Most who work in the private equity arena agree that deal flow today is far from what it was just one year ago. However, those deals that are taking place today seem to bring with them many technical tax considerations that are seen much less frequently during robust economic times. Consider the case illustration below, which is a basic framework increasingly common in today’s environment.
The target group is a federal consolidated chain composed of parent corporation P, which owns all the stock of subsidiary corporation S. P is a holding corporation and S is a large manufacturer with all the active business operations of the group. P is wholly owned by Seller, a single-member LLC, in turn wholly owned by a private equity fund, SF. SF is a large, diversely held limited partnership (i.e., no five or fewer persons own more than 50%) engaged in long-term investing and primarily dedicated to the capital appreciation of its underlying investments. SF is a typical leveraged buyout (LBO) fund widely held by a multitude of U.S. taxable, tax-exempt, and foreign investors. Buyer will be an entity of choice (an LLC or corporation) wholly owned by another LBO fund (BF) very similar to, although entirely unrelated to, SF.
Seller has $20 million of equity in, and $40 million of sub-debt lending to, P. All this $60 million has made its way into S, so P has a basis in S of $60 million. The equity and the lending have been in place for years. Further, Seller is guarantor on $20 million of unrelated third-party firstlien debt at the level of S. Buyer and Seller have generally agreed that Buyer will buy 100% of the common equity of P and Seller’s $40 million note for one dollar. Seller will simultaneously make a $10 million infusion into S in exchange for a preferred interest that it will retain, and Seller’s $10 million infusion will be used to repay half of the S first-lien debt, at which point the third-party lender will entirely release Seller from its guarantee. The group has an August tax year; for the sake of illustration, assume this transaction will close during this month (September).
At its year ended August 2009, the group has $20 million of net operating losses (NOLs) (all at the level of S; ignore any portion attributable to P from interest expense on the sub-debt, for instance) to carry forward (there is no carryback potential under current law), and S’s tax basis balance sheet shows no cash; accounts receivable of $10 million; inventory of $20 million; net property, plant, and equipment (PPE) of $5 million; and the first-lien debt of $20 million. Assume no other assets, liabilities, or debt for purposes of this illustration. Further assume that there are no excess loss accounts or deferred intercompany transactions that would complicate this illustration.
Assume that de-levering the group (to ensure its survival) is a requirement of Buyer and that Seller has no expectation of collecting on any part of its $40 million note (hence its willingness to sell the note with the equity of P for some part of one dollar). The group clearly cannot repay the $40 million, and Buyer has no expectation of collecting on its recently acquired note. Hence, the $40 million obligation will be eliminated in some fashion. The first issue for evaluation might be whether the group has cancellation of debt (COD) income and, if so, what its tax impact is.
Sec. 108(e)(4) provides that, for purposes of determining the debtor’s income from discharge of indebtedness, the acquisition of outstanding indebtedness by a person bearing a relationship to the debtor specified in Sec. 267(b) or Sec. 707(b)(1) from a person who does not bear such a relationship to the debtor shall be treated as the acquisition of such indebtedness by the debtor itself. Immediately before the proposed transaction, Buyer is of course unrelated to P. However, immediately after, Buyer is related, and this Sec. 108(e) (4) “relatedness” issue becomes potentially relevant via the Regs. Sec. 1.108- 2(c)(3) six-month presumption that the indebtedness was acquired in anticipation of becoming related.
However, one can question whether Buyer must be one single newly formed acquisition vehicle to acquire Seller’s stock and debt. For instance, BF might form a separate wholly owned Buyer corporation to acquire Seller’s equity interest that will sit sister to another newly formed separate and “unrelated” wholly owned Buyer corporation to acquire Seller’s $40 million sub-debt note. (For a thorough discussion of the various potentially applicable “relatedness” Code sections with respect to these two corporations (e.g., Secs. 267, 707, and 414), see Keller, Tax Clinic, “Transactions Between Private Equity Fund–Owned Portfolio Corporations: An Update,” 39 The Tax Adviser 568 (September 2008)).
Assuming BF might have decided that it can structure around relatedness of the Buyer so as to avoid the reach of Sec. 108(e)(4), the statutory language is clear that although the acquirer of the outstanding indebtedness must be related to the debtor, the seller must not be. In the instant case, Seller is related to P under Sec. 267. As such, although Buyer’s technical considerations of its own relatedness to P are interesting, they are irrelevant in this illustration because Seller is in fact related to P. Sec. 108(e)(4) simply does not operate here.
