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Tax Considerations

Tax Basis

Tax basis is the carrying cost of an asset on a company's tax balance sheet, and is analogous to book value on a company's accounting balance sheet. In most cases, assets are initially recorded at acquisition cost for both book and tax purposes. However, book value and tax basis may diverge over time due to different depreciation/amortization methodologies (e.g. straight-line depreciation for accounting purposes versus accelerated depreciation for tax purposes).

The taxable gain, if any, recognized by the seller (either individual investors or corporate shareholders) upon the sale of stock or assets is equal to the purchase price less the tax basis in the stock or assets sold. If the tax basis exceeds the sale price, the seller recognizes a loss on the transaction rather than a gain.

When the transaction results in a gain, the seller's tax burden is determined by a number of factors, including whether or not the transaction is taxable, whether the seller is taxable or tax-exempt, whether the gain is taxed as ordinary income or a capital gain, the seller's holding period (how long the sold stock/assets were held by the seller before sale), and the applicable tax rate.

There are two types of tax basis: inside basis and outside basis. The inside basis is the tax basis that a company has in its assets. The outside basis is the tax basis that a shareholder (which could be corporate entity) has in the shares of a company. The basis to be used in calculating taxes depends on how the transaction is structured.

Broadly speaking, acquisitions can be structured as either asset or stock sales. In a taxable stock acquisition, the buyer acquires stock from the target company's shareholders, who are taxed on the difference between the purchase price and their outside basis in the target's stock. In a taxable asset acquisition, the selling corporation is taxed on the excess of the purchase price over its inside basis in the assets sold, and the selling corporation's shareholders are taxed on the distribution of sale proceeds.

When a parent company develops a subsidiary internally, rather than through acquisition, the parent's inside and outside bases in the assets and stock of the subsidiary, respectively, are equal. Since most taxable acquisitions are structured as stock purchases without a Section 338 election, the buyer's outside basis in an acquired subsidiary usually exceeds its inside basis in that subsidiary (since the acquirer's basis in the target's stock would be stepped up for tax purposes, while the acquirer's basis in the target's assets would be carried over). If the subsidiary was purchased in a non-taxable transaction, the parent's outside basis in the subsidiary's stock will equal the seller's basis, adjusted for the parent's interest in subsequent taxable income earned by the subsidiary and distributions made by the subsidiary to the parent. As in a regular stock purchase, the parent will assume a carryover basis in the assets acquired, so the parent's outside basis will likely exceed its inside basis.

Taxable Stock Acquisition of a Freestanding C Corporation

  • One layer of tax – Selling shareholders recognize a taxable gain or loss on their disposition of target stock equal to their cash proceeds less their outside basis in the stock.
    • Since, from the IRS' perspective, no sale of assets has occurred, the target does not incur a tax liability in connection with the transfer of assets.
    • However, if a Section 338 election is made to treat the transaction for tax purposes as an asset sale, the target will recognize a taxable gain or loss.
    • The gain will be taxed as a long-term or short-term capital gain depending on individual shareholders' holding periods.
  • The acquirer assumes a stepped-up cost (FV) basis in the target's stock and a carryover basis in the acquired net assets, unless a Section 338 election is made.
  • None of the asset write-ups or intangibles recognized in the purchase price allocation for accounting purposes, including goodwill, are tax-deductible.
  • The target's tax attributes survive the acquisition and carry over to the acquirer, but their use is subject to limitation under Section 382.

Example A – Taxable Stock Acquisition

Alpha acquires the stock of freestanding C corporation Tango for $50 in cash. Tango's inside basis in its assets is $25 and Tango's shareholders have an aggregate outside basis of $15.

(A) What is Tango's taxable gain?

Tango has no taxable gain because this is a stock acquisition.

(B) What is the aggregate taxable gain to Tango's shareholders?

The taxable gain is the value of consideration received less the shareholders' aggregate basis in the stock sold, or $50 − $15 = $35.

(C) What is Alpha's resulting basis in Tango's assets?

Carryover basis of $25.

(D) What is Alpha's resulting basis in Tango's stock?

Stepped-up basis of $50.

Taxable Asset Acquisition of a Freestanding C Corporation

  • Potentially two layers of tax:
    • Corporate layer – Target recognizes a taxable gain or loss on the sale of assets.
    • Shareholder layer – Selling shareholders recognize a gain taxed as ordinary income if the target liquidates equal to the after-tax liquidating dividend less shareholders' basis in the stock.
  • The acquirer assumes a stepped-up cost (FV) basis in the target's net assets.
  • The acquirer allocates the purchase price to the acquired assets and liabilities for tax purposes in the same manner as it does for accounting purposes.
  • The depreciation and amortization of all asset write-ups and intangibles recognized in the transaction, including goodwill, are tax-deductible.
  • The target's tax attributes, such as non-operating losses (NOLs), may be used immediately to offset the target's taxable gain. Any remaining tax attributes are lost if the target liquidates.

