Complexities of Stock Deals in M&A Transactions

Editor: Anthony S. Bakale, CPA, M.Tax.

CPAs rarely, if ever, should expect to see a taxable acquisition structured as a stock purchase. The primary reason is that the buyer will inherit both the known liabilities of the acquired business as well as the unknown liabilities of the acquired business, and it would not receive a step-up in the basis of the assets purchased for federal tax purposes. But never say never.

A number of years ago, there was a shift from transactions structured as asset acquisitions to the purchase of stock treated as a purchase of assets. Under Sec. 338(h)(10), a corporate buyer in conjunction with the seller may make an election to treat the purchase of stock of the target corporation as an asset acquisition where the gain is reported on the target corporation’s consolidated return or by the shareholders of an S corporation. Sec 336(e) allows for similar treatment if the buyer is not a corporation. When this is coupled with the ability to treat stock acquisitions as asset purchases under federal tax law, a basis step-up is achieved.

Likely reasons for the shift in structure to stock acquisition is attorneys have become more comfortable in drafting representations and warranties to cover any adverse effect from acquiring unknown liabilities and the availability of “reps and warranties” insurance. In addition, a stock acquisition simplifies the transfer of various business agreements, contracts, licenses, etc., to the buyer group since a stock acquisition does not create a legal change in ownership of these underlying rights.

However, many recent transactions in the author’s practice have been structured as a taxable acquisition of stock with no elections under Sec. 338(h)(10) or 336(e). In these instances, the buyer may be a private-equity firm that wants to avail itself of Sec. 1045 rollover treatment, or it has not-for-profit investors that are unconcerned with the potential double tax; or the target may have depreciated assets or tax attributes the buyer wishes to preserve; or the buyer cannot qualify for the election under Sec. 338 because the target is a stand-alone C corporation. In addition, the seller may want to avail itself of the gain exclusion provisions under Sec. 1202 or have the opportunity to do a Sec. 1045 rollover. Whatever the reasons are for the shift in structure, the end result is complexities that many tax practitioners are not familiar with handling. Further complicating this scenario is FASB Accounting Standards Codification Topic 820, Fair Value Measurement, for GAAP purposes that requires the acquisition to be accounted for on a fair value basis.

Example: An LLC taxed as a partnership acquires all of the stock of a C corporation. Investors make contributions to capital of the LLC, and the LLC in turn gets financing from a bank with the C corporation target being treated as the co-borrower on the loan. The acquiring LLC uses the debt and equity to finance the acquisition of the C corporation stock. For tax purposes, the end structure is an LLC with an investment in C corporation stock, debt, and equity. The C corporation is an operating business that has cash flow from operations. The challenge becomes how does the LLC get the cash to amortize the acquisition indebtedness?

If the C corporation distributes some of its cash flow to the LLC, the result is likely a taxable dividend to the LLC parent along with the interest expense being treated as investment interest expense. The LLC owners would have dividend income and may be limited with respect to the deductibility of the interest under Sec. 163 investment interest expense rules. An additional challenge is the situation may not be identified until it is time to start completing the tax returns because, for GAAP purposes, the parent LLC and its operating C corporation will be viewed as one reporting group with the target’s assets being reported on the consolidated or combined balance sheet at fair value at the time of acquisition.

A better result may be reached if the LLC makes a check-the-box election to be taxed as a C corporation and then further elects to file a consolidated return with its subsidiary. With this structure, the limitation on the deductibility of the interest expense is avoided; however, the flowthrough nature of the LLC is given up in return. Another alternative could be to structure a management fee agreement between the operating C corporation and the LLC so that enough cash flow exists for the LLC to amortize the acquisition indebtedness. However, care needs to be exercised to not change the economics of the deal by adding the management fee after the fact.

A further complication is that the corporation’s assets carry over with respect to basis and depreciation methods in a stock transaction for tax purposes, while for GAAP reporting purposes, the opening balance sheet will be booked up for fair value reporting. Care must be taken to ensure that the historical tax depreciation schedules are maintained and that the purchase accounting entries for GAAP can be unwound. This is in addition to performing a Sec. 382 analysis if the target has a net operating loss or credit carryforwards.

The purchase of C corporation stock by an S corporation may create an additional trap for the unwary. This transaction structure will create the complexities outlined in the LLC acquisition scenario above with one more potentially negative consequence. For example, presume that an S corporation purchases C corporation stock for $1 million when the underlying basis of the C corporation’s assets is $250,000. Similar to the result above, if the S corporation borrows to finance the acquisition, the interest expense will be treated as investment interest expense if traced to the acquisition of the C corporation stock. Even if the interest is deductible to the S corporation shareholder for federal purposes, it may not be deductible for state purposes.

This situation may tempt the practitioner to advise his or her client to make a QSub election for the acquired C corporation under Sec. 1361. However, after carefully examining the consequences of a QSub election, one will note that it creates a deemed liquidation of the target under Sec. 332. In a deemed liquidation into the parent under Sec. 332, the parent takes a carryover basis in the target’s assets as its stock basis. So in this particular example, the parent would lose $750,000 in stock basis when a QSub election is made.

Conclusion

Taxable stock acquisitions are an attractive way for the target’s owner to pay one level of tax on the sale and potentially pay no tax if Sec. 1202 applies. For buyers, the structure will likely result in the easy transfer of all of the target corporation’s business contracts and agreements and registrations and licenses, but proper planning needs to take place to avoid the potential negative tax consequences and complexities of a taxable stock purchase.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.