Sec. 108(e)(4) aside, Buyer must nonetheless de-lever the group. A simple discharge by Buyer triggers COD income. So what else might Buyer consider here to remove the sub-debt but at the same time avoid the associated COD income? Sec. 108(e)(6) provides that, for purposes of determining the debtor’s income from discharge of indebtedness, if a debtor corporation acquires its indebtedness from a shareholder as a contribution to capital, that corporation shall be treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness.
Buyer acquired all of P’s equity and Seller’s $40 million sub-debt note for one dollar. As such, Buyer’s adjusted basis in the note is nil. Buyer’s contribution of the note will be treated as if P satisfied its $40 million sub-debt with an amount of money less than one dollar. The remainder is COD income, so this does not appear to solve the COD income issue. But what if, instead of a post-closing action of Buyer, Seller was to contribute its note to the capital of P prior to any transaction with Buyer?
Before considering some negotiated effort with Seller to assist Buyer with its tax efficiencies, it seems prudent to decide exactly what impact COD income might have on the group if it were in fact realized. Of course “negotiated effort” here for some tax practitioners might mean a suggestive mention by Buyer of its preference for a structure that Seller would then decide to consummate on its own, without interaction, counsel, or assistance of Buyer, and prior to any definitive binding arrangement with Buyer for the sale of P, so as to satisfy its own objective of assuring it will secure the closing of a deal with Buyer. In addition to an understanding of the group’s tax impact of COD income, Buyer might also prepare in advance to understand what tax consequences, if any, would likely result to Seller if it were in fact to contribute the sub-debt prior to a transaction with Buyer.
Insolvency, Excluded COD Income, and Attribute Reduction
Gross income includes income from discharge of indebtedness. However, Sec. 108(a)(1)(B) provides that gross income does not include any amount that would otherwise be included in gross income by reason of the discharge of the taxpayer’s indebtedness if the discharge occurs when the taxpayer is insolvent. Of interest here, but not necessarily relevant based on the facts provided above, is Sec. 108(a)(1)(A), which provides for the same exclusion from income as Sec. 108(a)(1) (B) but applies when the discharge occurs in a title 11 (bankruptcy) case. Note that demonstrating insolvency in a transaction such as the instant case is subjective but critical. Many tax practitioners agree that bankruptcy solidifies the exclusion of COD income (from later IRS challenge) by very simple and direct application of the statute.
In the instant case, P appears clearly insolvent. Insolvency is defined in Sec. 108(d)(3) as the excess of liabilities over the fair market value of assets, determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge. Buyer is willing to pay, and Seller is willing to accept, one dollar for all the common equity of P, but only in the context of a platform whereby P can be expunged of its $40 million sub-debt and an equity infusion is made to bring the S first-tier lending down to $10 million. Reasonable minds might likely conclude here that P must be insolvent at least to the extent of $40 million prior to this transaction in light of what Buyer and Seller have agreed. In other words, if Buyer will pay one dollar for all the common equity of P in the context of a platform where all the $40 million subdebt is gone, presumably it would require Seller to convey (and Seller would be amicable to convey) $40 million to Buyer for a similar transaction but whereby Seller will retain the note and expect continued debt service.
Sec. 108(b)(1) provides that the amount excluded from gross income under Sec. 108(a)(1)(B) shall be applied to reduce the taxpayer’s tax attributes. “Tax attributes” in this illustration are, in order and properly contemplating the consolidated attribute reduction rules of Regs. Sec. 1.1502-28, NOLs of P (none) first, P’s basis in S next, and then S’s attributes (via the lookthrough rule) last. The end result of the excluded COD income is that S’s $20 million NOLs are reduced to zero first, then basis of S’s property is reduced as prescribed by Sec. 1017.
Note also that any loss for the tax year of the discharge is reduced as well. The COD income event will occur in this month, which is the first month of the group’s new tax year. Assume for now that there will be no loss for the current year of the discharge (the August 2010 tax year), so, for simplicity of illustration, keep immediate focus on the $20 million of NOL carryovers. Those are now gone, leaving $20 million of excluded COD income remaining.
The normal ordering rules of Sec. 108 provide that S next loses tax basis in its property, and the regulations under Sec. 1017 more specifically provide that PPE basis is first reduced before accounts receivable and inventory. Using the balance sheet figures above, the remaining $20 million of excluded COD income reduces PPE basis from $5 million to zero and then erodes $15 million of basis in accounts receivable and inventory. The problem at this point is that assuming accounts receivable are collected and inventory is turned at or near historic carrying basis, the group can expect phantom income on realization of these assets.
