When contemplating a merger or acquisition, buyers assess a variety of items about the target entity, such as internal controls, quality of customers, accounting practices, financials, projected growth, and so much more. What many buyers may not know is that mergers and acquisitions (M&As) also have a slew of tax ramifications that, if not handled properly, could negate all the advantages of pursuing a transaction.
To start with, structuring the transaction as an “asset sale” will have different tax ramifications than structuring the transaction as a “stock sale,” and buyers should appreciate and understand the differences.
In an asset sale, the buyer purchases individual assets of the target company — such as equipment, fixtures, leaseholds, licenses, goodwill, trade secrets, trade names, and telephone numbers — but does not take ownership of the legal entity. Generally, the buyer does not assume the target entity’s cash or its liabilities but does take ownership of its net working capital, which often includes accounts receivable, inventory, prepaid expenses, accounts payable, and accrued expenses. This is known as a cash-free and debt-free transaction.
Asset sales not only let the buyer choose specific assets they want to purchase, but they also allow for a “step-up” in the company’s depreciable basis of those assets to fair market value. The sales price of the assets becomes the buyer’s starting tax basis. By allocating a higher value to these assets and allowing the buyer to restart depreciation, the company will have a more favorable cash flow during the vital first years of the transition.
Buyers also tend to prefer asset sales because they can more easily avoid inheriting undisclosed liabilities, especially contingent liabilities in the form of product liability, contract disputes, product warranty issues, and employee lawsuits.
But asset sales aren’t perfect. Certain assets — such as intellectual property, contracts, leases, and permits — are more difficult to transfer. Issues such as obtaining consents, assigning contracts, and refiling permits may delay the transaction.
In a stock sale, the buyer purchases the target entity’s stock, thereby obtaining ownership of the legal entity. Unlike an asset sale, stock sales do not require transfers of individual assets because the title of each asset remains with the acquired entity.
With stock sales, buyers lose the ability to gain a stepped-up basis in the target company’s assets, and they do not get to restart depreciation. The tax basis of the assets at the time of sale gets transferred to the new owner, and the purchasing entity will continue to depreciate the assets as if no sale occurred. If the selling entity transfers highly depreciated assets, the buyers will lose out on depreciation deductions compared to what they could have reported in an asset sale.
Buyers may accept more risk when purchasing the company’s stock, since they are assuming all contingent risk, whether or not it is known or disclosed. In other words, future lawsuits, environmental concerns, OSHA violations, employee issues, and other liabilities all become the responsibility of the new owner. (These potential liabilities can be reduced to some extent through representations, warranties, and indemnifications in the stock purchase agreement.)
If the target entity has government or corporate contracts that are difficult to assign, a stock sale may be the better option because the corporation — not the owner — retains ownership. Also, if a company is dependent on a few large customers, a stock sale may reduce the risk of losing these contracts. Note that in both of these situations, prior approval of a stock sale may be required under the contract.
Other Tax Considerations
M&As might have a negative effect on certain tax attributes. The following issues are important to consider in due diligence:
- Net operating losses (NOLs). The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) temporarily boosted the benefits of NOLs. NOLs from 2018 through 2020 can now be carried back for five years or carried forward to offset 100% of future taxable income (compared to the prior allowance of 80%). NOLs can be quite powerful — especially after this boost from the CARES Act — and unfortunately, many NOLs are lost when there has been a significant change in ownership, such as in a merger or acquisition.
- COVID-19 relief. If a buyer is acquiring a company that received some form of financial relief during the COVID-19 pandemic, such as a Paycheck Protection Program (PPP) loan, they may encounter issues following a merger or acquisition. Fortunately, the IRS released a procedural notice late last year that addresses PPP loans in merger and acquisition transactions. If the target entity has taken out a PPP loan and has not yet fulfilled its obligations for forgiveness, the acquiring entity may be eligible for forgiveness of loans they assume, but only if they follow certain procedures.
- State and local taxes (SALT). Acquiring a new entity and its business locations, customers, vendors, or employees could alter the buyer’s SALT liabilities. For example, if the buyer acquires a new business location or starts serving customers in other states, they will likely have to file income tax or sales tax returns (or both) in those new states.
This article only highlights some of the many tax matters that need to be considered in M&As. If you are considering a transaction, whether you are on the buying or selling side, reach out to your CRI advisor for help.