Taxable Acquisitions

Taxable Acquisitions The transaction is taxable because most, if not all,

consideration is cash. Consequently, the deal will not qualify as non-taxable under I.R.C. Sec. 368.

There are many reasons why cash is used as consideration rather than stock Value of acquiring companies stock too low Dilution Target’s shareholders don’t want stock: the stock may be

too risky, the shareholders may not care about tax deferral.

LBO firms always use cash.

Items to Consider inan Acquisition

The tax consequences of the transaction for target shareholders

The incremental tax costs and tax benefits if the buyer changes the basis in the target’s assets

The effect on the target company’s tax attributes

PRACTICE CASES 1-4:Given Information

GivenAsset purchase price $2,000Stock purchase price $1,370ADSP $2,000T's net asset basis $200T shareholder's stock basis $200Corporate tax rate 35%Individual investor capital-gains tax rate 20%After-tax discount rate 10%Amortization/depreciation period 10Depreciation method straight-lineStep-up $1,800Annual incremental amort./deprec. $180

T has no liabilities, NOLs, tax-credit carryforwards, or loss carryforwards. T’sshareholders are individual investors, not corporate or tax-exempt entities. Inall cases, the method of payment is cash and purchase accounting is used.

Problem--Comparison of Tax Effects of Various Taxable Acquisition Structures

Transaction StructureAsset Acquisition Stock AcquisitionNo With a Without a

Liquidation Liquidation 338 Election 338 ElectionPurchase Price $ $ $ $

Tax Costs: Tax paid by T Tax paid by A--from 338 election Tax paid by T's shareholders Total Tax Paid $ )$ $ $

T Shareholder Consequences: Gross cash received n/a Less: Shareholder taxes n/a After-tax cash to T's shareholders n/a $ $ $

A Net After-tax Cost: Gross cost $ $ $ $ Less: Present value of tax benefits Net after-tax cost of the acquisitions $ $ $ $

A's Tax Basis in the T's: Stock n/a n/a $ $ Assets $ $ $ $

GivenAsset purchase price $2,000Stock purchase price $1,370ADSP $2,000T's net asset basis $200T shareholder's stock basis $200Corporate tax rate 35%Individual investor capital-gains tax rate 20%After-tax discount rate 10%Amortization/depreciation period 10

Case 1—Taxable Asset Acquisition w/o a Complete Liquidation of the Target

No change in the identity of the target’s shareholders--they retain control of the target firm

Taxable gain at target corporation level No taxable gain recognized by target shareholders Step-up in tax basis of the target’s assets Target’s tax attributes survive Possibility of tax-based goodwill Possibility of financial-accounting-based goodwill

Case 1—Taxable Asset Acquisition w/o a Complete Liquidation of the Target

To determine how both the seller and buyer allocate the selling price to the assets sold and purchased, must use residual method (see I.R.C. Sec 1060).

Under the residual method, sale price is allocated first to cash and cash equivalents, then to FMV of investment securities (CDs, marketable securities, etc.), then to FMV of tangible assets( receivables, inventory, fixed assets), then to FMV of specific intangible assets (customer lists, formulas, covenants not to compete). Remainder of purchase price allocated to goodwill.

Amounts allocated to goodwill, covenants not to compete are amortizable over 15 years under I.R.C. Sec 197.

Case 1—Taxable Asset Acquisition w/o a Complete Liquidation of the Target:

Non-Tax Issues Acquiring firm may avoid unrecorded

liabilities Cost’s of transferring title to assets may be

high Some assets may be difficult to transfer or

assign: certain contracts, licenses, government permits, etc.


Transaction StructureAsset AcquisitionNo

LiquidationPurchase Price 2,000.00$

Tax Costs: Tax paid by T (630.00) Tax paid by A--from 338 election 0.00 Tax paid by T's shareholders 0.00 Total Tax Paid (630.00)$

T Shareholder Consequences: Gross cash received n/a Less: Shareholder taxes n/a After-tax cash to T's shareholders n/a

A Net After-tax Cost: Gross cost 2,000.00$ Less: Present value of tax benefits (387.10) Net after-tax cost of the acquisitions 1,612.90$

A's Tax Basis in the T's: Stock n/a Assets 2,000.00$


Estimation of Tax Benefits From Stepping-up the Tax Basis of a Target’s Assets

Incremental Tax PV of TaxPeriod Depreciation Savings Savings

1 $180.00 $63.00 $57.272 180.00 63.00 52.073 180.00 63.00 47.334 180.00 63.00 43.035 180.00 63.00 39.126 180.00 63.00 35.567 180.00 63.00 32.338 180.00 63.00 29.399 180.00 63.00 26.72

10 180.00 63.00 24.29Total $1,800.00 $630.00 $387.10

GivenPurchase price $2,000T's net asset basis $200Step-up $1,800Amortization/depreciation period 10Depreciation method straight-lineAnnual incremental amort./deprec. $180Corporate tax rate 35%After-tax discount rate 10%

Taxable Asset Acquisition w/o a Subsequent Liquidation

Target:Receives $2,000 in cash

in return for all of its assets(basis = $200). Recognizes a gain of $1,800 and paystax of $630. Has $1,370 of

cash after-tax.