A few tangential sections warrant consideration. First, excluded COD income that makes it to the point of reducing basis in property under Sec. 1017 is the subject of a floor. Regs. Sec. 1.1017-1(b) (3) provides that if COD income arises from a discharge of indebtedness while the taxpayer is insolvent, the amount of any basis reduction under Sec. 108(b)(2) (E) will not exceed the excess of the aggregate of the adjusted bases of property and money held by the taxpayer over the aggregate of the taxpayer’s liabilities immediately after the discharge. S has $35 million of assets and $10 million of remaining first-tier lending immediately after the discharge; hence, the floor is $25 million. Since only $20 million of attribute reduction is left after reducing NOLs to zero, this floor provision is not restrictive in this illustration.
Second, Sec. 108(b)(5) provides an election to apply attribute reduction first against depreciable property prior to the reduction of NOLs. Although valuable in certain circumstances (e.g., where the taxpayer has significant PPE and there is no Sec. 382 event commingled with the COD income event), this elective section does nothing advantageous in the instant case. Finally, there is an ownership change in the instant case that sets Sec. 382 in motion for myriad additional complications.
Change of Control and Built-In Loss Considerations
A detailed dissection of Sec. 382 is beyond the scope of this discussion. However, certain portions of Sec. 382 are relevant in the instant case in deciding just how aggressive Buyer might attempt to be to avoid or reduce the negative implications of COD income. The sale of 100% of P’s common equity to Buyer is clearly an ownership change. Thus, Sec. 382 is in motion and the group can only use its NOLs in the postchange period to the extent of Sec. 382’s annual limitation. Inasmuch as Seller sold P’s common shares for some part of one dollar, the group’s post-change NOLs are rendered essentially useless by Sec. 382. Even if the alternative election under Sec. 108(b)(5) accomplished some preservation of the $20 million NOLs (e.g., there was $30 million of PPE basis here instead of $5 million), Sec. 382 destroys the NOLs anyway. In such instance, no practitioner should be terribly excited about potential structural alternatives to preserve NOLs because Sec. 382 destroys them regardless. Note that this might very well not be the case in a COD income situation in which there is no commingled change of control.
Sec. 382(h) also provides for certain built-in loss (BIL) rules (applicable for the five-year period beginning on the ownership change date) that might frustrate tax planning aimed at avoiding the negative implications of attribute reduction on property basis. Using the Sec. 382(h)(8) “gross up” methodology, the value of the group’s assets cannot exceed the portion of the one dollar that Buyer paid for P’s stock adjusted upward for the $10 million of first-tier lending inside S at the time of the ownership change. As such, the assets have a value of $10 million (ignoring the fractional dollar) and a basis of $35 million. The resulting BIL of $25 million is larger than the threshold set forth in Sec. 382(h)(3)(B); hence, it must be contemplated.
Post-change depreciation and amortization deductions on PPE assets that existed inside the group during the pre-change period are BIL deductions. Similar to the limited use of pre-change NOLs, these future depreciation and amortization deductions will likewise be limited by the Sec. 382 BIL rules. As such, any well thought out restructuring to limit the impact of attribute reduction on PPE basis is severely frustrated by these Sec. 382(h) BIL rules. Like the expected impact on pre-change NOLs in a COD income situation where there is also a Sec. 382 event, practitioners should not be terribly excited about potential structural alternatives to preserve PPE basis because these Sec. 382(h) BIL rules destroy post-change depreciation and amortization deductions regardless.
Seller’s Sub-Debt Note Contribution
Under Sec. 1017(a), excluded COD income is applied to reduce the basis of any property held by the taxpayer at the beginning of the tax year following the tax year in which the discharge occurs. In the instant case, the $20 million of remaining excluded COD income does not reduce PPE, accounts receivable, and inventory until September 1, 2010. As a potential structural alternative to preserve PPE basis in connection with Sec. 1017(a)’s timing, some practitioners might suggest that the taxpayer monetize property before the beginning of the year following the year of the COD income event.
Others might suggest, for instance, that a corporate taxpayer form a new wholly owned nonconsolidated corporate subsidiary in which all its assets are contributed before the first day of the next year. This might otherwise be a straightforward Sec. 351 formation, and, provided the practitioner is comfortable with considerations such as business purpose (if he or she decides it is necessary), avoidance of Sec. 269, and making a Sec. 362(e)(2) election, the attribute reduction might stop at the basis of the new nonconsolidated corporate subsidiary’s stock and not reach the specific assets therein. Relating such structural considerations to BF, for instance, the tax basis of that new subsidiary’s stock in the hands of its corporate parent might arguably never matter because BF will simply plan to exit its investment at one level of tax with a sale of parent taxpayer’s stock.
