Uncertainty remains in the global market. While the impacts of COVID-19 continue to reverberate, market consolidation may present opportunities—in particular, for distressed acquisitions. As always, as these opportunities 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 influence cash flows and closing conditions, among other elements in the deal-making process.
Following are a few key tax takeaways for mergers and acquisitions as we navigate the current environment.
Equity Sale Versus Asset Sale
In any M&A transaction, one of the first steps is to determine how the transaction will be structured; 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 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 gain rate, as opposed to potentially paying tax at higher ordinary rates for the sale of the company’s assets.
An asset sale, however, is commonly preferred by the buyer as a way to reduce potential risk associated with undisclosed liabilities. This way, the buyer can individually select which income-generating assets to add to their portfolio to produce an acceptable return on investment after any acquisition debt. Examples may include equipment, inventory, real estate, customer lists, patents, and so on. Asset sales allow buyers to step up the tax basis of assets to reflect current tax value and to realize depreciation benefits.
For the seller, however, an asset sale may drive up the tax bill and may even provoke double taxation. For the buyer, even though an asset sale is preferred, sometimes a stock sale is required for legal or regulatory continuity of business reasons. Buyers and sellers typically negotiate these terms by compromising on price and payment to level the playing field.
Tax Due Diligence
As parties pursue mergers and acquisitions, buyers should consider tax planning before the letter of intent is signed. Several factors play a role in realizing beneficial tax results and determining the timing of these requests in the deal process, especially as the impacts of COVID-19 develop. For example, as noted above, asset sales are typically more tax-favorable for the buyer. If you are looking to purchase a business, in some cases you can treat the transaction and certain qualifying equity purchases as an asset sale. To accomplish this, a Section 338(h)(10) or 336(e) election would be required, which would move the benefits to the buyer. This planning opportunity is better positioned prior to the signing of the letter of intent to avoid further considerations.
Buyers of equity should investigate 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 whether any debt modifications or loan restructurings were made between the creditor and debtor. These debt modifications may have provided much-needed cash flow and relief, but 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 can leverage several tax opportunities to maximize the deal.
Consider the ability to carry back net operating losses (NOLs) from 2018 to 2020 for five years. This provision provides both buyers and sellers an incentive to negotiate the carryback of the NOLs for a possible refund. In addition, the Act also suspends current law and lifts the NOL limit of 80 percent of taxable income through 2021. At present, most states have not adopted these changes so NOLs will carry forward for state purposes and potentially provide a future tax benefit at the state level.
In most previous M&A transactions, it was not customary to amend the company’s pre-closing-period tax returns, including pre-closing-period tax refund claims. The act’s NOL carryback 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 expense that can be deducted from a taxpayer’s adjusted taxable income. Beginning in tax years 2019 and 2020, most businesses now can calculate the interest limitation based on 50 percent of adjusted taxable income instead of 30 percent of adjusted taxable income.
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 will 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 have 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, opportunities will arise for synergistic mergers, new relationships, and resource-sharing as we heal and weather the storm together.
Contact R&A to discuss any questions regarding M&A opportunities you may be considering.
About this Author
Laura specializes in income tax return preparation, compliance, and research for individuals and businesses. She also is experienced in preparing compiled and reviewed financial statements, individual and S-Corporation taxation, multi-state taxation, and income tax credits including the R&D credit.