By: Robert C. Hackney
When it comes down to the structure of your merger and acquisition transaction, there are tax motivations driving the Seller and the Buyer. This blog post will help you understand what they are and why they are important for you to know before getting into this part of the acquisition discussion and process.
So, what are the typical seller’s tax motives and what the typical buyer’s tax motives?
Taxable Sale or Tax Free Reorganization?
In my opinion there are two generic tax structures. Under the federal tax laws, corporate acquisitions can be structured either as taxable sales or as tax free reorganizations. If the transaction is categorized as a sale, then the seller’s gain or the seller’s loss relating to the transaction is immediately recognized. The effect of the sale to the buyer is generally that a new basis is obtained by the buyer for the acquired assets or the acquired stock and that basis is equal to the amount that the buyer has paid for the stock or the assets.
Basis
An asset’s basis is the value at which the asset is carried on the taxpayer’s balance sheet upon acquisition of an asset. The taxpayer pays value or cost for an asset and typically this is used as the original basis of the asset. That original basis is later subject to adjustments both up and down. The basis may be increased by capital expenditures or decreased by depreciation, amortization, or other items chargeable against the asset. The result is an adjusted basis in the asset.
Gain or Loss
When an owner of an asset sells or exchanges the asset, there is a gain or a loss for tax purposes. That gain or loss is measured by taking the difference between the amount obtained for the asset and the amount of the asset’s adjusted basis at the time of the sale or the exchange. Consequently, the amount of the basis or the adjusted basis at the time of the owner’s disposition of the asset, represents the amount that the owner can recover which will not be subject to taxation.
In a taxable sale transaction, the seller’s basis in the property that it receives is equal to the property’s fair market value. What this means is, that if the seller receives cash and stock, the stock would be valued at fair market value for purposes of the seller’s basis. In a sale, both the seller’s and the buyer’s basis is frequently referred to as the cost basis.
Deferred Gain or Loss
If the transaction is able to qualify as a reorganization, the actual recognition of the seller’s gain or the seller’s loss in connection with the transaction will be deferred until some future taxable disposition occurs. Generally, due to this deferral of recognition, the buyer’s basis in the acquired property would be the same as the seller’s basis prior to the time that the reorganization occurred. In that situation, the buyer’s basis would be generally referred to as a carryover basis.
Substituted Basis
The basis that the seller has after reorganization, is usually called “substituted basis” because it is the same as the basis he had in the property that he transferred. So, if he had a million dollars basis in his assets, and he took some other property from the buyer in exchange for the property received by the buyer in the reorganization, then his basis in that property would also be a million dollars and he would have a substituted basis in the new property.
Qualifying for a Regoranization
Generally speaking, a taxable sale is much easier to accomplish than a reorganization, since to qualify the transaction as a reorganization, there must be very strict compliance with numerous complicated tax regulations that will be the subject of another blog post. I will caution you, however, that there must be strict adherence to the statutory requirements because it is very easy to violate the statutory guidelines and to therefore fall outside the tax free reorganization protection that is afforded by these rules and regulations. The IRS does not like tax deferred transactions, simply because you are delaying the payment of tax to them, therefore, they will demand strict legal compliance in a tax deferred transaction.
Seller’s Motives
Let’s look at the motives that a seller will have in an acquisition transaction. We need to evaluate both the selling corporation and the selling shareholders’ motives in connection with these transactions.
There are four factors in motivation.
• The first is the timing of the recognition of the gain or the loss.
• The second is the nature of the gain or the loss as to whether it is “capital” or “ordinary”, which is important for a number of reasons.
• The third is the timing of payment and
• The fourth is consideration involving acceptance of an acquirer’s stock.
Will the Seller expect a large gain or a loss?
First of all, the buyer must know his seller as well as he possibly can. When you are involved in the due diligence process, you should try to determine the needs or the wants of the seller. This is obviously easier if you have got only one seller as opposed to fifty selling stockholders or a thousand selling stockholders, but you generally have to figure out the seller’s perspective when you are trying to structure the transaction. If the seller is in a position where he is going to realize a large gain in connection with this transaction, and believe me, most sellers are going to want to realize a large gain, then the postponing of the recognition of that gain will probably be the seller’s major consideration.
