M&A Tax Considerations for Buyers and Sellers When

M&A Tax Considerations for Buyers and

Sellers When Negotiating, Structuring

and Pricing Deals

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, APRIL 22, 2015

Presenting a live 90-minute webinar with interactive Q&A

Jonathan Golub, Attorney, Royse Law Firm, Palo Alto, Calif.

Michael Kross, Senior Director, BDO USA, LLP, San Francisco

Roger Royse, Attorney, Royse Law Firm, Palo Alto, Calif.

The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening

is no longer permitted.

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-888-450-9970 and enter your PIN when prompted. Otherwise, please

send us a chat or e-mail [email protected] immediately so we can address the

problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

NOTE: If you are seeking CPE credit, you must listen via your computer — phone

listening is no longer permitted.

Viewing Quality

To maximize your screen, press the F11 key on your keyboard. To exit full screen,

press the F11 key again.

FOR LIVE EVENT ONLY

Continuing Education Credits

For CLE credits, please let us know how many people are listening online by

completing each of the following steps:

• Close the notification box

• In the chat box, type (1) your company name and (2) the number of

attendees at your location

• Click the SEND button beside the box

For CPE credits, attendees must listen throughout the program, including the Q &

A session, and record verification codes in the corresponding spaces found on the

CPE form, in order to qualify for full continuing education credits. Strafford is

required to monitor attendance.

If you have not printed out the “CPE Form,” please print it now (see “Handouts”

tab in “Conference Materials” box on left-hand side of your computer screen).

Please refer to the instructions emailed to registrants for additional information.

If you have any questions, please contact Customer Service at 1-800-926-7926

ext. 10.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the ^ symbol next to “Conference Materials” in the middle of the left-

hand column on your screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a

PDF of the slides for today's program.

• Double click on the PDF and a separate page will open.

• Print the slides by clicking on the printer icon.

FOR LIVE EVENT ONLY

M&A TAX CONSIDERATIONS FOR

BUYERS AND SELLERS

IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.

Royse Law Firm, PC Palo Alto, San Francisco www.rogerroyse.com www.rroyselaw.com Skype: roger.royse Twitter @rroyse00

April 22, 2015

Roger Royse (650) 813-9700 Ext 201 [email protected]

Jonathan Golub (650) 813-9700 Ext 208 [email protected]

http://www.rogerroyse.com/

http://www.rroyselaw.com/

mailto:[email protected]

mailto:[email protected]

OVERVIEW OF TRANSACTIONS • Tax Free Reorganizations:

– Type A – Merger

– Type B – Stock for Stock

– Type C – Stock for Assets

– Type D – Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations

– Type E – Recapitalizations

• Compensation Issues

• Taxable Transactions: – Stock Sale

– Asset Sale

• S Corporation Strategies

• Use of LLCs

• Foreign Corporations

6

TAXABLE VS. TAX FREE

• Type of Acquisition Currency – Stock – Securities/Debt – Deferred payments, earn outs – Compensatory

• Nature of the Buyers and Seller – Foreign Parties – Tax Attributes of Parties

• Shareholder Level Considerations – Tax Sensitivity of Shareholders – Appetite for Complexity & Risk

7

CONTINUITY OF INTEREST

8

• IRS – 50% Safe Harbor, Rev. Proc. 77-37 • IRS – 40% in Temp. Reg. 1.368-1T(e)(2)(v), example (1) • John A. Nelson – 38% Stock • Miller v. CIR – 25% Stock • Kass v. CIR – 16% Stock is Insufficient • 2011 Regulations address changes in value between the date of

signing and close; – if fixed consideration (Consideration is “fixed” if contract states exact number of shares

and other cash or property to be exchanged) • Consideration is valued as of last business day before the first day the contract is binding and • If a portion of the fixed consideration is other property identified by value, then the specified

value is used for that portion (see Reg. 1.368-1(e)(2)). – 2011 Proposed Regulations (Prop. Reg. 1.368-1(e)(2)(vi)) – consideration that varies as

the value of issuing corporation stock changes prior to closing will not fall below (or above) contractual floor (or ceiling) markers for purposes of continuity of interest. If binding contract uses average value of issuing corporation stock that average value can be used for continuity of interest.

• Post transaction sales and redemptions

TAX FREE REORGANIZATIONS

• Type A – Merger • Type B – Stock for Stock • Type C – Stock for Assets • Type D – Spin Off, Split Off, Split Up, and Type D

Acquisitive Reorganizations • Type E - Recapitalizations

• Ruling Guidelines – Rev. Rul. 77-37 – Rev. Proc. 86-42 – Rev. Rul. 73-54 (terms) – Rev. Proc. 89-50 – Rev. Proc. 96-30 (Type D Checklist)

9

TYPE A REORGANIZATIONS – SECTION 368(a)(1)(A) STATUTORY MERGER

Requirements: • Necessary Continuity of Interest • Business Purpose • Continuity of Business Enterprise • Plan of Reorganization • Net Value

Tax Effect: • Shareholders – Gain recognized to the extent of boot • Target – No gain recognition • Acquiror takes Target’s basis in assets plus gain

recognized by Shareholders • Busted Merger – taxable asset sale followed by

liquidation

• Statutory Merger – 2 or more corporations combined and only one survives (Rev. Rul. 2000-5)

• Requires strict compliance with statute

• Target can be foreign; Reg. 1.368-2(b)(1)(ii)

• No “substantially all” requirement

• No “solely for voting stock” requirement

Target Acquiror

Shareholders

10

TYPE B REORGANIZATIONS – SECTION 368(a)(1)(B) STOCK FOR STOCK

11

• Acquisition of stock of Target, by Acquiror in exchange for Acquiror voting stock

• Acquiror needs control of Target immediately after the acquisition

• Control = 80% by vote and 80% of each class

Target Acquiror

Shareholders

• Acquiror’s basis in Target stock is the same as the Shareholder’s Solely for voting stock

• No Boot in a B

• Reorganization Expenses – distinguish between Target expenses and Target Shareholder expenses (Rev. Rul. 73-54)

• Creeping B – old and cold stock purchased for cash should not be integrated with stock exchange

TYPE C REORGANIZATIONS – SECTION 368(a)(1)(C) STOCK FOR ASSETS

12

• Acquisition of substantially all of the assets of Target, by Acquiror in exchange for Acquiror voting stock

• “Substantially All” – at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets

• Target must liquidate in the reorganization

• 20% Boot Exception – Acquiror can pay boot (non-stock) for Target assets, up to 20% of total consideration; liabilities assumed are not considered boot unless other boot exists

Target Acquiror

Shareholders

Target Assets

Acquiror Stock

Acquiror Stock

• Reorganization Expenses – Aquiror may assume expenses (Rev. Rul. 73-54)

• Assumption of stock options not boot

• Bridge loans by Acquiror are boot

• Redemptions and Dividends – who pays and source of funds

TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) DIVISIVE SPIN OFF, SPLIT OFF,

SPLIT UP

13

• Divisive – transfer by a corporation of all or part of its assets to another corporation if, immediately after the transfer, the transferor or its shareholders are in control of the transferee corporation. • Stock or securities of the transferee must be distributed under the plan in a

transaction that qualifies under Section 354, 355, or 356.

