Category Archives: Tax

Inside/Outside

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As I’ve said before, taxes and tax attributes play a major role in M&A negotiations. Recall that, unfortunately, deal structuring is usually a zero-sum game, and a deal structure that favors one party tax-wise is usually to the other party’s detriment. An easy way to consider the tax consequences of different deal structures is to use a simplified inside/outside tax basis framework.

First though, a small refresher on tax basis and gains. The tax basis of assets is usually analogous to the book or accounting value of assets except where it has diverged over time due to depreciation or amortization methodologies. A gain occurs on the difference between the purchase price and the tax basis (a loss occurs if the tax basis exceeds the purchase price). Lots of additional factors effect the size and nature of a gain – ordinary or capital gain, the tax status of seller, holding period, tax rate, etc.

Now to the inside versus outside tax basis framework. Inside basis refers to the basis a company has in its own assets. Outside basis is the basis that a shareholder has in the shares of another company. Deal structure will dictate how the inside and outside gains or losses occur.

Deals are structured as either asset or stock deals:

  • In a taxable asset deal, the seller is taxed on its inside asset basis and its shareholders are taxed on the gains of these sales proceeds. This is two levels of tax. The purchaser of the assets acquires a stepped up (fair value) basis in the assets and the new, greater depreciation and amortization are tax deductible.
  • In a taxable stock deal, seller shareholders are taxed on their outside basis in the seller’s stock (only); there is no tax liability incurred in connection with the assets. This is one level of tax. The purchaser gets a stepped up (fair value) basis in the stock and a carry-over basis in the assets.

That’s it. There is a special case to be considered when the acquisition target is a corporate subsidiary and is at least 80% owned by its parent. In this case, the target can sell assets and distribute their proceeds to the parent shareholders without actually incurring a 2nd layer of tax (because, technically, the distribution of proceeds should qualify as a tax-free liquidation). In deals like this, the main consideration is the difference between inside and outside bases.

Also, there are several tax-free structures where the major determinant is the form of consideration paid by the buyer (cash or stock) rather than the structure (asset or stock). Essentially, if around 50% of the purchase price is paid in stock of the purchaser the deal may be tax-free because deals that use an abundance of buyer stock can qualify as “reorganizations”.

For a more detailed approach to tax repercussions of different deal structures, go to my prior blog posting here.

Deals are often scuttled due to tax considerations and, more specifically, failure to account for a deal structure’s impact on the sellers’ after tax proceeds. Understand the inside/outside tax bases, analyze, and win more deals.

Posted by: Mory Watkins

M&A Tax Checklist

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After valuation, one of the most important negotiated numbers in an M&A transaction is tax. Tax in corporate M&A is pretty much a “zero-sum” game — tax impact from a deal structure that is tax-beneficial to the seller will usually be tax-adverse to the buyer, and vice versa.

Today, I’m going to offer up a concise M&A tax planning checklist. The basic idea here is to gather the info and run the numbers to analyze both the present and future tax effects of each deal structure under consideration; that is, a) the immediate taxes associated with the acquisition, and b) the future taxes and benefits associated with realizable basis step-ups, NOL carryovers, and so forth over time. Both present and future details must be analyzed for all deal structures. Only then can a negotiation ensue where buyer and seller compare figures and divide up perceived costs and benefits…ideally, equitably.

If you’re a competent financial modeler, you can easily do your own back of the envelope tax analyses. You can find a good explanation of NOLs and a template to run different transaction scenarios here. A tax professional is needed, of course, to crunch the definitive numbers.*

Here is the information you’ll need to run your analyses:

  1. Stock and asset basis
  2. Seller plans for proceeds (i.e., “individual shareholders to receive proceeds and hold purchaser stock for negotiated period”, etc.)
  3. Applicable tax rates for all parties (target, target shareholders, purchaser)
  4. Depreciation and amortization schedules for acquired assets
  5. Tax status of sellers (suspended losses, special tax status, relevant estate planning considerations, etc.)
  6. Management participation and compensation related to deal structure (if any)
  7. Planned asset dispositions (if any)
  8. Available target NOLs and other loss/credit carryovers
  9. Purchaser NOLs (may limit target gains)
  10. Availability and timing of taxable income vis a vis applicable deductions/loss carryovers

Understanding tax implications of deal structures from the seller’s perspective frequently means the difference between closing and not closing a strategic acquisition. Use this checklist and methodology to balance your motivations with your seller’s chief concern and goal: maximizing after tax proceeds from selling the business.

Posted by: Mory Watkins

*This posting doesn’t constitute tax advice; always seek tax guidance from a tax professional.

Earnouts (Part Two)

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Some while ago, I posted about earnouts and how a quarter of all business acquisitions have an earnout component in one form or another. I examined the difficulty of creating a good earnout, and I offered up a couple choice pieces of advice.

Today, I’d like to take another look at earnouts, but this time concentrating more on seller implications. Sellers aren’t always rational during the sales process, but for the most part they are dialed into concerns related to the after-tax proceeds from the sale of their business. It gets a little trickier than you might think when the sale involves earnouts, so both buyer and seller would do well to understand the fundamentals of earnout tax considerations*.

The best way to think of an earnout is that it is a type of “installment” sale, but with contingent payments (I’ll get to the latter part in a moment). An installment sale is a sale in which at least one payment will be received after the close of the taxable year in which the sale occurs. The key feature of an installment sale is, of course, that it essentially recognizes taxable gain as payments are received, rather than all at once in the year of disposition. Loss of installment sale status accelerates tax payments so that tax may even be due before the actual cash is collected (note that the installment method will automatically apply by default unless the seller elects out).

Okay, special installment rules apply where there is a contingent payment (i.e., earnout) that occurs as part of the sale because the aggregate selling price cannot be determined by the close of the taxable year in which the sale occurs. The tax man will determine which of three categories the sale falls under — 1) a sale with a stated maximum selling price, 2) a sale with a fixed period, or 3) a sale with neither a stated maximum selling price nor a fixed period:

  • A sale with a stated maximum selling price will assume that all contingencies are met such that it maximizes the payments to the seller and accelerates payments to the earliest date or dates under the purchase agreement.
  • For a sale where the maximum selling price cannot be determined but the maximum period over which payments may be received can, the seller has to recover the basis ratably over that period. Then, if the actual payment received is less than the amount of basis that should be recovered, the taxpayer usually doesn’t recognize a loss, but instead the excess is carried forward (and the loss may be recognized in the final year).
  • For a sale with neither a stated maximum selling price nor a fixed period, the IRS will closely scrutinize whether a sale has actually occurred (the seller may be just receiving rent or royalties). If a sale is deemed to have occurred, the seller usually must recover his basis in equal annual installments over a period of 15 years.

Lastly, three common situations to watch out for…

  1. In cases where the earnout numbers get kind of crazy (very large contingent payments that are “difficult” to achieve), be aware that the maximum selling price rules above can both accelerate recognition of and change the timing and nature of gains.
  2. In cases where the earnout numbers get “lumpy” (an earnout gain is recognized in early years, but little or no earnout gain is earned later), the seller may be ultimately left with a large capital loss that can be hard to deduct.
  3. Stock sales with a Section 338(h)(10) election that include an earnout deserve special consideration due to a common trap that results in excess gain recognition in the year of sale.

Buyers and sellers are increasingly using earnouts to bridge the valuation gap and get deals done. Becoming more aware of seller-side tax treatment of earnout arrangements can help strategic buyers inject additional value into transactions.

Posted by: Mory Watkins

*This posting doesn’t constitute tax advice; always seek tax guidance from a tax professional.