If you are dealing with a fire sale, however, and the seller anticipates that he is going to incur a loss in connection with the transaction he probably will prefer to arrange the transaction as a taxable sale, so that the loss can be deducted immediately subject, of course, to the limitations on the deductibility of capital losses. Those are the simple situations where you’ve have got just one or a few sellers and you can figure out pretty readily whether or not the seller is going to have a gain in connection with the transaction or a loss. But what about if you have a number of different stockholders, they all have a different basis in their stock and they all have different motivations? Well, in that situation, the potential conflict among the desires and the motives of the selling stockholders could be resolved by structuring the transaction to comply with the installment sale provisions of the Internal Revenue Code. If you are able to do that, then the sellers who have a loss on the sale would be entitled to recognize such loss in full in the year of the sale, despite the receipt of the sale proceeds on an installment basis. Sellers in an installment sale situation who would realize a gain would be permitted to report their gain ratably over the period in which the payments being made by the buyer are received by the selling stockholder.
Consider how many shareholders are involved
As a buyer, you may want to also consider the possibility that if you have a manageable number of selling stockholders, you may wish to make immediate full payment to those stockholders who would be realizing a loss in connection with the transaction and pay those stockholders who would be receiving a gain on an installment basis. There are some serious securities law considerations with that kind of a transaction, however, and I think that it would only be viable if you had a very small group of people as selling stockholders, keeping in mind that you need to watch out for the registration requirements of the Securities Act and also the Tender Offer Rules. But, assuming you have a very small number of selling stockholders that kind of a structure could be worked out.
Timing and type of gain or loss
Timing of the gain, or loss, is important but it is not going to be the only consideration that a seller gives to the transaction. The second thing the seller is going to look at is the type of a gain, or loss, that is going to be realized, and by this I mean that whether or not these gains or losses will be categorized as capital gains or ordinary gains.
The characterization of gain or loss as either ordinary or capital is important in a taxable asset acquisition because the parties can allocate the purchase price among the assets being sold so that the seller’s gain, or loss, is established and the buyer’s basis for depreciation and also for gain or loss on later disposition is established.
The seller may have capital losses and capital losses can only be deducted immediately to the extent of capital gains, consequently the seller in such a situation will want to allocate the purchase price so that he can maximize his capital gain and minimize his ordinary income. In such a situation, the buyer is going to want to allocate as much of the purchase price as possible to fixed assets, or inventory, or receivables so that those items can be depreciated or amortized which will reduce future ordinary income for the buyer.
Generally speaking, the seller should not care how much of the purchase price the buyer allocates to fixed assets, inventory, or receivables if he doesn’t need capital gains to deduct his capital losses.
Timing of Payments
The third area that motivates sellers is the area dealing with timing of the payments to be received from the buyer. Sellers may be willing to go forward with a taxable transaction and therefore incur substantial tax liability if they have serious doubts about the buyer’s financial ability to get them paid out over a period of time. A seller may also need cash for reinvestment and a seller will also consider the cost of deferral of payment as against the amount of consideration in interest payments that are being received to determine if the interest received is adequate to offset the deferral. The doubt as to the buyer’s financial ability to pay is usually a problem faced in financed buyout situations where the seller is asked to take some of the financing back in connection with the transaction. Again, if the seller needs the proceeds from this transaction for reinvestment purposes, the buyer needs to make that determination early on.
Cash or Buyer’s Stock?
The fourth area of interest is where the buyer is trying to get the seller to take paper in the form of the buyer’s securities. The seller is going to look at the present and future valuation of the buyer and he may want some kind of consideration that is tied to future developments. Those are usually in the form of equity kickers, which would allow the seller to have the ability to cash in on the success of the venture if things go extremely well for the buyer after the sale. In most situations where a buyer wants the seller to take securities, the seller will usually try to get the buyer to give registration rights as part of the acquisition agreement. Again these could either be demand registration rights or piggyback registration rights.
Buyer’s Motives
Let’s look briefly at the motives of the acquirer in connection with one of these transactions. The acquiring company’s motives in structuring the transaction will be different because generally there is going to be no concern about recognition of gain or loss because no gain or loss is realized by the acquiring company when the deal closes unless the acquiring company is providing appreciated property as consideration in the transaction.