Transferor Transferee

Shareholders

Transferee Stock

Transferee Stock

Transferor Assets

TYPE D REORGANIZATIONS – SECTION 368(a)(1)(D) NON-DIVISIVE

14

• If shareholders of Transferor stock receive Acquiror stock and own at least 50% of Acquiror stock, the transaction may be treated as a non-divisive D REORG even if it fails as an A REORG for lack of continuity

Transferor Acquiror

Shareholders with 20%

Acquiror Stock

Acquiror Stock

Transferor Assets Merger

Merger Treated as Acquisitive D

Failed Type C Treated as D

Shareholders

Transferor Acquiror Assets

Cash & Stock

Liquidation / Reincorporation

Shareholders

Transferor Acquiror

NET VALUE RULES

15

• 2005 Proposed Regulation 1.368-1(b)(1): Exchange of no net value (liabilities exceed value) does not qualify as a reorganization

• Example:

– Acquiror owns all of the stock of both Merger Sub and Target. Target has assets with FMV of $100 and liabilities of $160, all of which are owed to B. Target transfers all of its assets to S in exchange for the assumption of Target’s liabilities, and Target dissolves. The obligation to B is outstanding immediately after the transfer. Acquiror receives nothing in exchange for its Target stock.

• Explanation:

– Under paragraph (f)(2)(i) of the Reg, Target does not surrender net value because the FMV of the property transferred by Target ($100) does not exceed the sum of the amount of liabilities of Target assumed by Merger Sub in connection with the exchange ($160). Therefore, under paragraph (f) of the Reg., there is no exchange of net value. See Prop. Reg. 1.368-1(f)(5) Example 3.

• Alabama Asphalt

NON-QUALIFIED PREFERRED STOCK

16

• Preferred Stock – limited and preferred as to dividends; and does not participate in corporate growth if: – (1) shareholder has right to require issuer to redeem

– (2) issuer is required to redeem

– (3) issuer has right to redeem and is more likely than not to exercise that right; or

– (4) dividend rate varies based on interest rate, or commodity price or other index

• Redemption right exercisable within 20 years and not subject to contingency that renders likelihood remote

• Excludes stock compensation that may be repurchased on separation from service

• Conversion feature not enough to participate in growth

• Generally treated as boot to shareholders

TRIANGULAR OR SUBSIDIARY MERGERS

17

2. Reverse Subsidiary Merger

Target Acquiror

Merger Sub

Acquiror Target

Merger Sub

1. Forward Subsidiary Merger


18

Section 368(a)(2)(D) Forward Triangular Merger

• A statutory merger of Target into Merger Sub (at least 80% owned by Merger Sub)

• Substantially all of Target’s assets acquired by Merger Sub

• Would have been a good Type A merger if Target had merged into Merger Sub

Target Acquiror

Target Shareholders

80%

Tax Consequences • Merger Sub takes Target’s

basis in assets increased by gain recognized by Target

• Acquiror takes “drop down” basis in stock of Merger Sub (same as asset basis)

Merger Sub


19

Section 368(a)(2)(E) Reverse Triangular Merger

• Merger of Merger Sub into Target where – (i) Target shareholders surrender control (80% of voting and nonvoting classes of stock) for

Acquiror voting stock and

– (ii) Target holds substantially all the assets of Target and Merger Sub

– Shareholder loan issues

Target Acquiror

Target Shareholders

80%

Tax Consequences • Non-taxable to Target and carryover

basis • No gain to Acquiror and Merger Sub

under Sections 1032 and 361 • No gain to Target shareholders except

to the extent of boot • Acquiror’s basis in Target stock

generally is the asset basis, but Acquiror can choose to take Target shareholders basis in stock (if it is also a B)

• If transaction is also a 351, Acquiror can use Target shareholders’ basis plus gain

Merger Sub

DOUBLE MERGER

20

Acquiror

Target Shareholders

Step 2: A-type Forward Merger Step 1: Reverse Triangular Merger

Target Acquiror

Merger Sub

Target Shareholders

80%

Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger.

REV. RUL. 2001-46

Merger Sub Target+Sub

Merger Sub Survives

Slide Intentionally Left Blank

DOUBLE MERGER – WHOLLY OWNED LLC

22

Target+Sub

Acquiror

LLC

Merger LLC Survives

Step 2: A-type Forward Merger Step 1: Reverse Triangular Merger

Target Acquiror

Merger Sub

Target Shareholders

80%

Second step is merger into LLC under Reg 1.368-2(b)(1) (good forward merger)

REV. RUL. 2001-46

Target Shareholders

TYPE E REORGANIZATIONS – SECTION 368(a)(1)(E) RECAPITALIZATIONS

• Useful for single company restructuring

• Often used to transfer control of a company from one generation to the next

• Typical situation = founders of business want to pass on control to children. They engage in a Type E recapitalization to change their voting common stock to non-voting common stock or preferred stock, leaving children with voting control of the company

– There may be estate and/or gift tax consequences to such a transaction

• An important requirement to qualify for tax free treatment under a Type E recapitalization is that the old stock/securities must have the same value as the new stock/securities for which they are exchanged

– A recent IRS Memo (Legal Advice Issued by Field Attorneys 20131601F) stated that where the value of the stock received was in excess of the value of the stock surrendered, there was no Type E recapitalization and therefore the excess amount of stock received was taxable

23

VOTING POWER

Issues to consider in calculating voting power:

“Control” relevant in sections 269, 304, 355(e), 368, 382, 957 and 1504

• What sort of capital structure does the company have? For example:

– One or more classes of stock with the same voting rights;

– Separate classes of stock that vote for different directors;

– Separate classes with a different number votes per share;

– Supermajority provisions;

– Veto powers.

• How do you determine voting power when shareholders have agreement on voting?

– e.g. shareholders agree to abstain from voting, vote together, or transfer shares to a voting trust

• How do you determine voting power with regard to foreign entities that are treated as a corporation for U.S. tax purposes?

24

PROPOSED REGULATIONS ON LOSS IMPORTATION

• General Rule: The acquirer's basis in assets acquired under Section 368 is usually the transferor’s basis

– Section 362(e)(1) provides an exception for assets with built-in losses on the date of the transfer

– The IRS has issued Proposed Regulations explaining how these “anti-loss importation” rules apply (also applies to Section 334(b) transactions)

• Under the Proposed Regulations, if the aggregate basis of all “Importation Property” is greater than the aggregate value of such property then the basis of all the Importation Property is its value on the date of transfer

– Importation Property is property where:

• (1) the gain or loss is not subject to US tax in the hands of the transferor on a hypothetical sale immediately before the transfer; and

• (2) the gain or loss is subject to US tax in the hands of the transferee on a hypothetical sale immediately after the transfer

25

PROPOSED REGULATIONS ON LOSS IMPORTATION

Issues to Consider

• Flow-through entities

– For flow-through entities such as a partnerships or S Corps, the importation property test is made by reference to the partners or shareholders, not the entity itself

– The hypothetical sale will consider allocations of gains and losses as per the organizing instrument

– The Proposed Regulations contain an anti-avoidance principal for REITs and RICs which applies the look-through principal above if the REIT/RIC acquired the property as part of a plan to avoid the anti-importation rules

• Controlled Foreign Companies (CFCs) and Passive Foreign Investment Companies (PFICs)

– Under the Importation Property test, a gain or loss on the sale of an asset by a PFIC or CFC is not considered subject to US tax even though it may result in an inclusion under Section 951(a)

