Top 10 tax issues in merger & acquisition transactions

March 24, 2016|Christa Baldridge

Many issues impact a sale transaction and understanding tax implications early in the process is vital. Generally, tax considerations will drive the buyer and seller to adopt opposing positions. Therefore, the ideal transaction structure requires the blending and negotiation of tax and deal considerations.

Ideas discussed below apply to stock and asset business sales which generate a tax event.

1. Recognize the impact of seller’s tax versus book depreciation

The net tax value of fixed assets can vary greatly from book value due to recent years’ availability of bonus depreciation and the expensing provisions under IRC section 179. If purchasing stock, this results in less tax depreciation for the buyer in future years. If selling assets, this can result in substantial ordinary income recapture and unanticipated tax liability. In addition, the sale of other current assets, such as prepaid expenses and inventories, can result in similar tax impacts.

2. Inventory and accounts receivable write-offs

Tax rules do not always follow GAAP and transaction advisors need to consider the permissible ways to claim write-downs for tax purposes when adjustments are negotiated. Adjusted reserves may not result in tax deductions, however, if inventory is disposed of or A/R is written off to bad debts, there is potential for tax deduction.

3. Purchase price allocations

Allocation between fixed assets can have a significant tax impact. Generally the seller wants to allocate more purchase price to capital gain and the buyer wants a “stepped up” basis in assets. To avoid post-agreement conflict between parties in asset purchase transactions, document the purchase price allocation by asset class, per IRS Form 8594, in your definitive agreement.

4. Future cost segregation considerations

If a cost segregation study is desired by the buyer, it is advisable to generally assign combined amounts to “fixed assets.” The IRS has prevailed in court (TC Memo 2012-8) that the Form 8594 reported and agreed upon sale allocation cannot be reallocated between building, land, equipment, etc. in situations a precise category or asset is identified in the legal agreement.

5. 338(h)(10) election

When a stock purchase is optimal for legal purposes and asset sale desired for tax purposes, parties can elect IRC section 338 to treat the sale of stock as an asset sale for tax purposes. Generally, the parties have negotiated the tax implications that accompany such a transaction. Elections under IRC section 338 requires filing of Form 8023 and is documented at time of closing. Filing of Form 8883 for asset sale price allocation is also required.

6. Liquidation timing of an S corporation, LLC or partnership upon an asset sale

Timing of the asset sale does not need to coincide with the ultimate liquidation of the company stock, although it may be desirable within the same tax year. Planning the timing of liquidation is important in order to coordinate any potential loss upon liquidation to the individual sellers to offset capital gains, often passed through to owners at the time of sale. Capital losses on stock/interest liquidations can only be deducted against current capital gain income or up to $3,000 per year against other ordinary taxable income, with the remainder carrying forward to future years.

7. Timing of deductions

Provided accelerated deductions do not affect purchase price EBITDA, accelerating deductions can provide tax planning opportunities. Tax deductions related to accelerated depreciation, accounting method changes, etc. can be accelerated to the advantage of a seller. These deductions are often ordinary income deductions, and result in higher capital gain income upon a sale.

8. Built-in gains tax

Built-in gains (BIG) tax is the tax on built-up value inside a C corporation that occurred prior to the election to become an S corporation. Upon sale of the company, the gain on assets with built-in value can be taxed at corporate tax rates. The Protecting Americans From Tax Hikes Act of 2015 (PATH Act) signed into law in late December 2015 permanently changed the federal BIG tax look back period to five years. State rules must be reviewed, as Wisconsin and other states have not yet conformed to this federal law and Wisconsin is currently still using a 10-year BIG period.

9. Alternative Minimum Tax (AMT) impacts

Planning in the year of a sale can be beneficial in mitigating the impact of AMT. AMT can impact S corporation and partnership/LLC sellers in the year of sale unexpectedly, if the majority of income from sale is capital gains. If taxpayers’ large income is primarily capital gains, income normally “above” the AMT income range can still impact the taxpayer. The estimated transaction state income tax payments may not be deductible in a specific year if AMT applies, as state tax payments are not an offset to Alternative Minimum Taxable Income. Planning state estimates should be reviewed to optimize the year of deduction.

10. Multiple tax analysis needed

There are a variety of tax issues to consider in a transaction and both parties should have their own advisors calculate the ultimate tax impact for accuracy. It is common to have conflicting results, and consensus on taxation is necessary prior to negotiation. Tax issues, like all major issues, should be negotiated prior to the letter of intent.

Ultimately, if the opportunity to address tax issues is delayed or missed, there are often material economic consequences. The issues discussed here are just a sampling of the various and nuanced tax considerations that will arise in a given deal.

Adapted from an article that originally ran in WICPA’s March/April 2016 issue of On Balance magazine.

Christa Baldridge, CPA, is a shareholder at Schenck SC. She has more than 15 years of experience providing tax planning, consulting and compliance services to privately held businesses and individuals, with a concentration in serving the manufacturing and distribution industries.