This article was updated September 15, 2020.
A fundamental tension can exist between buyers and sellers when negotiating transactions; buyers typically favor an asset purchase and sellers prefer to sell stock. The opposing methods are often born from conflicting perspectives regarding legal, logistical, and tax considerations of a transaction.
As the economic outlook and deal market remain uncertain during COVID-19, buyers, however, might have an uncommon opportunity to access the tax benefits of purchasing assets while still allowing sellers to sell stock. The opportunity can be completed without both sides losing other valuable tax benefits as well.
While there’s never a one-size fits all approach to transaction planning, considering and modeling alternative transaction structures—including stock, asset, and deemed-asset purchases—could help determine which is the best fit for increasing the present value of a company’s tax attributes.
Below, we explore these potential structures and how they could benefit your organization.
Limitation on Tax Attributes
Following a stock sale, an annual limitation on net operating losses (NOLs), built-in losses, and certain tax credits—collectively deemed tax attributes—can either limit or eliminate a buyer’s ability to use such attributes to reduce current and future tax payments.
This annual limitation on the use of tax attributes is generally the fair market value of a corporation’s stock multiplied by an applicable federal interest rate (AFR). The IRS publishes the AFR monthly, although the stock value for such purposes is subject to certain anti-abuse adjustments.
The June 2020 AFR was 1.09% and dropped to 0.89% for September 2020.
A low or decreasing AFR, coupled with depressed valuations, produces a significantly restrictive limitation. A buyer’s ability to utilize acquired tax attributes to reduce tax costs, when subject to such a limitation, is significantly impaired.
As the economic value of these tax attributes is diminished, so too is the seller’s ability to monetize the future benefit of the attributes via a premium to the purchase price.
Limitations on Built-in Losses
Moreover, if an acquired company’s tax-basis in its assets exceeds the assets’ fair market value at the time of an acquisition—for example, the company has an overall built-in loss—the benefit of recognizing that built-in loss during the five-year period following a transaction will be similarly limited.
There can be an array of unexpected consequences to recognizing a limited built-in loss. Recognition can come in the form of an actual sale of such assets or via annual tax depreciation and amortization cost recovery deductions.
Recognized built-in losses that exceed the annual limitation can’t be used to:
- Offset current-year income
- Carried back to offset prior year income
Further, because the annual limitation is applied first to current-year built-in losses—to the extent that the annual limitation is exceeded—no other tax attributes may be used to reduce tax payments during that year.
Due to the latent nature of these built-in losses, such limitations are often overlooked when forecasting cash taxes in a financial model. As such, the cash tax cost could be materially understated for years following the acquisition.
A technically simplistic solution would see the buyer and seller structuring the acquisition as an asset acquisition.
This would provide the following benefits:
- The tax attributes can be fully utilized to offset any gain on the sale, assuming no preexisting annual limitations.
- The buyer receives a so-called tax basis step-up to equal fair market value of such assets, rather than remaining at their historic basis. Such basis can be recovered without being subject to an annual limitation, which could provide a larger reduction in future tax payments.
- The seller can monetize that tax benefit transmitted to the buyer and reduce gain by utilizing the tax attributes that would otherwise transfer to the buyer without value.
However, as previously noted, there are a variety of non-tax reasons why a seller could be unwilling or unable to sell assets rather than stock.
For example, certain legal restrictions—such as restrictions on assigning contracts or a seller’s desire to absolve itself of historic liabilities of the business—could require a stock sale.
Deemed Asset Acquisition
Nevertheless, a deemed asset acquisition can be effectuated for tax purposes without changing the legal form from a stock purchase.
A Section 338(g) election allows a buyer to unilaterally elect to treat what would otherwise be a stock acquisition as an asset acquisition solely for tax purposes. The seller is treated as if it sold the stock of the company from both a legal and tax perspective.
However, if the election is made by the buyer, the target entity is deemed to sell its assets to a new target entity in a fully taxable asset sale. That deemed asset sale to a so-called new target, now owned by buyer, affords the buyer asset purchase treatment as described above. It also allows the so-called old target to utilize all available tax attributes to offset tax liability from the deemed asset sale.
Alternatively, the company, immediately prior to closing, may convert to a limited liability company (LLC), treated for tax purposes as a taxable liquidation, wherein resulting gain to seller may be reduced by existing tax attributes.
Further, the acquisition of an LLC is treated for tax purposes as a taxable asset acquisition and produces similar tax benefits to the buyer.
If you’re considering a transaction where the anticipated tax payment on the sale of the target company’s assets can be fully offset by its tax attributes, then you would want to consider alternatives to a stock acquisition for tax purposes.
Alternative transaction structures could increase either the seller’s proceeds from the transaction or the buyer’s post-close annual earnings.
We’re Here to Help
Transactions are incredibly nuanced; specifics related to every deal need to be considered. To learn more about how to structure your transaction ahead of a deal, or other transaction opportunities, contact your Moss Adams professional.