$2,000 cash

All of thetarget’s assets

Target Shareholders:No direct tax effect.

Acquirer Shareholders:No direct tax effect.

Acquirer:Purchases the assets of the

target for $2,000 cash.Takes a basis in the

target’s assets equal to theprice paid ($2,000).

Case 2—Sale of the Target Firm’s Assets Followed by a Liquidation

T distributes the after-tax proceeds of the asset sale to its shareholders in return for their shares

Taxable gain at target corporation level Taxable gain recognized by target shareholders Step-up in the tax basis of the target’s assets Target’s tax attributes do not survive Possibility of tax-based goodwill Possibility of financial-accounting-based goodwill

Case 2—Sale of the Target Firm’s Assets Followed by a Liquidation

Buyer and seller use Section 1060 approach to allocate purchase price. Amount of purchase price allocated to goodwill is amortizable over 15 years by the acquiring corporation.

Non-tax issues are the same as in Case 1.


Transaction StructureAsset AcquisitionNo

Liquidation LiquidationPurchase Price 2,000.00$ 2,000.00$

Tax Costs: Tax paid by T (630.00) (630.00) Tax paid by A--from 338 election 0.00 0.00 Tax paid by T's shareholders 0.00 (234.00) Total Tax Paid (630.00)$ (864.00)$

T Shareholder Consequences: Gross cash received n/a 1,370.00 Less: Shareholder taxes n/a (234.00) After-tax cash to T's shareholders n/a 1,136.00$

A Net After-tax Cost: Gross cost 2,000.00$ 2,000.00$ Less: Present value of tax benefits (387.10) (387.10) Net after-tax cost of the acquisitions 1,612.90$ 1,612.90$

A's Tax Basis in the T's: Stock n/a n/a Assets 2,000.00$ 2,000.00$


Taxable Asset Acquisition with Subsequent Liquidation of the Target

Target:Receives $2,000 in cash in

return for all of its assets(basis = $200). Recognizes a

gain of $1,800 and pays tax of$630. Distributes $1,370 of cash

after-tax.

$2,000 cash

All of thetarget’s assets

Target Shareholders:Receive $1,370 in cash, recognize a gain

of $1,170 ($1,370 - $200 basis) andpay tax of $234. Cash after-tax is $1,136.


Acquirer:Purchases the assets of the

target for $2,000 cash.Takes a basis in the

target’s assets equal to theprice paid ($2,000).

$1,370 cashAll of the

target’s stock

Case 3—Purchase of the Target’s Stock Followed by a § 338 Election Under § 338, the acquirer can elect to treat a stock

purchase of a freestanding C corporation as a taxable asset purchase if it acquires at least 80% of T’s stock within 12 months in a taxable manner.

Taxable gain at target corporation level Taxable gain recognized by target shareholders Step-up in the tax basis of the target’s assets Target’s tax attributes do not survive Possibility of tax-based goodwill Possibility of financial-accounting-based goodwill

Case 3—Purchase of the Target’s Stock Followed by a § 338 Election Target corp is treated, for tax purposes, as if it sold its

gross assets to the new target for what is known as the aggregate deemed sale price (ADSP).

ADSP = P + L + t(ADSP-BASIS) where P is the price paid for target stock, L is the liabilities of the target (assumed by acquirer), t is the corporate tax rate, and BASIS is the adjusted basis of the gross assets.

The ADSP is allocated to assets deemed sold and purchased under Sec. 1060 approach. Goodwill is amortizable over 15 years.

Case 3—Purchase of the Target’s Stock Followed by a § 338 Election:Non-tax Issues

Transactions cost of obtaining stock lower than for obtaining assets-no asset transfer costs.

Problem of non-transferable assets avoided. Unknown liabilities of target still present,

although acquirer only liable up to the value of assets in new subsidiary.


Transaction StructureAsset Acquisition Stock AcquisitionNo With a

Liquidation Liquidation 338 ElectionPurchase Price 2,000.00$ 2,000.00$ 1,370.00$

Tax Costs: Tax paid by T (630.00) (630.00) 0.00 Tax paid by A--from 338 election 0.00 0.00 (630.00) Tax paid by T's shareholders 0.00 (234.00) (234.00) Total Tax Paid (630.00)$ (864.00)$ (864.00)$

T Shareholder Consequences: Gross cash received n/a 1,370.00 1,370.00 Less: Shareholder taxes n/a (234.00) (234.00) After-tax cash to T's shareholders n/a 1,136.00$ 1,136.00$

A Net After-tax Cost: Gross cost 2,000.00$ 2,000.00$ 2,000.00$ Less: Present value of tax benefits (387.10) (387.10) (387.10) Net after-tax cost of the acquisitions 1,612.90$ 1,612.90$ 1,612.90$

A's Tax Basis in the T's: Stock n/a n/a 1,370.00$ Assets 2,000.00$ 2,000.00$ 2,000.00$


Taxable Stock Acquisition of the Target w/ a § 338 Election

Target:Target corporation’s owners change. The

target’s assets are deemed sold to a hypothe-tical buyer after the stock acquisition for

ADSP ($2,000). The asset sale gives rise to again of $1,800 and tax of $630. The tax ispayable by the acquirer since the target is a

subsidiary of the target at the time of thedeemed asset sale. The tax attributes of thetarget vanish after the deemed asset sale.



