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23rd Annual Health Sciences Tax ConferenceAcquisitions of closely held businesses
December 11, 2013
Page 2 Acquisitions of closely held businesses
Disclaimer
Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.
Page 3 Acquisitions of closely held businesses
Disclaimer
EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit ey.com.This presentation is © 2013 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party.Views expressed in this presentation are not necessarily those of Ernst & Young LLP.
Page 4 Acquisitions of closely held businesses
Presenters
Laura MacDonough1101 New York Avenue N.W. Ernst & Young LLP Washington, DC+1 202 327 [email protected]
David MillerErnst & Young LLP1 Victory ParkSuite 20002323 Victory AvenueDallas, TX+1 214 969 [email protected]
Torsdon PoonErnst & Young LLP 1101 New York Avenue N.W.Washington, DC+1 202 327 [email protected]
Carole BelmarVice President, TaxationTeam Health, Inc.Knoxville, TN
Page 5 Acquisitions of closely held businesses
Agenda
Mergers & acquisitions with:C corporations
Section 336(e) regulationsAcquisitions and personal goodwill
S corporationsQualification as an S corporationS corporation due diligencePost-acquisition restructuringOther planning considerations
PartnershipsAcquisition of a business owned in partnership solutionAcquisition of an interest in an existing partnershipAcquisition of a partial interest in a business: dealing with the anti-churning rules
Page 6
Mergers & acquisitions with C corporations
Page 7
Section 336(e) regulations
Page 8 Acquisitions of closely held businesses
Background and benefits
Section 336(e)
What is it? To whom does it apply?
Sell-side deal optimization
Benefits
Provides that certain stock sales and dispositions may be treated as asset transfers for US federal income tax purposes
S corporationsPrivate equityCorporations
Operational benefitsFlexibility in structure Section 336(e) versus Section 338(h)(10)
Page 9 Acquisitions of closely held businesses
Example 1: effect of forward cash merger
The tax effect of a forward cash merger and that of a 336(e) transaction are similar.Although Partnership owns the assets of Target directly in a forward cash merger, an even more similar result occurs if Partnership subsequently drops Target assets into a new corporation under Section 351.
Taxable forward merger results in a new entity owning Target’s assets.Licenses to Target may not be transferrable.
Stock purchase with 336(e) election offers same basis step-up in Target’s assets as that of the taxable forward merger, but Target continues to own all assets.336(e) election thereby offers same result but is less operationally invasive than a taxable forward merger.
Seller
Target
Taxable forward merger
Seller
TargetP’shp
P’shp
Stock purchase with 336(e) election
Page 10 Acquisitions of closely held businesses
Example 2: private equity (PE) club deal
336(e) election offers an opportunity to separate wanted and unwanted businesses in typical private equity fund structure.Distribution of unwanted business and sale of wanted business are available, provided each fund is unrelated (owns less than 50% of Parent Holdco).
336(e) election is available for both the distribution of unwanted and the sale of wanted.
Parent Holdco
PE Fund 1 PE Fund 3PE
Fund 2
Holdco
Wanted Corp.
Unwanted Corp.