– The IRS is aware of the issue and has invited comments

26

TARGET DEBT SECURITIES

27

• Exchange of Target securities for Acquiror securities is tax free under Sections 354 and 356, to the extent that the principal amount of Acquiror debt is less than the principal amount of Target debt

• Portion attributable to cash basis accrued interest is taxable

• Possible COD income

– Example: • Target bonds with an issue price (stated principal amount) of

$1,000 exchanged for Acquiror stock or debt worth $900; Target has COD of $100

DIVIDEND EQUIVALENCY

28

• Section 356(a)(2) – Boot as dividend or capital gain; post-reorganization redemption test of Rev. Rul. 93-61

• Clark – hypothetical post-reorganization redemption reduced shareholder’s interest from 1.32% to .92% - substantially disproportionate under Section 302(b)(2)

• Section 302(b)(1) – redemption that results in meaningful reduction in voting power is redemption and not essentially equivalent to a dividend

• Section 302(b)(2) – greater than 20% reduction is substantially disproportionate

• E&P Limitation on Dividend – should be Target’s E&P but unclear if Merger Sub’s E&P counted; PLR 9118025, PLR 9041086, and PLR 9039029

CONTINGENT STOCK, ESCROWS, AND EARN-OUTS

29

• Escrows: – Target shareholders usually treated as owner of escrowed Acquiror shares unless

otherwise agreed – Especially true if Target shareholders have right to vote and receive dividends – Not clear who is owner if Target shareholders do not have right to vote or receive

dividends

• Earn-Out Stock: – Target shareholders not considered owners until Acquiror shares are issued – Not treated as boot – Imputed Interest

• Rev. Proc. 84-42 Ruling Guidelines – use of escrow or contingent stock – (1) stock must be distributed within 5 years, subject to escrow or contingency – (2) valid business purpose – (3) maximum number of shares cannot exceed 50% – (4) trigger event not controlled by Target shareholders and not based on tax liability – (5) Formula is objective and readily ascertainable – (6) Restrictions on assignment and substitution – (7) In the case of escrows, Acquiror shares shown as issued to Target shareholders,

current voting and dividend rights, and vested

UNVESTED STOCK RECEIVED IN A TAXABLE OR NON-TAXABLE DEAL

30

• Rev. Rul. 2007-49 - The revenue ruling addresses: – (1) the exchange of fully vested stock for unvested stock of an

acquiring corporation in a tax-free reorganization, and

– (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange

• Under either (1) or (2), the Rev. Rul. provides that the exchange constitutes a transfer of property subject to Section 83. – The service provider would need to file an 83(b) election to avoid

the recognition of compensation income in the future as the shares vest.

– The Rev. Rul. also provides that the spread will be zero, so there is no downside to the service provider’s 83(b) election.

OPTIONS

31

• Assumption or Substitution

– No tax on substitution of NSO

– No tax on substitution of ISO, so long as the substitution is not a modification. There is no “modification” so long as:

• (1) the aggregate spread in new option does not exceed the spread in the old; and

• (2) the new option does not have more favorable terms than the old; see Sections 424(a) and 424(h)(3)

OPTIONS – CASH OUT

32

• Cancel options for cash payment

– NSO • Ordinary income – compensation – withholding or 1099

• Deduction to Target or Acquiror? – TAM 9024002 – employer deducts based on method of accounting; not clear if cash

out at close is pre-acquisition Target deduction or post-close Acquiror deduction in absence of scripting the timing

– Under the cash method, the deduction generally arises when the employer has “paid” the property to the employee. See Regs. §1.461-1(a)(1). Under the accrual method, the deduction arises when the employer's obligation to make the property transfer becomes fixed, the property's value is determinable and economic performance occurs. See Regs. §§1.461-1(a)(2) and -4(d)(2)(iii)(B)

– ISO • FICA

• Exercise and disqualifying disposition treated differently

409A

33

• Deferred compensation

— A deferral of compensation occurs whenever the service provider (employee) has a legally binding right during a taxable year to compensation that will be paid to such person in a later year. Treasury Regulation Section 1.409A-1(b)

• Consequences of violating 409A

— Amounts which were to be deferred are subject to immediate taxation

— Additional 20% penalty on such amounts

— Interest penalty

— CA state tax penalty

• Bonus or Carve Out Plans

• Participation in Earn Outs (Reg. 1.409A-3(i)(5)(iv))

— Payments of compensation in this context may be treated as paid at a designated date or pursuant to a schedule that complies with 409A if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally pursuant to the change in control event

280G GOLDEN PARACHUTE RULES

34

• 20% excise tax and loss of deduction on Excess Parachute Payment – “Excess Parachute Payment” means the amount by which the Parachute Payment

exceeds the Base Amount

– “Parachute Payment” means a payment, the present value of which, exceeds three times the Base Amount

– “Base Amount” means the average annual compensation for past 5 years

– Must be paid to a disqualified individual (meaning employee, officer, shareholder, or highly compensated individual)

– As compensation, AND

– Contingent on a change in control (50% change ownership or effective control, or ownership change in a substantial portion of the company’s assets)

• Reduce Excess for reasonable compensation

• Exclude reasonable compensation for future services

• Exception for small business corporation and non publicly traded corporation that has 75% uninterested shareholder approval

• Withholding requirement

280G – OTHER ISSUES

35

• Non-Publicly Traded Stock

– Approval of 75% of shareholders after adequate disclosure

– Vote determines the right of the shareholder to the payment

– Ignore shares held by persons receiving the payment

• Reduction for Excess (299% of payments)

WARRANT TERMINATION PAYMENTS

36

• Companies frequently grant stock warrants to investors

• Stock warrants are often held for many years before being exercised, however the holding period for the stock does not start until the date of exercise

– Stock therefore needs to be held for another year after exercise to get long term capital gains treatment

• However, if the stock warrant is terminated instead of being exercised then any gain on the warrant termination payment is treated as gain on the sale of the warrant

– The holding period is the holding period of the warrant

– The warrant shall have the same character as the underlying asset

TAXABLE STOCK PURCHASES

37

Cash Reverse Triangular Merger

• Treated as Stock Sale

• Shareholders have gain or loss

• Acquiror takes cost basis in Target shares

Merger Sub

Target Shareholders

Target Acquiror

PERSONAL GOODWILL

• Key questions: (1) Who owns the goodwill (individual or company)? And (2) Was that goodwill ever transferred?

• Two key cases:

– Bross Trucking, Inc. – goodwill may be transferred to a company via an employment contract if that employment contract grants the company a right to future services (e.g., through a non-compete provision)

• Note: non-compete provisions are generally invalid in California absent the sale of a business

– Martin Ice Cream – the court held that customer relationships and distribution lists were an asset of the shareholder because they were never transferred to the company (the business began as a sole proprietorship and then part of the business was specifically transferred to a new company)

38

PERSONAL GOODWILL

• Issues:

– Is a buy/sell non-compete sufficient to satisfy the right to future services?

• What does the scope of the non-compete need to be? (geographic area, time, etc.)

– Is a fiduciary obligation not to compete sufficient?

– Is a non-solicitation and/or non-use of trade secrets provision sufficient?