In the instant case, absent some Sellerinitiated restructuring, the group will have excluded COD income from the transaction that might ultimately generate tax (assuming profitability is regained post-closing). The group will lose the usefulness of its NOLs and the depreciation/ amortization shield on PPE (for the five-year period discussed above) via the reach of Sec. 382 no matter what clever structuring might be done. As such, the focus should be on the $15 million loss of accounts receivable and inventory basis. Although well beyond the scope of this discussion, also consider Sec. 56(g)(4) (G)’s impact on the basis of these assets for adjusted current earnings or alternative minimum tax purposes depending on the allocation method employed.
Although there may be various ideas to eliminate or buffer this particular result (e.g., the potential use of LIFO for inventory), the simplest seems to be for Seller to contribute its $40 million sub-debt note to the capital of P prior to any transaction with Buyer. Assuming Seller has not previously charged off some or all of its basis in its $40 million note (e.g., it believed a bad debt deduction was warranted in some prior period), the contribution will have the effect of satisfying the $40 million note with $40 million of money. Hence, no COD income results and structuring efforts are practically complete. But what might Buyer expect Seller to suggest, if anything, are its tax implications from making this contribution?
Seller’s Tax Implications
Seller’s contribution of its $40 million sub-debt note to the capital of P will increase its basis in its equity of P to $60 million. Seller sells its equity investment in P for one dollar to Buyer, and Seller harvests a $60 million loss. Note that without the contribution, Seller sells (separately) its $20 million equity investment in P for some portion of one dollar and its $40 million sub-debt note for the remaining portion of that same dollar, the end result of which is an aggregate loss of the same amount ($60 million). Further, the holding period in the assets sold is no different in either instance. That leaves a potential character difference to consider, and Buyer should perhaps expect Seller to evaluate whether the realization of its $40 million note for nil, if Seller in fact leaves it in place and does not contribute it to P’s capital before a transaction with Buyer, gives rise to an ordinary deduction for Seller.
For the portion of the partner base of SF comprising U.S. taxable individuals, the passthrough of an ordinary deduction presumably carries with it a rate arbitrage benefit (e.g., the difference between a 35% maximum rate for an ordinary deduction and a 15% rate for a long-term capital loss). However, some portion of SF’s investor base comprises tax-exempt and foreign investors. Therefore, it would be expected that SF’s governing documents contain a common prohibition against the type of investments that generate unrelated business taxable income (UBTI) and effectively connected income (ECI). In that respect, it is not likely that SF (or any typical LBO fund like it) would attempt to argue that it is in a trade or business of lending and hence is entitled to an ordinary loss in connection with a lending transaction. So Buyer should expect Seller to decide in the instant case that its loss is the same amount and character and has the same holding period, whether the proposed transaction is structured as initially described above or Seller makes this pre-transaction contribution of its note to P’s capital. If Seller agrees that its tax consequences are no different in either option and it contributes all $40 million of its note, all potential of excluded COD income reducing S’s accounts receivable and inventory is gone. Even if Seller was willing to contribute only a portion, but not all, of its note (e.g., for some other nontax business or legal considerations), the risk of losing accounts receivable and inventory basis is likewise gone, provided Seller would be willing to contribute at least $15 million.
New Tax Year
Assume Seller contributes $15 million of its note to P’s capital. That leaves $25 million of excluded COD income that will reduce attributes as discussed above. The group will lose all its NOLs and all the remaining basis in its PPE regardless of Sec. 108’s default method of attribute reduction or the elective method under Sec. 108(b)(5). Because Sec. 382 effectively destroys the NOLs and the depreciation and amortization shield on PPE (for the next five years, as discussed above), Buyer might decide it does not necessarily care to structure any further with respect to the remaining $25 million of excluded COD income. However, that might be a shortsighted decision.
What if the group expects to suffer an operating loss during the current fiscal year in which the transaction takes place? The COD income attribute reduction order in Sec. 108(b)(2)(A) first reduces loss for the year of discharge (the entire year, even if the discharge occurs on the first day of the year) and then reduces NOLs carrying in to that year from prior years. If the group suffers operating loss for its normal fiscal year ending August 31, 2010, it will lose that first before it loses the $20 million carryover NOLs. Note that the operating loss for most of the current year is not restricted by Sec. 382, making it considerably more valuable than the carryover losses and basis in PPE. In this instance, a break of the Buyer-group year at the end of the month of the transaction (September) might help preserve a large portion of the group’s current-year loss.
