In the midst of continued uncertainty oscillating in the global market, opportunities emerge in times of challenge for market consolidation and distressed acquisitions.
As these deals take shape, it is important to consider overall tax planning strategies, as well as the tax implications in the current climate. Market factors along with legislative changes can impact cash flows and closing conditions, among other elements in the deal-making process.
Let’s take a look at the key tax takeaways for mergers and acquisitions as we navigate these uncharted waters.
Equity Sale vs Asset Sale
In any M&A transaction, one of the first steps is to determine how the transaction will be structured, and the type of transaction—equity sale or asset sale—will determine how each party will be taxed.
In an equity (or stock) sale, the buyer purchases an ownership stake in the entire business. This purchase is generally favored by the seller, as all of the known and unknown liabilities are transferred to the buyer. Also, sellers benefit by selling the entire entity to leverage the low long-term capital gains rate, as opposed to paying higher capital gains tax for the sale of the company’s assets.
An asset sale, however, is one commonly preferred by the buyer as a way to reduce any risk associated with undisclosed liabilities. This way, the buyer can individually select which income-generating assets to add to their portfolio in order to produce an acceptable return on investment after any acquisition debt. Some examples may include equipment, inventory, real estate, customer lists, patents, etc. Asset purchases allow buyers to step up the tax basis of assets to reflect current tax value and to realize depreciation benefits sooner than an equity sale. In some instances, the buyer can get significant, immediate tax deductions for cost of acquired assets.
For the seller, however, an asset sale may drive up the tax bill and may even provoke double taxation for corporations looking to liquidate after the transaction. In other cases, the seller may have net operating losses or credits that can offset the tax cost. Buyers and sellers typically negotiate these terms by compromising on price and payment to even out the playing field.
Tax Due Diligence
As parties pursue mergers and acquisitions, buyers should consider tax planning before the letter of intent is signed. There are a number of factors that play a role in realizing beneficial tax results and the timing of these requests in the deal process, especially as the impacts of COVID-19 develop. For example, as we discussed above, asset acquisitions are typically more tax-favorable for the buyer. If you are looking to purchase a subsidiary corporation or an S Corporation, a qualifying stock purchase may be treated as an asset acquisition for tax purposes. The buyer and seller would make this election, which may provide a hybrid of benefits to both the buyer and the seller. Many of these terms are negotiated prior to the signing of the letter of intent; therefore, it’s best to address the tax implications early in the process.
Buyers of equity should look into whether the seller received any financial aid through the various federal, state, and local stimulus packages enacted in response to COVID-19. In addition to any cash injections, buyers should determine if any debt modifications or loan restructurings were made between the creditor and debtor. While these debt modifications may have provided much-needed cash flow and relief, such changes could trigger a taxable event and thereby offset the intended benefits of the aid.
Tax Benefits of the CARES Act
With the number of tax changes seen in the CARES Act legislation, buyers and sellers in mergers and acquisitions leverage a number of tax opportunities to maximize the deal.
Consider the ability to carry back net operating losses (NOLs) from 2018-2020 for five years. This provision provides both buyers and sellers in stock acquisitions an incentive to negotiate the carryback of the NOLs for a higher refund. In addition, the Act also suspends current law and lifts the NOL limit of 80 percent of taxable income through 2021. Additional losses can be carried forward. Corporations should look at these rules carefully to properly plan and avoid pitfalls, such as neglecting to count short-year tax years in the NOL carryback planning.
In most previous M&A stock purchase agreements, it was not customary to amend the company’s preclosing-period tax returns, including preclosing-period tax refund claims. The Act’s NOL carry back provision gives both the buyer and seller reason to come together and negotiate this aspect of the deal.
In another advantageous move, the CARES Act also modified Section 163(j) and increased the limitation amount of business interest income that can be deducted from a taxpayer’s adjusted taxable income. Beginning in tax years 2019 and 2020, businesses now have the ability to calculate the interest limitation based on 50% of earnings before interest, taxes, depreciation, and amortization (EBITDA) instead of 30% of EBITDA.
This change now allows additional business interest expense deductions for previous years—another angle to consider as deals are being negotiated.
When in the planning process for an equity acquisition, it is important to look into both the current and projected tax liabilities of the target company and how they plan to be woven into the deal, including state, local, and payroll tax issues. Further, the buyer’s footprint in new locations and/or new markets may affect state and local tax implications, marking additional considerations in the transaction. Rest assured that most deals incorporate some level of indemnification for undisclosed tax issues and provide a safety net for overlooked tax liabilities.
For transactions that recently closed, transactions that are still being negotiated, and transactions that are on the horizon, tax benefits should be quantified and considered as part of the transaction documents.
As the impact of the pandemic continues to unfold, there will be inevitable opportunities for synergistic mergers, new relationships, and resource sharing as we heal and weather the storm together.
If you have any questions, please contact me at firstname.lastname@example.org or (805) 963-7811 regarding merger or acquisition considerations in your market.