• Best practice = shareholders should sell their “personal goodwill” separate from the stock/asset sale

39

QSBS ISSUE FOR CASH FREE STOCK SALES

• Target companies may be acquired on a cash free/debt free basis, however this often necessitates a cash dividend to shareholders immediately prior to the sale

• During negotiations, both Acquiror and Target shareholders typically treat this dividend as part of the acquisition price, however the form of the transaction is a dividend

• This pre-sale dividend can create problems for shareholders’ QSBS relief:

– Under the QSBS rules, the maximum taxable gain considered available for relief is the higher of $10 million or ten times stock basis

– If the dividend payment is treated as a pre-sale distribution then it will reduce the basis of the stock and may therefore reduce the amount of gain available for QSBS relief

• Taxpayer may choose to file on the basis that the dividend is, in substance, part of the sale proceeds, however this could be subject to challenge by the tax authorities

40

CASH FORWARD MERGER

41

Asset Sale Followed by Liquidation of Target

• Target has gain on sale

• Target shareholders have gain on liquidation (unless 332 applies)

• Acquiror takes cost basis in Target assets

• S corporations with no h10 election

Target Shareholders

Merger Acquiror Survives

Target Shareholders

Variation with Merger Sub:

Target

Target

Acquiror

Acquiror

Merger Sub

SECTION 382 – LIMITATION ON LOSSES AFTER CHANGE IN OWNERSHIP

42

• Section 381 – Survival of Tax Attributes

• Section 382 – When there has been an ownership change of a

corporation with loss carry forwards, use of Net Operating Losses (NOLs) against future income is limited to the product of the value of the Target and the long term interest rate.

– “Ownership Change” occurs if, within a 3 year testing period, the percentage of stock of Target held by 5 Percent Shareholders increases by more than 50% over lowest percentage held by such shareholders during the test period.

BUSTED 351

43

Shareholders Target Shareholder

Business

Acquiror

Target

Stock

Merger

Acquiror

Stock

Rev. Ruling 70-140

Weikel v CIR, 51 TCM 432 (1986)

Substantial business purpose Step 1: Incorporate Target Step 2: Merge Target into Acquiror

USE OF WHOLLY OWNED LLC

44

Target Acquiror

LLC

T Shareholders

Merger of Corporation into LLC • Reg. 1.368-2(b)(1) – by operation of law, all assets and liabilities of

Target become those of LLC, and Target ceases legal existence • A Type Reorganization

“CHECK AND MERGE” TRANSACTION

45

• The Code provides for tax-free mergers of corporations into other corporations and partnerships into other partnerships, but there is no provision for a tax free merger of a partnership (or an LLC taxable as a partnership) into a corporation

• Two-step check and merge process:

– (1) the LLC elects to change its entity classification from a partnership to a corporation; and

– (2) the LLC (now taxable as a corporation) merges into another corporation

• Will the step-transaction doctrine merge the two steps?

– An entity classification does not need a business purpose and applies to all parts of the Code including the step transaction doctrine (Reg. 301.7701-3(g)(2)(i))

– Courts have to respect the entity classification election and therefore the two steps should be respected

• 351 “holding” requirement problem

SECTION 351 / 721 ROLLOVER

46

Target

Target Shareholders

PEG

• 80% vote & value • Taxation of boot • Debt + non-qualified

voting stock • Assumption of liabilities

Cash out some and rollover

Target

Target

Target Shareholders PEG

PEG

NewCo

NewCo

Target Shareholders

Target Shares

Cash

Cash

Cash

Cash

Cash Assets

Assets

LLC TECHNIQUES

47

Acquiror

Step 1 Step 2

LLC

Former Target Shareholders

Target

$

Target

Target Corp.

LLC

T Shareholders

1. Cherry picking consideration

2. Partial purchase of shares or put/calls

3. Collapsing investor groups into one owner

INSTALLMENT METHOD

48

• Gain on each payment = gross profit ratio times payment – Gross profit ratio = ratio of total gain to purchase price

– Pre-transaction planning opportunities to utilize basis

• Section 453A – interest charge to the extent taxpayer holds more than $5 million face amount of Section 453 obligations

• Section 453 Limits – Not available for publicly held stock or securities, or inventory

– Not available for sales for demand notes or readily tradable notes

– Not available for instruments secured by cash or cash equivalents

– Obligor must be purchaser (cannot use parent debt)

• Section 453 applies unless taxpayer affirmatively elects out

• Section 453(h) – Target shareholders who receive Acquiror debt in liquidation of Target allowed to use installment reporting

CONTINGENT PAYMENTS AND EARN-OUTS

49

• Distinguish Equity vs. Debt • 3 Issues

– (1) allocation between interest and sales proceeds; – (2) timing of realization of sales proceeds; and – (3) timing of basis recovery

• Interest – 1.1275-4(b)

• Contingent payment debt for cash or publicly traded property – use non-contingent bond method; projected non-contingent and contingent payments

– 1.1275-4(c) • Contingent debt instrument issued for non-publicly traded property –

bifurcate into non-contingent debt instrument and contingent debt instrument; contingent payment treated as principal based on present value, excess is interest

• Buyer’s basis is non-contingent portion plus contingent payments treated as principal

CONTINGENT PAYMENTS AND GAIN RECOGNITION

50

Reg. 15A.453-1(c)

• If capped by maximum amounts, assume maximum for purposes of gross profit percentage (accelerates gain, backloads basis) – If no cap, but term, basis recovered ratably over term

– If neither time nor amount is capped, basis recovered ratably over 15 years

• Election out of Section 453 – FMV of contingent obligation is amount realized

• Open transaction treatment – rare and extraordinary situations only

SECTION 338 ELECTION

51

• Section 338(g) – Target in stock sale treated as selling all its assets followed by liquidation post close (soaks up NOLs)

• Section 338(h)(10) – Sale and liquidation deemed to occur pre-close; joint election; S corporation or sale out of a consolidated group

• Adjusted Grossed-Up Basis – New Asset basis is basis in recently purchased stock (last 12 months) grossed up to reflect minority shareholder’s basis + liabilities of Target (including taxes in 338(g))

• Adjusted Deemed Sale Price – grossed up amount realized of recently purchased stock plus liabilities of old T (on day after acquisition date)

Partnership Structure with Profits Interest

52

Target

Acquisition Structure:

Hold Co, LLC

Post Acquisition:

Target converts to wholly-owned LLC - treated as a tax-free liquidation into Hold Co, LLC if a single member LLC

Target Shareholders

100%

100% 100%

Merger

$$

Merger Co

Acquiror

Hold Co, LLC

Target Shareholders 100% less

profits interest

100%

Issuance of unvested profits

interest

Acquiror

Target, LLC

338(g) ELECTIONS

53

• If there is a US Buyer of a foreign owned foreign target, then 338(g) election steps up basis and eliminates E&P and foreign tax credits

• Target may be able to offset 338(g) gains with NOLs

PURCHASE PRICE ALLOCATION

54

• Asset Sale or 338 Election – Sections 1060 and 338 classes based on FMV – Class I – cash and equivalents – Class II – actively traded personal property under 1092 – Class III – debt instruments and marked to market – Class IV – inventory – Class V – assets other than those in I-IV or VI – Class VI – goodwill and going concern

• Agreement Allocations – Danielson Rule – Parties bound by agreement unless IRS determines that the allocation

is NOT appropriate

• SFAS 141R – Purchase Price Allocations – Assets booked at FMV as of closing date (not signing date) – Bargain purchase results in accounting gain – Earn Outs – estimated and recorded – Deferred tax assets for excess tax deductible goodwill over book value – Transaction related costs recognized (expensed)

S CORPORATIONS AND 338(h)(10)

55

T (S Corp) Acquiror

Merger Sub

Target Shareholders

• Character difference – ordinary income assets

• California 1.5% tax on S corporations

• All Target shareholders must consent on Form 8023

• Deemed 338 election for subsidiaries

• 1374 – BIG Tax • Minority shareholders in rollover • Hidden tax in liquidation or

deemed liquidation in installment sale.