A September tax year might be attained, for instance, by causing Buyer to be a newly formed September year-end corporate parent that will elect consolidation with P and S. Alternatively, the yearend change provisions of Rev. Proc. 2006- 45 might be evaluated if, for instance, it is preferred to form Buyer as an LLC. One ancillary item is worth noting: In the facts above, the group has no carryback potential under current law. Carryback potential might be fruitful, however, under the five-year carryback proposals of tax bills currently moving through Congress (see S. 823 and H.R. 2452). If a five-year carryback provision was enacted and the group did have income in the third through the fifth prior years, it might specifically be disadvantageous to break the tax year at the end of September 2009 because NOLs of current and prior years go back first before being reduced by excluded COD income. At the time of this writing, these proposed five-year carryback provisions have not been finalized.
Structural considerations appear complete— but maybe not. With respect to Seller’s $10 million infusion above for payment on S’s first-tier lending, Buyer would of course generally prefer Seller to make that infusion at the level of the Buyer entity. However, assume Seller will infuse only at the level of S for myriad reasons that will almost always be the case in practice (recall that S is the operating entity). Also assume that legal counsel is otherwise diligent in forming the preferred stock issued by S to Seller in exchange for Seller’s $10 million infusion as “plain vanilla, garden variety” preferred stock under Sec. 1504(a)(4)—i.e., it does not vote, is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, has redemption and liquidation preferences that do not exceed the stock’s issue price, is not convertible into another class of stock, etc. The obvious reason for conveying a preferred interest to Seller is to ensure that, if Seller will in fact demand the interest at the level of S, it does not jeopardize the ability of Buyer, P, and S to make a consolidated federal tax filing election, assuming Buyer will be a corporation. The issue is then, considering the relative value (or lack thereof) of the group suggested by the terms of this transaction, whether there might be a material concern that the preferred stock has run afoul of Sec. 1504(a)(4)(B)’s significant corporate growth participation prohibition.
There appears to be no clear answer. Consider, for instance, Technical Advice Memorandum 200116002 in the context of Sec. 305. Assuming the tax preparer responsible for the federal income tax filing(s) of Buyer, P, and S for the year of the transaction finds the requisite level of authority to prepare and sign a return prepared on a consolidated basis, what would be the risk if the IRS were to scrutinize the transaction and decide that Seller’s preferred stock does not meet the Sec. 1504(a)(4)(B) requirement? Among other potential considerations, Seller’s interest in S now exceeds 20%, and there is a risk of deconsolidation of the group and the potential application of the loss duplication rules in Regs. Sec. 1.1502-36(d). Specifically, it appears there is potential risk of erosion of the tax basis of S’s assets via application of the attribute reduction rules in Regs. Sec. 1.1502-36(d)(2).
In this illustration, a twofold application of the loss duplication rules could conceivably apply to (1) the issuance of preferred shares by S, which might not qualify under Sec. 1504(a)(4), and (2) the acquisition of all the P stock by Buyer (assuming Buyer is formed as a corporation). The question to be evaluated for each of these is whether there would be a “transfer” of loss shares by P in S that would trigger the attribute reduction rules set forth in Regs. Sec. 1.1502-36(d)(2). In this regard, note that Regs. Sec. 1.1502- 36(f)(10) defines a “transfer” as deeming to occur when a subsidiary and its immediate parent corporation cease to be members of the same consolidated return group.
The IRS has indicated that its position in the first scenario involving the issuance by S of preferred shares is that P would be treated as “transferring” its loss shares in S by reason of the deconsolidation, thereby triggering the attribute reduction rules. As for the second scenario, the Service’s position appears to be that Buyer’s acquisition of P’s stock will trigger the attribute reduction rules with respect to P’s loss shares in S, unless Buyer elects to file a consolidated return with P and S immediately following its acquisition of the P stock. Although the loss duplication regulations do not specifically address the fact pattern of these two scenarios, notice, for instance, Example (3) in Regs. Sec. 1.1502-36(b)(3), which notes that a transfer does not occur if the subsidiary and its immediate parent continue as members of the same consolidated group.
In the instant case, it appears advantageous to form Buyer as a corporation and to cause Buyer to file a consolidated return for it, P, and S from inception. On the chance that the Service could potentially decide that the preferred shares of S do not qualify under Sec. 1504(a)(4) and the group experiences a deconsolidation, consider making a protective election under Regs. Sec. 1.1502-36(d)(6) to avoid attribute reduction at the corporate level of S. This appears to cure the issue with no further negative tax consequences. In the event that it might later be determined that a deconsolidation occurred as a result of the issuance of the S preferred shares, the only downside would be a reduction in the basis of the S shares held by P. As mentioned above, query whether BF will care because it can exit its investment in the business with one level of tax via the sale of its shares of Buyer, which will include P and S below it.
Frank O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or email@example.com