Example B – Taxable Asset Acquisition

Suppose instead that Alpha acquires Tango's assets for $50. Tango is then liquidated and distributes the after-tax cash proceeds from the sale to its shareholders. Tango's tax rate is 35%.

(A) What is Tango's taxable gain?

The taxable gain equals the consideration received less Tango's inside basis in its assets, or $50 − $25 = $25.

(B) What is the aggregate taxable gain to Tango's shareholders?

The taxable gain equals the after-tax proceeds distributed less the shareholders' aggregate basis in the stock sold, or $50 × (1 − 35%) − $15 = $17.5.

(C) What is Alpha's resulting basis in Tango's assets?

Stepped-up basis of $50.

(D) What is Alpha's resulting basis in Tango's stock? Why?

Stepped-up basis of $50 because taxes were paid at the shareholder level upon liquidation.

An acquisition of a freestanding C corporation will usually be structured as a purchase of stock because an asset purchase usually results in double taxation (i.e. the seller is taxed on the sale of assets, and the seller's shareholders are taxed on any after-tax proceeds from the sale distributed by the seller).

Taxable Acquisition of a Corporate Subsidiary

In some situations an asset sale will not result in double taxation. For example, if the target is a corporate subsidiary (with at least 80% ownership by the parent company), the target can generally sell its assets and distribute the proceeds (after the first level of tax on the asset sale) to the parent company without incurring another level of tax on the proceeds so distributed (the distribution of proceeds is a tax-free liquidation of a subsidiary under IRC Section 332). In this case, the parent's decision to whether to sell stock or assets will depend primarily on whether there is a difference between inside and outside basis.

Example C – Sale of a Corporate Subsidiary

Alpha agrees to acquire Tango, a wholly owned subsidiary of Sierra. The purchase price is $1,000, Sierra's inside basis Tango's assets is $400, and Sierra's outside basis in Tango's stock is $500. The tax rate is 40%.

(A) Does Sierra prefer to structure the deal as an asset or stock sale?

In this case, the seller (Sierra) prefers to structure the deal as a stock sale because its after-tax proceeds would be higher by $40. However, the buyer (Alpha) is not indifferent to the deal structure. Note that in a stock purchase, Alpha assumes a carryover basis in Tango's assets of just $400. In an asset purchase, on the other hand, Alpha would assume a stepped-up basis of $1,000.

(B) What is the present value (PV) to Alpha of the tax savings arising from the incremental depreciation/amortization of the asset step-up if the deal is structured as an asset acquisition? Assume the asset step-up is depreciated/amortized over 15 years and the discount rate is 10%.

If the deal is structured as an asset purchase, Alpha enjoys a benefit of $122 from tax savings realized over 15 years. So, to convince Sierra to agree to an asset purchase, Alpha might offer to compensate Sierra for the $40 of incremental taxes by increasing the purchase price by $40 ÷ (1-40%) = $67.

(C) If Alpha increases the purchase price by $67, what is the PV to Alpha of future tax savings from the asset basis step-up?

When a wholly owned subsidiary is created internally, the parent's inside and outside bases are usually equal.

Tax-Free Acquisitions

As we have seen, one major determinant of the tax implications of an M&A transaction is the acquisition structure (asset vs. stock purchase). The other major determinant is the form of consideration (cash vs. stock) paid by the acquirer to the seller(s).

  • If the consideration is mostly cash or debt, the deal is likely to be taxable.
  • If at least 40% of the consideration is acquirer stock, the deal is more likely to be non-taxable (50% is the technical threshold, but transactions with as little as 40% stock consideration have qualified for tax-free treatment).

Debt as consideration in an acquisition refers to the assumption of a target's debt by the buyer. A transaction in which acquirer stock comprises a significant portion of the total consideration (40% or more) may meet the tax definition of a "reorganization", which is generally not taxable. Such transactions often take the form of "A", "B", or "C" reorganizations, which we will discuss more in our dedicated topic on tax-free acquisitions.

Summary

There are four basic tax structures whose general tax properties we summarize below:

Exhibit A – Comparison of M&A Tax Structures

  Taxable Non-Taxable
    Asset
Acquisition
 Stock
Acquisition
 Asset
Acquisition
 Stock
Acquisition
 
Tax paid by selling shareholders?   Taxed on any liquidating dividend  STCG or LTCG  Taxed to the extent boot is received  Taxed to the extent boot is received
 
Tax paid by target?   Yes No No No
 
Buyer's inside basis in target's net assets?   Stepped-up   Carryover   Carryover   Carryover
                 
Buyer's outside basis in target's stock?   Stepped-up if target is liquidated   Stepped-up Carryover Carryover

Note: "boot" refers to the portion of consideration not paid in acquirer stock.

The following framework is redundant to what we have already discussed, but may be helpful in visualizing the buyer's tax basis in net assets acquired from a freestanding C corporation for each of these tax structures:

Keep in mind two points to help you recall whether or not the buyer is entitled to a tax basis step-up in the acquired net assets and/or stock:

  • Payment of taxes gives rise to basis step-ups.
  • Non-payment of taxes gives rise to basis carryover.
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