• 3.8% NIIT Tax

S CORP 338(h)(10) ELECTION AND 453B(h) BASIS ALLOCATION ISSUE

56

• Gain to Shareholders in year of sale: $1 million x 80% = $800,000; A/B of Shareholder = $1.8 million

• No 331 liquidation: $1 million cash decreases A/B by $1 million to $800,000; $800,000 A/B in Note = $3.2 million gain

• 331 liquidation – apportion basis: $1.8 million basis apportioned $360,000 to cash and $1,440,000 to Note; Gain in cash of $640,000 and gain in note of $2,560,000 for a total of $3.2 million gain (GP % on liquidation is 64%)

• Defer cash portion and include in installment obligation: gain on liquidation equal to zero; Shareholder A/B in note of $1 million; profit % is 80%

Target Acquiror

Shareholders

$1 million cash $4 million 453 Note

Stock Sale

$1 million basis

Cash - $1 million / $1 million A/B Assets - $4 million / zero A/B

Reg. 1.338(h)(10) – 1(e) Example 10

S CORP NO 338(h)(10) ELECTION – DISAPPEARING BASIS

57

Liquidate Target into Merger Sub or check the

box Q-Sub

T (S Corp) Acquiror

Merger Sub

T Shareholders

Carryover Basis

S CORP INVESTMENT STRUCTURE

58

Holdings, Inc. (S Corp)

Target, Inc. (QSSS)

T Shareholders

Step One:


Target, LLC (QSSS)

Step Two:

T Shareholders


Target, LLC (QSSS)

T Shareholders

Step Three:

Investor

$$

Membership interest

Step One: Shareholders of Target, Inc. transfer all Target, Inc. stock to Holdings, Inc. in

exchange for Holdings, Inc. stock. Holdings, Inc. makes an S election and Target, Inc.

elects to be treated as a qualified subchapter S subsidiary (QSSS).

Step Two: Target, Inc. converts to an LLC for state law purposes (Target, LLC).

Step Three: Investor purchases a membership interest in Target, LLC from Holdings,

Inc.


Section 336(e)

60

Acquiror

Shareholder $

Target Stock

Basic Model (for stock sales): Target is treated as selling all of its assets to an

unrelated person while owned by its former shareholders and then reacquiring

same upon acquisition by Acquiror.

$

$ Assets

Assets

= Actual

Component

= Deemed

Component

Acquiror Shareholder

Target Target 3rd Party

Section 336(e) does not apply to sales to a “related person.” The attribution

rules could give rise to an unexpected “related person” situation where the

seller acquires at least 5% of the acquiring partnership as part of the

transaction. For example, where an investment partnership acquires a target

and provides a modest partnership interest to the selling shareholders.

FOREIGN CORPORATIONS

61

• Section 367(a) – outbound transactions – Foreign corporation not treated as a corporation except as provided in

regulations

– Generally, gain recognized unless: • No more than 50% of stock of foreign Acquiror received by US transferors,

• No more than 50% of stock of foreign Acquiror owned after the transfer by US persons that are officers or directors or 5% Target shareholders,

• Gain Recognition Agreement ("GRA") is entered into by 5% US transferee shareholders

• 36 month active trade or business test met,

• No intent to substantially dispose of or discontinue such trade or business,

• FMV of the assets of transferee must be at least equal to the FMV of the US target, and

• Tax reporting

• Section 367(b) – inbound and foreign to foreign transfers – US Acquiror and foreign Target

• Target can be treated as a corporation

• May be income to Target’s US shareholders to extent of Target’s accumulated E&P


62

• Anti-Inversion Rules – tax outbound reorganization and/or tax foreign Acquiror as a U.S. taxpayer; Code Section 7874

– If ownership of former U.S. Target shareholders in foreign Acquiror is 80% or more; foreign Acquiror is treated as a U.S. company

– If ownership continuity is between 60-80%; foreign Acquiror is NOT treated as a U.S. company, but U.S. tax attributes cannot be used to offset gains

– 20% excise tax on stock-based compensation upon certain corporate inversion transactions

– 7874 exception available for companies with “substantial business activities” in the foreign jurisdiction which exist when:

• (1) The number of employees and the amount of employee compensation in the foreign jurisdiction is at least 25% of the number of employees and amount of employee compensation in the total group;

• (2) The value of group assets (only tangible property held for use in the trade or business) located in the foreign jurisdiction is at least 25% of the total group assets; and

• (3) The income derived from the foreign jurisdiction is at least 25% of the group income


63

• Anti-Inversion Rules cont.

– New Regulations under Section 7874(c)(6) will disregard a portion of foreign acquiring stock where more than 50% of the foreign group property is foreign group non-qualified property

– Foreign group property is all group property except that held by the domestic target

– Foreign group non-qualified property is cash and marketable securities other than that relating to the active conduct of a banking or insurance business

• Controlled Foreign Corporations (“CFCs”)

– A foreign entity is classified as a CFC if it has “United States Shareholders” who collectively own more than 50% of the voting power or value of the company. For the purposes of the CFC rules, a “United States Shareholder” is defined as US persons holding at least a 10% interest in the foreign corporation.

1248 AMOUNT ON SALE OF CONTROLLED FOREIGN CORPORATION

64

Section 1248

• Seller of Controlled Foreign Corporation (CFC) must treat as dividend gain to extent of E&P

• 1248 inclusion carries foreign tax credits

• 1248 amount determined at year end and pro rated based on day count, so post closing events can have an effect on the 1248 amount

JOINT VENTURE STRUCTURES

65

• Section 367 Issues

• Disguised Sale – Effect of assumed

liabilities

US Company Foreign

Company

LLC

US & Foreign Assets

TRANSACTION COSTS

66

• Must capitalize “Facilitative Costs” that relate to a “Categorized Transaction” unless an exception applies

• Categorized Transactions

– (1) Acquisition of assets constituting a trade or business

– (2) Acquisition of an ownership interest in an entity if the acquirer and target are related after the transaction

– (3) Acquisition of an ownership interest in the taxpayer

– (4) Restructuring, recapitalization, or reorganization of the capital structure of the entity

– (5) A Section 351 transfer

– (6) Formation of a disregarded entity

– (7) Acquisition of capital

– (8) Stock issuance

– (9) A burrowing; and

– (10) Writing an option

TRANSACTION COSTS

67

• “Facilitative Costs”

– Costs incurred in the process of investigating or pursuing a Categorized Transaction

• Includes valuation costs and registrar and transfer agent fees

• Excludes consideration for the transaction (not a Facilitative Cost, but may be capitalized under other principles) and business integration costs

– Exceptions

• Does not include costs relating to a “Covered Transaction”

– Covered Transaction

» Taxable acquisition by the taxpayer of assets constituting a trade or business

» Taxable acquisition of ownership interest, regardless of whether taxpayer is the target or acquirer, if the two parties are related after the transaction

» Type A, B, C, or Acquisitive D reorganizations

TRANSACTION COSTS

68

• “Facilitative Costs” cont.

