective Asset Acquisitions:Taxable Acquisitions of S Corporations (or of Certain Subsidiaries in Affiliated Groups) Section 338(h)(10) Elections

  20. 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.

  21. §338(h)(10) Deemed Asset Purchase P Corporate S/Hs Actual Sale of T Stock Ignored 2 Deemed Liquidation of Old T for Proceeds 1 Deemed Taxable Sale of Assets New T Old T Proceeds Fiction of an asset purchase by “New” Target; asset sale by “Old” Target

  22. §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.

  23. §338(h)(10) Election (Deemed Asset Purchase):Sample Transaction #1 Takes $100 basis in stock Buyer Seller (S/Hs) $100 Stock (ignore for tax purposes) Stock: FMV = $100 Basis = $0 “$100” Deemed Liquidation Takes $100 basis in assets Deemed Taxable Sale of Assets “New” Target S Corporation “$100” Assets: FMV = $100 Basis = $0 • Buyer acquires stock of S Corp. • Assume all assets generatecapital gain. • What are the net after-tax proceeds to Seller?

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

  25. §338(h)(10) Election (Deemed Asset Purchase):Sample Transaction #2 Takes $100 basis in stock Buyer Seller (S/Hs) $100 Stock (ignore for tax purposes) Stock: FMV = $100 Basis = $0 “$100” Deemed Liquidation Takes $100 basis in assets Deemed Taxable Sale of Assets “New” Target S Corporation “$100” Assets: FMV = $100 Basis = $0 • Assume 50% of assets generate capital gain, and 50% generateordinary income. • What are the net after-tax proceeds to Seller?

  26. §338(h)(10) Election (Deemed Asset Purchase):Sample Transaction #2 Results • Seller (S/Hs) receives $100 for its S Corp. stock but ignores the stock sale for tax purposes. • For tax purposes, S Corp. is deemed to receive the $100 for its assets. S Corp. thus recognizes $50 in capital gain and $50 in ordinary income. • The capital gain and ordinary income are both passed-thru to Seller. Seller pays tax of roughly 20%, or $10, on the $50 capital gain, and pays roughly 40%, or $20, on the $50 of ordinary income. • Seller is left with $70 at the end of the day. S Corporation Deemed Proceeds $100 Asset Basis - 0 Gain = $100 Allocation: Capital Gain = $50 Ordinary Income = $50 Seller (S/Hs) Capital Gain Reported $50 Rate (x20%) Capital Gains Tax = $10 Ordinary Income Reported $50 Rate (x40%) Tax on Ordinary Income = $20 Proceeds $100 Tax - 30 Net = $70

  27. §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).

  28. §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.

  29. §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

  30. 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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