33.33% 33.33% 33.33%
Purchaser
Unwanted Corp. stock Unwanted
Corp. stock
Unwanted Corp. stock
Page 11 Acquisitions of closely held businesses
Comparison of Section 336(e) to 338(h)(10)
Section 338(h)(10) Section 336(e)
Election maker Joint seller and purchaser election Seller and target election by agreement
Timing Election within 8.5 months Election on tax return(s)
Type of purchaser Corporate purchaser Corporate or noncorporate purchasers
Type of Seller and Target
US corporation seller and consolidated affiliate corporation target or nonconsolidated affiliate target; or S corporation target
US corporation seller and affiliated (but not necessarily consolidated) target; or S corporation target
Time frame 12-month acquisition period, limited creeping 12-month disposition period
Amount of stock disposed of
Sale of 80% vote and value (excluding Section 1504(a)(4) stock)
Sale and/or taxable distribution of 80% vote and value (excluding Section 1504(a)(4) stock)
Related parties Related-person restriction (Section 318(a) attribution)Note: 50% threshold for corporation attribution
Related-person restriction (Section 318(a) attribution but not between partnerships with < 5% partners)Note: 50% threshold for corporation attribution
Foreign Seller or Target
Not available if seller or target is foreign Not available if seller or target is foreign
Qualitative nature No carryover basis in whole or in part/no transfer of stock in a transaction to which Section 351, 354, 355 or 356 applies
No carryover basis in whole or in part/no transfer of stock in a transaction to which Section 351, 354, 355 or 356 applies
Page 12 Acquisitions of closely held businesses
Flexibility of Section 336(e) vs Section 338(h)(10)
Section 336(e) offers flexibility regarding the type of business entity that can acquire a Target.
Seller
Target
Corporate purchaser required for 338(h)(10)
Seller
Target
P’shp
Stock purchase/distribution with 336(e) election
Acquirer P’shp Individuals
Public
Page 13 Acquisitions of closely held businesses
Summary of seller and purchaser considerations
Seller Purchaser
Benefits • Can market-basis step-up to purchaser if willing to make 336(e) election
• Ability to sell with step-up and without requiring intellectual property relicensing
• Opportunity to carve out unwanted subsidiaries
• Basis step-up• Don’t need corporate purchaser• Can liquidate target promptly
Traps • Loss limitation on distribution • No notice provisions• Creeping transactions• Consistency rules• Loss of net operating losses
Contractual provisions/considerations
• Breach of contract for failure to make 336(e) election
• Require or prohibit 336(e) election in stock purchase agreement
Reporting • File election jointly with target• Enter into binding agreement with target to
make election
• No participation in election• Reporting with respect to target
during creeping acquisition for consolidated and S corporation returns
Page 14 Acquisitions of closely held businesses
Section 338(h)(10) with S corporationconsiderations
For 338(h)(10) election to be valid, target must have valid S election in effect.All shareholders (including non-selling) must consent.Incremental cost:
Potential ordinary income (cash-basis receivables, depreciation recapture, etc.)Built-in gains taxState and local income taxes
Page 15 Acquisitions of closely held businesses
Section 338(h)(10) with S corporationconsiderations
Installment sale considerations:Corporate gain deferral, except for corporate level taxesShareholder gain acceleration (basis allocation issue)
Defer all payments to maximize gain deferral?Contingent installment sale rules
Basis allocation ruling for fixed-period contingent installment noteState tax planning
Involves deferral of all payments to avoid gain recognition at corporate levelQuestionable viability of planning
Page 16 Acquisitions of closely held businesses
Reporting considerations
Election is joint between Seller and Target (or between S corporation target and its shareholders).
Target essentially represents the Purchaser(s) in the election because there may be many.
