RSM Resources

If buyers and sellers don’t address tax issues early on when considering a merger or acquisition deal, they could risk leaving millions of dollars on the table, say merger-and-acquisition (M&A) professionals.

That analysis should be underway well before the parties ever sign a letter of intent, says Tom Cronin, a managing director with RSM McGladrey’s national tax practice.

"Even though it’s nonbinding, the letter of intent establishes principles," Cronin says. "If you commit to a structure that’s disadvantageous in terms of tax, you may have to sacrifice something else in the negotiations later to recover it."

Because it affects the bottom line of an M&A transaction so significantly, formulating the right tax-efficient plan can play a key part in closing a successful deal.

While the business’ strategic goals such as geographic expansion typically drive mergers and acquisitions, "if the tax implications haven’t been thought through, the deal isn’t close to being done," Cronin says.

Just as you’d analyze the IT systems, benefits package and cash reserves of a targeted firm, calculating the impact of tax on a potential deal is an essential element of the due diligence process. Does the target have any unpaid tax liabilities? If you’re a buyer, are there hidden surprises waiting for you, like executive "golden parachute" packages that would be triggered once the ink’s dry on a sale? Is there a more tax efficient structure to accomplish this transaction that you haven’t considered?

No two deals are the same. But there are some general variables to consider in any M&A transaction, starting with whether the deal is structured to be taxable or tax-deferred.

Tax-deferred transactions

In a tax-deferred transaction, the seller typically gets a substantial part, if not all, of its proceeds in the form of stock in the purchasing company. Because the seller continues its investment in the surviving firm without realizing a gain, there’s no tax consequence until that stock is sold. This alternative can make sense for sellers who don’t need the immediate liquidity — provided they think the buyer’s shares are a good long-term investment.

The most common form of tax-deferred acquisitions are type A, B and C reorganizations (referring to the sub-paragraphs in section 368(a)(1) of the tax code where they’re defined), which have different rules for what percentage, and what type, of stock must be used.

"These can be complicated deals," Cronin says. "There are several specific requirements that have to be met in order for a transaction to qualify as tax-deferred."

Taxable acquisitions

In a taxable M&A transaction, where the government takes its cut in the first year, two of the most critical factors influencing buyer-seller negotiations are:

• What the buyer is purchasing — assets versus stock.
• The legal structure of the seller.

In most M&A transactions, the buyer either purchases the seller’s assets (as a result of which the seller becomes a shell and is liquidated) or acquires stock. Which has the better tax implications? It generally depends on if you’re the party cutting the check, or cashing it, Cronin says.

Sellers typically negotiate for a stock sale, because the gain will be taxed only once, at the relatively low capital gains tax of approximately 20 percent, taking into account federal and state tax.

In an asset sale, on the other hand, the seller may be hit by two rounds of taxation: income tax at the corporate level and again at the shareholder level when the proceeds of the sale are distributed. (Assuming the seller is set up as a C corporation. An S corporation avoids this double taxation either entirely or, if it converted from C to S status less than 10 years ago, at least in part.)

Buyers, however, generally benefit from an asset-sale arrangement because it’s more flexible — they can negotiate to purchase pieces of the selling company rather than swallowing it whole, good parts and bad — and because they get a larger tax write-off. Assuming the fair market value of the assets purchased exceeds the depreciated book value, the difference, or "step up," can be deducted on an asset-by-asset basis determined in the purchase price allocation process, that itself may become a significant negotiation point.

Since taxwise, buyers benefit by assigning more of the purchase price to fast-depreciating assets like inventory and equipment — while allocation to longer-term assets like land generally favors sellers — purchase price allocation is a sticking point that comes up in most asset-acquisition deals, according to Cronin.

If the deal’s structured as a stock sale so this tax break isn’t available, typically the purchase price buyers are willing to pay will be reduced.

Experts say that overall, S corporations and limited liability company (LLC) legal structures are the most tax-efficient when a business is up for sale. Since the liability a C corporation incurs on an asset sale can exceed 50 cents on the dollar (in combined tax at both the corporate and shareholder level), companies planning ahead to go on the market should at least consider converting to S corporation status.

For example, a C corporation that sells its assets at a $100 gain pays income tax of $40 (taking into account the combined deferral and state tax rates), leaving $60 to distribute to shareholders. Upon receiving the $60, the shareholders pay a federal income tax of about $12, using the 20 percent individual long-term capital gains rate, leaving only about $48 in the shareholders’ hands after tax.

If the company had elected to convert to an S corporation over 10 years ago, only one tax would be imposed on the shareholders, at the 20 percent rate (Generally, if the conversion to S corporation status took place within 10 years some corporate tax would be due). The total federal tax would be $20, as compared with $52, and the after-tax profit available to the shareholders would be $80, rather than $48.

Other issues

There are other tax-related issues both parties to the transaction will have to address. State and local governments, for example, assess a range of income, sales, transfer and property taxes that vary considerably. Particularly if one or both parties do business in multiple states, or internationally, it’s important to get professional tax advice from those who possess the expertise in these areas early on in the process.

Before pursuing deals, most careful buyers spend at least some time on these tax issues as part of pre-acquisition planning and profiling the ideal target. Cronin says that sellers are smart to do the same, even if they won’t be actively on the market for a few years. Thinking ahead about the tax consequences of corporate structure, or the optimal time to make a planned stock or asset transfer, puts you in a stronger position once negotiations start.

The tax aspects of an M&A transaction can be significant enough to become the deal maker or deal breaker. Even if it isn’t a deal breaker, the tax equations may result in redistribution of the after tax proceeds and costs among the parties. Understanding the key issues involved helps sellers maximize their after-tax proceeds, buyers minimize their net costs, and better positions the new company emerging from the deal for success.