There are tax considerations, however, for the acquiring company and those are the retention of tax attributes of the target such as loss carryovers, earnings and profits. The acquiring company will also be concerned about the effect of the transaction on the basis of the property which is acquired in the transaction. If the transaction takes the form of a taxable purchase of assets, then the acquiring company will also be concerned about how the purchase price is to be allocated among the acquired assets. That may also be the case in certain stock purchases that are taxable transactions.
Cash or Stock Consideration
From a purely business standpoint, and not a tax standpoint, an acquiring company will also take into consideration things such as the availability of cash. While many acquiring companies like to use stock or other securities as consideration, because it alleviates the necessity to pay cash, an acquiring company also has to take into consideration what effect that issuance will have on its existing shareholders because that issuance will result in a dilution of the existing ownership as well as costs in the form of registration expenses if the securities have to be registered now or even if registration rights are granted and those expenses will have to be incurred in the future.
Use of Debt Instruments
Obviously if debt instruments are issued, the acquiring company has to take into consideration what effect it is going to have on their debt to equity position and whether or not that may violate any of the acquiring company’s existing lending arrangements. Usually the acquiring company will seek to structure the transaction as a tax free organization if there are valuable tax benefits in the selling corporation, such as, net operating loss carryovers, a high basis in the target’s assets, deficits in earnings and or depreciation methods that provide for an acceleration of depreciation. The flip side of the coin is that an acquiring company will generally try to eliminate a negative tax situation that exists in a target by effecting a taxable asset acquisition. Those negative tax situations will include things such as large accumulated earnings or possibly a low basis in the target’s assets.
Buyer’s perspective on basis
With regard to the tax considerations made by the acquiring company, they will look at basis. In a taxable transaction, the acquiring company’s basis in the property that it acquires generally is equal to the purchase price that it pays, as we have discussed before. In a tax free reorganization, the basis of the acquired assets generally carries over from the seller to the acquiring company, but is increased by any gain that the seller recognizes. This basis is obviously important because it becomes the measure whereby the gain or the loss at some time in the future will be determined and depreciation deductions will be calculated based on the basis that results from the transaction.
It’s very important to note that if the seller’s basis is in excess of the fair market value of the assets, then the acquiring company will most probably want a tax free reorganization so it can take on the seller’s high basis. If, on the other hand, the fair market value of the assets that are being acquired exceeds the seller’s basis, then the buyer is going to want to obtain a stepped up basis which is equal to what it costs the buyer for the assets. The buyer wants a higher basis for his depreciable assets because his depreciation is based upon the tax basis of the assets and not necessarily the purchase price. If the buyer intends to flip or sell some of the assets after the acquisition, and the buyer also wants as high a basis as possible, because that in turn would reduce the buyer’s gain since the gain is calculated on the excess over the assets basis.
Allocation of the Purchase Price
The allocation of the purchase price is another serious tax consideration for the buyer in the event that the transaction is structured as a taxable sale. The buyer wants as much of the purchase price as possible allocated to depreciable or amortizable property such as buildings, equipment, or covenants not to compete. Items such as land or goodwill are not depreciable assets and consequently the buyer is not going to want to allocate very much of the purchase price to those items.
Goodwill
I should mention here that with regard to goodwill the buyer won’t get any current or future ordinary deductions in connection with his purchase of goodwill, but can use that additional basis provided by goodwill to reduce any resulting gain on the ultimate sale towards this position of his business so that when the buyer sells the business, he will actually get some benefit from having paid a fairly high basis for the goodwill in the form of what he is going to save because he’s got a higher basis in the assets than he would otherwise have.
Summary
All of these items are the basic tax issues that motivate both sellers and acquirers and should be considered when you are planning your structuring. For example, if a taxable sale of assets has been agreed upon and the seller knows an allocation of the purchase price to more depreciable items will be of no determent to him, he may use that as a bargaining chip to trade with the buyer for something that he wants in the transaction, and even if he doesn’t get the additional item he is looking for he really hasn’t lost anything by allocating the purchase price the way the buyer wants it allocated.
Hopefully this information has provided a solid framework for an understanding of what tax considerations motivate buyers and sellers in an acquisition transaction.