Seller(s) and Target must enter into binding agreement to make election.Election is made on the consolidated return of the Seller and Target or, otherwise, on both returns if they are not filing consolidated returns by filing a Section 336(e) election statement (contents described in Treas. Reg. §1.336-2(h)).For allocation of aggregate deemed asset disposition price and adjusted gross-up basis, Form 8883 should be used with appropriate adjustments made.Creeping acquisitions raise reporting issues
Consolidated groups: timing for inclusion on Seller’s consolidated return vs Purchaser’s consolidated return prior to completion of qualified disposition dateS corporations: K-1 obligation prior to qualified disposition date after selling shareholders have disposed of stock
Page 17
Acquisitions and personal goodwill
Page 18 Acquisitions of closely held businesses
Personal goodwill vs corporate goodwill
Personal goodwill (PG): individual’s personality, business acquaintances, character, reputation, skill and knowledgeCorporate goodwill: intangible assets of a business, including client lists and records, trained personnel and favorable leasesExistence of PG
Personal service corporations (e.g., doctors, dentists, etc.)Closely held corporations for which shareholder provides personal servicesCorporations for which a shareholder’s personality, business acquaintances, character, reputation, skill and knowledge have increased the value of the business enterprise
Page 19 Acquisitions of closely held businesses
Taxable stock acquisitions and PG
Target
Individual A Public
Acquirer
$
Acquirer to acquire Target stock and Individual A’s PG from Individual A in exchange for cash in a taxable stock acquisitionTreatment of US federal income tax consequences to Individual A and Acquirer?Purchaser vs seller considerationsOther tax considerations:
Impact of covenant not to compete or long-term employment contractValuation issues
Impact of multiple shareholdersCharacter of PGApplicability of anti-churning rules
Page 20 Acquisitions of closely held businesses
Taxable asset acquisitions and PG
Target
A Public
Acquirer
Acquirer to acquire assets from Target and PG from Individual A in exchange for cash in taxable asset acquisitionsTreatment of US federal income tax consequences to Individual A and Acquirer?Purchaser vs seller considerationsOther tax considerations:
Impact of covenant not to competeor long-term employment contractValuation issues
$
Target assets
$
$
Impact of multiple shareholdersCharacter of PGApplicability of anti-churning rules
Page 21
Mergers & acquisitions with S corporations
Page 22
Qualification as an S corporation
Page 23 Acquisitions of closely held businesses
S corporation definition
An S corporation is a small business corporation that has filed a valid election to be treated as an S corporation.
The election is made on Form 2553.The election must be signed by a duly authorized officer of the corporation.In addition, each shareholder owning stock on the date the election is filed must consent to the election.If the election is to be effective retroactive to the beginning of the tax year, any person owning stock during the pre-election must also consent.
If an S election is missing an officer or shareholder’s consent, then the election is invalid.
Page 24 Acquisitions of closely held businesses
Small business corporation
A small business corporation is a corporation that:Is a domestic corporationIs not an ineligible corporationHas only individuals (other than nonresident aliens), certain trusts and certain tax-exempt organizations as shareholdersHas no more than 100 shareholdersHas only one class of stock
Page 25 Acquisitions of closely held businesses
Qualified Subchapter S subsidiary (QSub)
A parent S corporation may elect to treat a qualifying subsidiary as a Qsub.
A qualifying subsidiary is a domestic corporation (other than an ineligible corporation) that is wholly owned by a parent S corporation for US federal income tax purposes.
When a valid QSub election is made for a subsidiary, the subsidiary is disregarded for US federal income tax purposes.
Accordingly, its assets, liabilities and items of income, gain, loss, deduction and credit are treated as those of its parent S corporation.
Page 26 Acquisitions of closely held businesses
Failing to qualify as a small business corporation
If corporation is not a small business corporation at the time its S election is filed, the election is invalid.If a corporation ceases to be a small business corporation subsequent to the filing of a valid S election, its S election terminates.
A corporation’s S election will also terminate if it has excessive passive investment income for three consecutive tax years and Subchapter C earnings and profits at the close of each of these tax years.
Page 27 Acquisitions of closely held businesses
Failing to qualify as a small business corporation
If a corporation’s S election is invalid or subsequently terminated, it is a C corporation.
The QSub elections made for subsidiaries would be invalid or terminated; thus, the QSubs would also be C corporations.The corporation would be liable for corporate-level taxes.A Section 338(h)(10) election would be unavailable.
Note that the IRS may grant relief for an inadvertently invalid or terminated S election or QSub election (see Section 1362(f)).