– Exceptions cont.

• Bright Line Date

– Unless the cost is an “Inherently Facilitative Cost” then costs incurred before the “Bright Line Date” are not Facilitative Costs

– The Bright Line Date is the earlier of: (a) the execution of the letter of intent (or similar document); or (b) the authorization of the company’s board of directors

– Inherently Facilitative Costs are: (1) valuation; (2) costs to structure the transaction; (3) draft and review of documents; (4) regulatory approval; (5) shareholder approval; and (6) conveyance of property

– Success-Based Fees

• Costs for which the obligation to pay is contingent upon a successful closing are presumed to be Facilitative Costs, however the taxpayer may overcome this presumption by maintaining sufficient documentation

• Rev. Proc. 2011-29 provides a safe harbor permitting taxpayers to treat 70% of the success-based fees as being non-Facilitative Costs and treating the remaining 30% as Facilitative Costs.

69

www.rroyselaw.com

Palo Alto 1717 Embarcadero Road

Palo Alto, CA 94303

San Francisco 135 Main Street

12th Floor San Francisco, CA 94105

BDO USA, LLP, a Delaware limited liability partnership, is the U.S.

member of BDO International Limited, a UK company limited by

guarantee, and forms part of the international BDO network of

independent member firms. BDO is the brand name for the BDO

network and for each of the BDO Member Firms.

M & A Tax Considerations for Buyers &

Sellers

Selected Tax Issues

Webinar

Michael Kross, CPA JD

[email protected]

April 22, 2015

M&A Tax Considerations for Buyers and Sellers - Selected Tax Issues

Page 71

Initial Considerations

Identify Non-Tax and Tax Goals of Each Party

Understand the Economics of the Deal

Buyer’s Perspective vs. Seller’s Perspective

Types of Consideration

Cash?

Continuing Equity Interests?

Installment Payments (Notes/Debt/Contingent)?


Page 72

Basic Tax Structuring Alternatives

Taxable Stock Acquisitions

Taxable Asset Acquisitions

Tax-Free Stock Acquisitions

Tax-Free Asset Acquisitions

Tax-Free Contribution to Capital

This presentation will principally address selected tax issues with respect to

taxable stock and taxable asset acquisitions.


Page 73

Tax Considerations in Structuring Acquisitions

Legal and Tax Structure of Target and of Purchaser (or Purchaser Group)

Legal Form of Target such as Corporation or Partnership or LLC

Tax Treatment of Target such as C Corporation, S Corporation, Partnership or Disregarded Entity

Types of Shareholders of Target (i.e., Corporate, Individual, Tax-exempt)

Legal Form of Purchaser such as Individuals, Corporation, Partnership or LLC

Tax Treatment of Purchaser such as C Corporation, S Corporation, Partnership or Disregarded

Entity

Overlap in Ownership among Owners of Target and Between Target and Purchaser

Tax Aspects of Target

Outside Tax Basis of Stock vs. Inside Tax Basis of Assets

Built-in-Gain or Built in Loss Income or Deduction Items

Tax Attributes, such as Net Operating Losses (NOLs) and Tax Credits


Page 74

Tax Considerations in Structuring Acquisition

Taxable Acquisitions vs. Tax-Free Reorganizations

Carry Over Basis to Purchaser vs. Deferral of Gain to Seller in Tax-Free Reorganization

Taxable Stock Acquisitions vs. Taxable Asset Acquisitions with C Corporations

Double Taxation of C Corporation Liquidations (since 1986 repeal of General Utilities Doctrine)

Double Taxation generally imposed on Buyers in Stock Acquisitions vs. Sellers in Asset Acquisitions

Section 338(h)(10) Elections

Qualified Stock Purchase of S Corporation or Corporate Subsidiary treated as Asset Acquisition for

Income Tax Purposes

Substance vs. Form – Step Transaction Doctrine


Page 75

Some Consolidated Return Considerations

Consolidated Return Issues when Target is Member of Consolidated Group

Deferred Intercompany Transactions

Excess Loss Accounts

Tax Sharing Agreements

Loss Carrybacks

NOL Elections

Intercompany Loans

Uniform Loss Disallowance Rules


Page 76

Taxable Acquisitions of Target

Asset acquisitions

Stock acquisitions, without Section 338(h)(10) Election

Stock acquisitions, with Section 338(h)(10) Election

Stock acquisitions, with Section 336(e) Election


Page 77

Financial Accounting (GAAP) Verses Tax

Accounting

For Financial Accounting (GAAP) purposes, purchase accounting applies and the purchase

price is generally allocated among the assets of Target to determine the beginning balance

sheet of the Target.


Page 78

Financial Accounting (GAAP) Verses Tax

Accounting

For Tax Accounting purposes, the treatment depends on the form of the transaction:

In a Stock Acquisition of the Target, the purchase price is generally allocated only to the stock of the Target and the Target (now owned by Acquirer) retains its existing tax balance sheet and tax attributes (pre-acquisition tax basis in assets, net operating losses (“NOL's”), credits, tax liabilities, etc.).

In an Asset Acquisition of Target, the purchase price is generally allocated to the purchased assets based on fair market values and Target (owned by Seller) retains tax attributes (NOL's, credits, tax liabilities, etc).

It is sometimes possible to elect “deemed” Asset Acquisition treatment for tax purposes in a Stock Acquisition (make an IRC “Section 338, 338(h)(10) election or 336(e) election”).


Page 79

Taxable Asset Acquisitions - General Tax Treatment

1. Purchaser obtains a tax basis in Target’s assets based on purchase price. (This may

produce a future tax benefit to Purchaser.)

2. Tax attributes of Target (such as NOL’s and R&D credits) stay with Seller (through its

ownership of Seller) and do not carry over to Purchaser group.

3. Pre-acquisition liabilities of Target (including income tax liabilities) remain with Target

(i.e. Seller).

4. Two levels of income tax imposed on Seller. Corporation pays income tax based on its

tax basis in sold assets (but often may use NOL’s and credits to offset gain). Seller pays

income tax based on its tax basis in Target stock.

5. Sales taxes and/or transfer taxes are generally not imposed on purchase but may be

imposed in some jurisdictions.

6. Purchaser may be deemed to assume liability for pre-acquisition indirect taxes such as

sales tax and VAT/GST.

7. Tax Accounting Methods do not generally carry over to Purchaser group.


Page 80

Tax Considerations with Taxable Asset Acquisitions

Major Tax Considerations for Seller of Assets Amount realized on disposition of each asset

Overall gain or loss

Character of gain or loss

Timing of gain or loss recognition

Tax attributes available to offset gain recognized

Major Tax Considerations for Purchaser of Assets Initial cost basis of each asset

Potential additional adjustments to the tax basis of each asset due to contingent liabilities

Cost recovery for each asset or category


Page 81

Section 1060 as It Applies to Taxable Asset

Acquisitions

Defined as any transfer (directly or indirectly)

Of assets constituting a trade or business; and

With respect to which the transferee’s basis in such assets is determined wholly by reference to the

amount of consideration paid for such assets

Consideration allocated to assets in each class subject to fair market value limitation

Allocated within each class based on relative fair market values of assets

No limitation applies to Class VII (residual class)

Form 8594 compliance


Page 82

Identification of Asset Classes for Purchase Price

Allocation to Assets under Section 1060

Class I - cash and cash equivalents

Class II - marketable securities

Class III - accounts receivable

Class IV - inventories and other property held for sale to customers

Class V - all other assets

Class VI - section 197 intangible assets other than Class VII assets

Class VII - goodwill and going concern value


Page 83

Taxable Stock Acquisitions (without 338 Elections)

- General Tax Treatment of Corporate Target

1. Purchaser obtains a tax basis in Target stock based on purchase price. (Target’s tax basis

in assets is not adjusted due to purchase.)