Acquirer:Purchases the stock ofthe target for $1,370cash. After the 338

election, takes astepped-up basis in thetarget’s assets ($2,000).

$1,370 cash

All of thetarget’s stock


Taxable Stock Acquisition of the Target w/ a § 338 Election--Post-acquisition

Acquirer:Owns 100% of the target’s stock.Has a basis in the target’s stock of$1,370 and a basis in the target’s

net assets of $1,370.

Target:Now a wholly owned

subsidiary of the acquirer.Net asset basis is $1,370 andgross asset basis is $2,000.

Case 4—Purchase of the Target’s Stock w/o a § 338 Election

Same as Case 3, except the acquirer does not make the § 338 election

No taxable gain at corporation level Taxable gain recognized by the target shareholders No step-up in the tax basis of the target’s assets Target’s tax attributes survive No possibility of tax-based goodwill Possibility of financial-accounting-based goodwill Non-tax issues the same as in Case 3


Transaction StructureAsset Acquisition Stock AcquisitionNo With a Without a

Liquidation Liquidation 338 Election 338 ElectionPurchase Price 2,000.00$ 2,000.00$ 1,370.00$ 1,370.00$

Tax Costs: Tax paid by T (630.00) (630.00) 0.00 0.00 Tax paid by A--from 338 election 0.00 0.00 (630.00) 0.00 Tax paid by T's shareholders 0.00 (234.00) (234.00) (234.00) Total Tax Paid (630.00)$ (864.00)$ (864.00)$ (234.00)$

T Shareholder Consequences: Gross cash received n/a 1,370.00 1,370.00 1,370.00 Less: Shareholder taxes n/a (234.00) (234.00) (234.00) After-tax cash to T's shareholders n/a 1,136.00$ 1,136.00$ 1,136.00$

A Net After-tax Cost: Gross cost 2,000.00$ 2,000.00$ 2,000.00$ 1,370.00$ Less: Present value of tax benefits (387.10) (387.10) (387.10) 0.00 Net after-tax cost of the acquisitions 1,612.90$ 1,612.90$ 1,612.90$ 1,370.00$

A's Tax Basis in the T's: Stock n/a n/a 1,370.00$ 1,370.00$ Assets 2,000.00$ 2,000.00$ 2,000.00$ 200.00$


Taxable Stock Acquisition of the Target w/o a § 338 Election

Target:Target corporation’s owners change. Targettax attributes are limited under I.R.C. § 382.

The tax basis of the target’s assets do notchange.



Acquirer:Purchases the stock ofthe target for $1,370.

Takes a carryover basisin the target’s assets

($200).

$1,370 cash

All of thetarget’s stock


Taxable Stock Acquisition of the Target w/o a § 338 Election--Post-acquisition

Acquirer:Owns 100% of the target’s stock.Has a basis in the target’s stock of$1,370 and a basis in the target’s

assets of $200.

Target:Now a wholly owned

subsidiary of the acquirer.Net asset basis is $200.

Tax Consequences of Taxable Acquisition Structures (C Corps)

Asset Acquisition Stock AcquisitionWithout With With a Without a

Structural or Tax Issue Liquidation Liquidation 338 Election 338 Election

Consideration/Method of Payment Cash Cash Cash Cash

Taxable Gain at Target Corporation Level? Yes Yes Yes No

Taxable Gain Recognized by Target Shareholders? No Yes Yes Yes

Step-up in the Tax Basis of the Target's Assets? Yes Yes Yes No

Target's Tax Attributes Survive? Yes No No Yes

Accounting Treatment Purchase Purchase Purchase Purchase

Possibility of Financial-Accounting-Based Goodwill? Yes Yes Yes Yes

Possibility of Tax-Based Goodwill? Yes Yes Yes No

Taxable Acquisition Case Summary

Do the target firm’s shareholders care which type of acquisition strategy is used to acquire target? Why or Why not?

To determine target shareholders indifference price for either an asset sale or stock sale use the following formula: Passet = Pstock + tc(Passets - Basis) where Passet is price paid for asset acquisition, Pstock is price paid for stock acquisition, tc is the tax rate of the target, and Basis is the tax basis of the target’s assets.

Intepretation: Acquiring firm can pay less if the deal is done as a stock acquisition because the target (and target shareholders indirectly) avoid one layer of tax.

Taxable Acquisition Case Summary

If target shareholders are indifferent, which deal structure is best for the acquirer? Why?

To get step-up in basis, acquirer must compensate the target shareholders now for the additional tax incurred at the target level. Benefits of the step-up only accrue over time.

Consequently, most taxable deals of free-standing corporations (not subsidiaries) are done as stock acquisitions. Benefits of step-up overrated.

With stock deals, acquirer will have to book goodwill but no tax goodwill.

Documents

Taxable Acquisitions