Letís Make a Deal: Understanding Tax Implications is Important In Structuring an Acquisition

Acquisitions can provide companies with an avenue of growth and increase their profits exponentially. A major consideration when planning an acquisition is determining its structure. In addition to the liability and financing considerations, buyers and sellers must consider the implications of the acquisition for tax purposes. There is no right or wrong way to structure the transaction. Instead, developing a structure that is in the best interests of both buyers and sellers is key.

For some companies, acquiring another company to expand capacity, acquire a workforce, or move into new markets or product lines may be a good growth strategy. Properly structured, this strategy can create a winning situation for both the acquiring company and its target. But with the many ways available for structuring an acquisition, how do you decide which is best for your situation?

Choose the Transaction Type Carefully

When structuring a transaction, recognize the different implications of an asset purchase, in which the buyer acquires the corporationís assets, and a stock purchase, in which the buyer acquires the outstanding corporation stock from the seller.

Asset Purchase

Buyers may try to minimize potential contingent liabilities with an asset deal. In a stock purchase, the buyer indirectly assumes all liabilities of the company being purchased, regardless of whether the liabilities are recorded on the acquired companyís balance sheet. This means that if, after the purchase, the acquired company faces a legal attack for actions taken by the previous owners, the assets of the acquired corporation will be at risk. An asset purchase can eliminate much of this risk.

An asset purchase also gives the buyer a step-up in basis of the assets purchased. Because the buyer can now record the assets purchased at fair market value, rather than historical cost, it can take higher tax deductions for the depreciation or amortization of the assets.

Stock Purchase

A stock purchase, on the other hand, will not be eligible for a write-off until the stock is sold. And, if the stock is subsequently sold at a loss, the loss is generally only deductible if the buyer has capital gains from other sources.

This may pose a conflict of interest between the buyer and seller since the seller will generally receive more favorable tax treatment from a stock transaction. In addition, if the business is a C corporation, the seller can avoid double taxation on the sale proceeds with a stock transaction.

However, these seller advantages may be offset by the fact that the seller must provide more warranties and guarantees in a stock sale than in an asset sale. Because the attributes and liabilities of the corporation remain intact when the stock is sold, the buyer requires warranties and guarantees as protection from carry over liabilities. Also, selling stock eliminates the sellerís ability to use any significant net operating losses as tax shelters if the seller wants to continue other lines of business.

Know How To Allocate Intangibles

One significant tax consideration in an asset transaction is how to allocate the purchase price. The buyer usually wants to allocate as little as possible to pure capital assets, such as land, because those assets are nondepreciable. Similarly, the buyer would rather allocate cost to assets that will be written off quickly, such as receivables and inventory, instead of assets that must be depreciated over a longer period, such as buildings or possibly Internal Revenue Code Section 197 intangibles like goodwill and going concern value. Keep in mind that the Internal Revenue Service considers reasonableness and will not look favorably on situations where intangible assets are used strictly as tax-shifting devices.

In an acquisition transaction, many types of intangible assets can be identified:

  • Goodwill;
  • Customer lists;
  • Noncompete agreements;
  • Brand names; and
  • Patents.

The buyer may receive deductions for goodwill, customer lists and other intangible assets, although the deduction is generally amortized over a long period.

Generally, the portion of the purchase price allocated to consulting agreements and employment contracts becomes deductible by the buyer in the year payable to the seller.

Valuing a Covenant Not to Compete

The problem in valuing a covenant not to compete is to determine the value of the earnings that might be lost if a former owner competes against the business. To determine this, the valuator must consider such elements as the age and health of the seller, the importance of the seller to the business, and the reasonableness of the covenantís term.

The value of a businessís stock is closely tied to the ability to obtain a covenant from the seller. If the buyer is unable to obtain a covenant, the value of the business may be greatly diminished.

A covenant not to compete is the only intangible asset considered whether the transaction is a stock or asset deal. The buyer should attempt to document the reasonableness of the amount allocated to a covenant in a purchase transaction to avoid losing a tax benefit and possibly incurring additional penalties. In light of the tax differentials between capital gain and ordinary income (covenants produce ordinary income), allocations to covenants may be the strongest evidence of tax value.

Consider Tax-Free Mergers

Many acquisition deals are inspired by the desire to join two businesses, with continued involvement from both owners. This can be structured tax-free with a merger. A tax-free merger, in its simplest form, occurs when one company acquires a controlling interest in the other company, solely in exchange for at least 80% of its stock.

  • The acquiring company can form a subsidiary. This new entity purchases the acquired companyís stock in exchange for the stock of the parent company. Then, the acquired company dissolves, and its assets and liabilities become those of the newly formed company.

  • The interested companies can create a holding company, which acquires both companiesí stock in exchange for its own stock.

In both of these commonly used methods, the former shareholdersí tax basis in the stock they receive is equal to the tax basis of the stock they gave up, and they donít report taxable gain until the new stock is sold. This can be advantageous if the shareholders of the acquired company are not planning to cash out in the near future.

Consult an Expert

How you structure an acquisition can affect the amount of money or other property exchanged in the transaction. For this reason, determining an accurate value for the company or companies involved in the acquisition is vital. From there, you will be able to compute a price that will lead to a fair deal for each party, regardless of the structure.
Before reaching an agreement, both parties need good advice about the future impact of the various acquisition structures. Call us for help to ensure that you are structuring the best deal for your business.

June 1998