2. Tax attributes of Target (such as NOL's and research and development (“R&D”) credits)

carry over to Purchaser group (through its ownership of Target) but their use may be

limited.

3. Pre-acquisition liabilities of Target (including tax liabilities) attach with Target (i.e.

Purchaser).

4. One level of income tax imposed on Seller. Seller pays income tax based on Seller’s tax

basis in Target stock and tax rate.

5. Sales taxes and/or transfer taxes are generally not imposed.

6. Liability for pre-acquisition taxes, such as income taxes, sales tax and VAT/GST, attach

with Target.

7. Accounting methods of Target generally carry over to Purchaser group (through

ownership of Target) but may not if, for example, Target becomes member of

Consolidated Group



Page 85

Taxable Stock Acquisitions (without Section 338

Elections)

Major Tax Considerations for Seller of Stock Generally only one level of taxable gain.

Major Tax Considerations for Purchaser of Stock Purchased Target Corporation Generally Continues with Existing Assets and Liabilities

Tax Attributes generally carry over but may be limited

Attributes belong to corporation, and are generally transferred together with other corporate

assets

A stock transfer does not affect basis of target corporation’s assets or generally its accounting

methods

Sections 382 and 383 may limit purchaser’s ability to use acquired attributes following

ownership change


Page 86

Taxable Stock Acquisitions (without Section 338

Elections)

Taxable Year and Accounting Methods generally continue but there are

exceptions.

Consolidated Return Rules apply when Target Joins a Consolidated Group:

Target’s tax year ends (short period, closing of the books treatment of Target) when Target

becomes a member of the consolidated group.

Purchase of S Corporations:

Target’s tax year ends if Target ceases to qualify as an S corporation

(1) For example, if purchaser is a non-qualifying shareholder or Target becomes a member of

a consolidated group.

Pro-rata method of allocating items to pre and post period generally applies, but closing of the

books allocation method applies if there an exchange of 50% or more of the stock in the

corporation during such year or if all shareholders elect to apply closing of the books method to

pre and post acquisition periods.


Page 87

Taxable Stock Acquisitions (without 338 Elections)

- General Operation of Section 382 Limitations

Section 382 limitations on use of losses generally apply following an “ownership

change”.

Use of “pre-change” losses to offset “post-change” income subject to annual

section 382 limitation.

Limitations may also apply to recognized built-in losses.

Limitation generally equals the value of the loss corporation’s stock immediately

before the ownership change, multiplied by the long-term tax-exempt rate.


Page 88

Stock Acquisitions (without 338 Elections) -

General Policies of Section 382

Anti-trafficking rules - purpose of acquisition is irrelevant

An “ownership change” occurs on a testing date when the stock of the loss

corporation owned by one or more five-percent shareholders increases by more

than 50 percentage points during a testing period when compared with the lowest

ownership by each shareholder during that period

Rules for determining applicable testing period can require determining stock

ownership and stock transactions from formation of target.

Notice 2003-65, Section 338 Approach vs. Section 1374 Approach


Page 89

Stock Acquisitions (without 338 Elections)

General Operation of Section 383

Similar limitations apply to other attributes, such as:

Capital losses

Business credits

Foreign tax credits

Alternative minimum tax credits

Annual Section 382 NOL limitation must be converted to “credit equivalent”


Page 90

Taxable Stock Acquisitions (with Section 338

Elections) Deemed asset purchase and sale treatment requires Qualified stock purchase; and

Election on Form 8023

Qualified stock purchase Purchaser must be corporation

Stock meeting section 1504(a)(2) requirements must be acquired by “purchase”

Requires 12-month acquisition period

Fictions apply for most income tax purposes, but not for — Payroll tax purposes;

Information reporting purposes; or

Most employee benefit plan purposes.


Page 91

Taxable Stock Acquisitions (Section 338(g) vs.

338(h)(10) Elections)

Section 338(g) elections re-characterize old and new target transactions only Purchaser of stock has stock purchase

Sellers of stock have stock sale

The “old target” and “new target” have deemed asset purchases and sales

Very rarely made except for foreign target entities

Section 338(h)(10) election re-characterize certain seller’s transactions as well Sellers of S corporation stock have deemed taxable liquidation following deemed sale of assets

Eligible corporate sellers may have Section 332 treatment for deemed liquidation


Page 92

Taxable Stock Acquisitions (with Section

338(h)(10) Election)

1. Form is a Stock Acquisition.

2. Target is a member of a consolidated group or an “S” corporation.

3. Purchaser and Seller elect to treat acquisition as an Asset Acquisition for income tax

purposes under IRC Section 338(h)(10).

4. Purchaser generally obtains benefits of Purchase Accounting for income tax purposes.

5. Seller is subject to income tax, as if Target had sold assets and liquidated. NOL's and tax

credits remain with Seller and often may be used to offset gains and tax from deemed

asset sale.

6. Sales taxes and/or transfer taxes generally do not apply.

7. Pre-acquisition non-income tax liabilities remain with Target (now held by Purchaser).

(Note: Some exposure to income tax liabilities can also remain with Target.)


Page 93

Taxable Stock Acquisitions (Section 338(h)(10)

Election Requirements)

Qualified stock purchase of one of the following types of corporations: S corporation

Subsidiary member of consolidated group

Subsidiary member of non-consolidated affiliated group

Election on Form 8023

Joint election by all S corporation shareholders

Some states require separate state “Section 338” elections


Page 94

Benefits of Section 338(h)(10) Election to

Purchaser in a Taxable Stock Acquisition

Cost basis of assets deemed acquired

New accounting methods

New cost recovery methods

New elections

Elimination of earnings and profits

Eliminate reliance on old tax and accounting records

Tax consequences not dependent on form of transaction


Page 95

Taxable Stock Acquisitions (with Section

338(h)(10) Election) Considerations with S

Corporation Target

Consequences of an S corporation section 338(h)(10) election Deemed sale of assets by “old target” corporation, followed by liquidation

Deemed purchase of assets by “new target” corporation

Subject to built-in gains tax and state corporate level taxes for S corporations, only one level of tax is imposed on sale gains Deemed sale gain is allocated to shareholders on Schedule K-1 under normal S corporation rules

Basis increase reduces deemed liquidation gain


Page 96

Tax Free Mergers and Acquisitions

The tax treatment of tax free mergers and acquisitions is not discussed in detail in this

presentation.

In general, the purchaser in a tax free merger receives a carry over basis in the assets of the

target and the seller defers gain with respect to shares of the target it exchanges for shares

of the acquirer. The seller generally recognized income, or a taxable gain, with respect to

boot it receives in the form or cash or property.