Page 28
S corporation due diligence
Page 29 Acquisitions of closely held businesses
S corporation due diligence
Confirm S corporation status of targetConfirm QSub status of relevant subsidiary corporationsEvaluate exposure for corporate-level taxes applicable to S corporations
Last-in, first-out recapture taxBuilt-in gains taxPassive investment income taxState, local and foreign taxesPayroll taxes
Page 30 Acquisitions of closely held businesses
Common S corporation due diligence issues
Unable to locate copy of S election and/or QSub electionsMissing spousal consentImpermissible trust shareholder (or unable to locate election to treat as permissible shareholder)More than one class of stock
Disproportionate distributionsPersonal expenses paid by corporationUnreasonably high shareholder compensationNon-arm’s-length related-party transactions
Unreasonably low compensationBuilt-in gains tax (note differing recognition periods)
Page 31 Acquisitions of closely held businesses
Use of limited liability company (LLC) to address diligence issues
FactsBuyer wants to acquire Oldco, a purported S corporation, in a transaction that results in basis step-up. For legal and other business reasons, the transaction cannot be structured as actual asset acquisition.Buyer has concerns about validity of Oldco’s S election.
Current structure
Shareholders
Oldco
Page 32 Acquisitions of closely held businesses
Use of LLC to address diligence issues
Possible restructuring:Oldco shareholders form Newco; an S election is made for Newco.Oldco shareholders contribute stock of Oldco to Newco in exchange for Newco stock.Immediately following the contribution, Oldco is converted to an LLC under state law conversion statute.
A check-the-box election is NOT made.
Buyer acquires LLC.
Revised structure
OldcoLLC
Shareholders
Newco
Page 33 Acquisitions of closely held businesses
Use of LLC to address diligence issues
Results:Buyer is treated as having acquired assets of Oldco in a taxable asset acquisition.
Treatment provides buyer with certainty regarding basis step-up.Newco should be liable for any built-in gains (or other corporate level) tax resulting from sale transaction.
Oldco LLC should have successor liability for any corporate-level taxes incurred pre-restructuring.
Page 34
Post-acquisition restructuring
Page 35 Acquisitions of closely held businesses
(1) S Corporation transfers operating assets (and related liabilities) to LLC in exchange for LLC interests.
(2) S Corporation sells LLC interests to buyer.
New LLC
(1) Assets and
liabilities
(1) LLC interests
S Corporation
Buyer
(2) Cash
(2) LLC interests
Use of LLC to avoid termination of S election
Flow-through status is maintained because ineligible investor is a partner, not a shareholder.
Anti-churning rules should be considered.
If money is to be used in business, funds could be contributed to LLC.
Disguised-sale rules should be considered.
Page 36 Acquisitions of closely held businesses
Contribute unwanted assets to LLC and distribute to shareholders (or distribute outright)
Taxable gain
Form new S corporation; contribute stock of existing S corporation and make QSub election (or convert to LLC); distribute unwanted assets to S corporation; sell QSub stock (or LLC interests)Contribute desired assets to new QSub (or LLC) and sell QSub stock (or LLC interests)
Structuring alternatives for unwanted assets
Page 37 Acquisitions of closely held businesses
(1) Non-big assets
(1) Cash
Built-in gains tax planning: bifurcated asset/stock sale
Buyer
(2) Cash
(3) Cash
(3) Stock
(1) S Corporation sells non-big assets to Buyer for cash; Buyer gets step-up in basis.
(2) S Corporation distributes proceeds from sale to shareholders (or Buyer increases purchase price for stock).
(3) Shareholders sell S Corporation stock to Buyer; no §338(h)(10) election is made.
Shareholders
S Corporation
Page 38
Other planning considerations
Page 39 Acquisitions of closely held businesses
Taxable income planning
Eliminate indebtedness of QSub to parent prior to termination of S electionPlanning for income and expense recognition
Pre- or post-acquisitionTiming of compensatory deductions
Page 40 Acquisitions of closely held businesses
Contract considerations
Gross-up for incremental cost associated with Section 338 (h)(10)
Should be addressed in letter of intent
Section 1362(f) reliefResponsibility for filing final S corporation returnSigning of final S corporation returnRefund of Section 7519 deposit (and making of deposit if necessary)ElectionsIndemnificationsWorking-capital considerations
Page 41
Mergers & acquisitions with partnerships
Page 42 Acquisitions of closely held businesses
Partnership transactions
Acquisition of a business owned in partnership solution:Taxpayer does not own an interest in the existing partnership.Taxpayer does own an interest in the existing partnership.