Page 97

Liabilities of Target

In a Stock Acquisition (without a 338(h)(10) election), liabilities of the target generally

continue as liabilities of the target and are not included in the purchase price paid for the

stock of the target.

In an Asset Acquisition, liabilities of the target assumed, or taken subject to, as part of the

acquisition are generally included in the purchase price deemed paid for the assets of the

target.

In a Stock Acquisition (with a 338(h)(10) election), liabilities of the target are generally

included in the purchase price deemed paid for the assets of the target.

The purchase price paid for target is often subject to adjustment as liabilities of the target

are determined or become fixed.

Most acquisitions provide for working capital adjustments to the purchase price. Tax

liabilities of target are typically among the liabilities taken into account in determining the

amount of a working capital adjustment.


Page 98

Transaction Costs

Inherently facilitative costs incurred paid by the taxpayer in the process of investigating or

otherwise pursuing a “covered transaction” generally must be capitalized as a cost of the

transaction.

Other than inherently facilitative costs, amounts paid by the taxpayer in the process of

investigating or otherwise pursuing a “covered transaction” facilitates the transaction and

must generally be capitalized only if the amount relates to activities performed on or after

the earlier of the following dates: (1) the date on which a letter of intent, exclusivity

agreement, or similar written communication (other than a confidentiality agreement) is

executed by representatives of the purchaser and the target; or (2) the date on which the

material terms of the transaction, as tentatively agreed to by representatives of the

purchaser and the target, are authorized or approved by the taxpayer's board of directors (or

its committee) or, for a taxpayer that is not a corporation, are authorized or approved by

the appropriate governing officials of the taxpayer.

For a transaction that does not require authorization or approval of the taxpayer's board of

directors or appropriate governing officials, the date determined under the above rules is

the date on which the purchaser and the target execute a binding written contract reflecting

the terms of the transaction.


Page 99

Transaction Costs

A “covered transaction” includes the following transactions:

A taxable acquisition by the taxpayer of assets that constitute a trade or business;

A taxable acquisition of an ownership interest in a business entity (whether the

taxpayer is the purchaser or the target) if, immediately after the acquisition, the

acquirer and the target are related within the meaning of IRC Section 267(b) and

IRC Section 707(b); or

Most a tax-free corporate reorganizations.


Page 100

Transaction Costs

Success based fees, which are fees contingent on the completion of the transaction, must

generally be capitalized, except to the extent the taxpayers satisfies certain documentation

requirements. Taxpayers meeting certain requirements may elect a safe harbor allocation.

Taxpayers who make the election can treat 70% of the success-based fee as an amount that

doesn't facilitate the transaction and is therefore currently deductible. The remaining 30% of

the fee must be capitalized.

Borrowing costs generally must be capitalized as a cost of the borrowing as opposed to into

the cost of the transaction.

Certain de-minimis costs need not be capitalized as a cost of the transaction.

Costs not capitalized under these rules under IRC Section 263(a) may still be subject to

capitalization under IRC Sections 195 or 248.


Page 101

Transaction Costs

In a stock acquisition, transaction costs incurred by the target corporation to facilitate the

transaction may be considered incurred by the target on behalf of, and to benefit, the

selling shareholders and treated as a dividend or included in the consideration deemed

received by the selling shareholders from the sale, increasing their gain from the sale of the

target stock. However, if so treated, such costs may also be deemed expenditures of the

selling shareholders with respect to their sale of stock in the target, which may reduce their

gain from the sale of stock in the target.

Transaction costs incurred by the purchaser to facilitate the transaction would generally be

considered a cost of acquiring the stock and capitalized into the purchaser’s stock basis in

the purchased stock.


Page 102

Transaction Costs

In an asset acquisition, transaction costs incurred by the target corporation to facilitate the

transaction are generally considered incurred by the target reducing its gain from the sale of

assets by the target.

Transaction costs incurred by the purchaser to facilitate the transaction would generally be

considered a cost of acquiring the assets and capitalized into the purchaser’s basis in the

purchased assets.


Page 103

Contingent Liabilities

In an acquisition, the purchaser often assumes (directly or through its ownership of target)

certain contingent liabilities of target.

For income tax purposes, in an asset acquisition, or a stock acquisition with a 338(h)(10)

election, such contingent liabilities are generally to be treated by the seller as an additional

amount realized from the sale and by the purchaser as an adjustment to the asset purchase

price, as they accrue, or costs with respect to such liabilities are incurred. This means that

the purchaser may not generally receive a current income tax deduction, as these liabilities

accrue or costs with respect to such liabilities are incurred.

Similar treatment is often thought to apply to deferred revenue, which is a liability

commonly found on the balance sheets of targets.


Page 104

Deferred Revenue There is often a difference between the amount of deferred revenue booked for GAAP

purposes and the amount of the target’s deferred revenue for income tax purposes.

In an asset acquisition, tax deferred revenue assumed by the purchaser in the transaction is

generally to be recognized by the seller as an additional amount realized from the sale. For

the purchaser, as the purchaser incurs costs with respect to this deferred revenue, the

treatment of these costs for income tax purposes is not entirely clear under existing

authority. It is often thought that the purchaser should capitalize these costs as they are

incurred, into the purchase price of the purchased assets. Under this treatment, often these

capitalized costs would be allocated to increased goodwill, under Section 1060, which

increase could only be recovered over 15 years.

Alternatively, under a line of authorities (mainly dealing with subscription fees and services)

or through agreement, the seller may be treated as having paid the purchaser a separate

payment for agreeing to assume the obligation to perform the services required to generate

the deferred revenue. This separate payment should generate a deduction to the seller and

income to the purchaser, but the purchaser would then generally be entitled to deduct

currently its costs with respect to the deferred revenue. This treatment can be favorable or

unfavorable to the purchaser depending on timing and the amounts of the costs to be

incurred with respect to the deferred revenue.


Page 105

Deferred Revenue

In most taxable asset acquisitions, or stock acquisitions with a Section 338(h)(10) election,

the parties should consider the tax treatment to the parties resulting from the target’s

deferred revenue and their options with respect to the treatment of same.

See, New York State Bar Association Tax Section, Report on the Treatment of “Deferred

Revenue” by the Buyer in Taxable Asset Acquisitions, January 7, 2013.


Page 106

Accounting Methods

Purchasers and Sellers must generally apply their own method of tax accounting in reporting

a transaction.


Page 107

Common Tax Due Diligence Issues

1. Accounting methods including revenue recognition.

2. Limitations on NOL and tax credit use due to prior ownership changes.

3. State income tax compliance and exposure.

4. State sales and use tax compliance and exposure.

5. Foreign income and transfer tax (VAT) Compliance and Reporting.

6. Review prior acquisitions by Target.

7. Compensation and benefits compliance and exposure.

Payroll tax compliance and exposure.

Possible IRC Section 409A deferred compensation penalty exposure.

IRC Section 280G golden parachute penalty exposure.

IRC Section 162(M) exposure.

Stock option compliance related to IRC Sec 422.

8. Computational issues on all tax credits previously taken or carried forward.

Often it is possible to estimate the possible exposure for several of these items and negotiate indemnities, holdbacks and purchase price reductions.

Possible exposure may result in a restructuring of the acquisition.


Page 108

Disclosure

This outline is for information purposes only. Taxpayers are encouraged to consult their

own tax advisors with respect to these issues.

Documents

M&A Tax Considerations for Buyers and Sellers When