Acquisition of a partial interest in a business:Acquisition is of an interest in an existing partnership.Acquisition is of a partial interest in a business (forming a new partnership and dealing with the anti-churning rules).
Page 43
Acquisition of a business owned in partnership solution
Page 44 Acquisitions of closely held businesses
Acquisition of a partnership (no pre-existing ownership)
Target
Assets
Partner A Partner B
Buyer
Page 45 Acquisitions of closely held businesses
Acquisition of a partnership (pre-existing ownership)
Target
Assets
Partner A Buyer
Page 46 Acquisitions of closely held businesses
Acquisition of a partnership (pre-existing ownership)
Target
Partner A Buyer
Partial liquidation
From whom does Buyer acquire the purchased assets? Does it matter?
Page 47
Acquisition of an interest in an existing partnership
Page 48 Acquisitions of closely held businesses
Basic considerations and traps for the unwary
Amendment to partnership agreementInheriting your predecessor’s economic and tax attributes
Capital account, operating and liquidating distribution waterfallTax allocations: catch-up allocations, minimum gain, Section 704(c) built-in gain (and method)
Section 754 electionMechanics of Section 743 adjustment/interaction with Section 704(c)Built-in loss and mandatory adjustments
Partnership terminations Restart depreciationShort-period returns and new electionsConsequences to lower-tier partnerships
Page 49 Acquisitions of closely held businesses
Basic considerations and traps for the unwary
Section 706Intra-year allocations and permissible methodsPartnership year end change?
Section 706 — rules governing partnership year end based on year end of partnersMajority interest/principal partners/lease aggregate deferralSpecial rules for certain foreign and tax-exempt partners
Required change from cash to accrual method?Partnership generally prevented by Section 448 from using cash method of accounting if a C corporation is a partnerException for certain “small partnerships” meeting $5M gross receipts test
Entity-level taxes (withholding, employment, state, etc.)Tax protection agreementsCash contributions and related distributions
If newly admitted partner contributing cash and if related cash distribution to one or more existing partners, consider application of disguised-sale rules
Page 50
Acquisition of a partial interest in a business: dealing with the anti-churning rules
Page 51 Acquisitions of closely held businesses
Step 1: partnership formation
Seller
Seller Sub
5% interest in Target
$600m assets
Buyer
LLC
Page 52 Acquisitions of closely held businesses
Step 2: interest purchase
Seller Sub
LLC
70% interest in Target*
$420m cash
* Seller and Seller Sub own 30% combined going forward. $600m assets
Seller
Buyer
Page 53 Acquisitions of closely held businesses
Step 2a: partnership borrowing
Seller
Seller Sub
5%
95%
Note
$400m
$600m assets
Buyer
LLCBank
Page 54 Acquisitions of closely held businesses
Step 3a: debt-financed distribution
Seller
Seller Sub
5%
LLC Bank
95%
$400m note
$20m cash
$380m cash
$600m assets
Buyer
Page 55 Acquisitions of closely held businesses
Step 4a: interest purchase
Seller Sub
LLC Bank$400m note
70% interest in Target*
$140m cash
$380m cash*
$20m cash*
* Seller and Seller Sub own 30% combined going forward. $600m assets
Seller
Buyer
Page 56 Acquisitions of closely held businesses
Resulting structure
30%*
$400m note
70%
$520m cash*
$20m cash*
$600m assets* Seller and Seller Sub own
30% combined going forward.
Seller
Seller Sub
Buyer
LLC Bank
Page 57
Questions?