RSM Resources

The record pace of mergers and acquisitions (M&As) during thepast two years shows no signs of letting up, with the number of M&Adeals this year expected to exceed the estimated 25,000 in 2006.

Butdealmakers should plan carefully, because unforeseen tax issues canmake an otherwise appealing merger much less palatable. According to arecent national survey on M&A activity, 70 percent of respondentssaid hidden or unrecorded financial liabilities threatened successfulmergers or acquisitions. In that same study, nearly half of respondentscited incomplete tax planning as a significant risk in bringing twocompanies together.

Structure deals with an eye on taxes

Tohelp minimize tax-related M&A headaches, experts say it’s helpfulto begin by thoughtfully analyzing how to structure a proposedtransaction. In a taxable merger deal, a savvy buyer seeks to acquireonly the assets of a target firm, largely because that’s a good way toavoid assuming undisclosed tax or financial liabilities while gaining asizable tax write-off against depreciated assets. Conversely, sellersoften want to sell stock, because it’s a straightforward transactionsubject to taxation only once at a relatively low capital-gains rate.

Bridginggaps between the needs of buyers and sellers often requires creativity,says Bruce Shnider, a longtime M&A attorney and distinguishedvisiting professor at the University of Minnesota Law School. Forexample, he says, parties can structure an M&A deal to allow theprospective seller to issue stock but enable the buyer to treat it asan asset acquisition for tax purposes. Under this arrangement, thebuyer receives a "step up" in basis on acquired assets, providing ahigher platform for depreciation and amortization deductions, as wellas full disclosure on financial and tax liabilities. While the sellermust treat any asset sale gains above the tax basis as ordinary income,the bulk of the transaction typically is taxed as capital gains.

Inmany situations, the amount of ordinary income is trivial, and theparties can adjust the purchase price to take that into account. Insuch a scenario, the seller enjoys the full benefits of selling stock,and the buyer enjoys the benefits of purchasing assets.

In atax-deferred arrangement, a seller typically receives most or all ofthe sale’s proceeds as stock in the purchasing company, and the sellerwill have no tax liability until selling the stock. Because the IRS hasrelaxed so-called "continuity of interest" regulations in recent years,sellers no longer have to hold stock in the new entity for an extendedperiod. This choice, while complex, can work well in situations wherethe seller wants to cash out, and the buyer doesn’t have a lot of cashfor the purchase, Shnider says.

Address common tax traps

Onceboth parties approve the deal structure, key leaders can dig deeperinto other potentially nasty tax traps. Some of these include:

State, local and transfer taxes.If the merging businesses have operational or sales presence inmultiple states, this can raise significant issues. The United Statesalone has more than 7,500 taxing authorities in 45 states and theDistrict of Columbia that impose sales-and-use taxes on the purchase oftangible goods. This means prospective buyers should look closely athow effectively the business has collected, reported and paidsales-and-use taxes to various jurisdictions. If the buyer cannot getgood documentation that the seller has paid these liabilities in full,Shnider suggests reopening price negotiations to account for thepotential cost or drafting an indemnification clause in the purchaseagreement that makes the seller liable for all outstanding tax mattersprior to close.

On property tax matters, experts say the buyershould verify any lien records and seek proof of payment for the mostrecent tax cycle. Even if payments are up-to-date, buyers may face areassessment of property values after purchasing corporate property,which often leads to a tax increase.

Aggressive tax positions.In concert with a careful review of a target company’s current taxliabilities, a prospective buyer should also take time to evaluate thetarget’s overall tax posture. If questionable tax compliance practicesgo unchallenged, the buyer may risk failing future audits, leavingitself open to potentially sizable tax liabilities. Note this majortell-tale warning sign: any existing target company correspondence withtaxing authorities about unresolved payment issues.

While aseller may offer explanations of these unresolved payments, the buyerneeds to recognize how that opens the door to potential taxliabilities, penalties and interest, which can add up to a materialnumber, Shnider says.

Golden parachute provisions. Manycompanies offer executive pay agreements through which a change incontrol can accelerate vesting of deferred compensation or require thepayout of a large severance package. Such "make-whole" provisions — ifnot properly managed — can deliver a nasty tax surprise.

Forexample, if a public company pays an executive $100,000 a year andawards that employee $299,000 in severance after a change in control,there is no tax liability. But, if the payout exceeds three times basepay, the company loses the ability to take a compensation deduction andfaces a 20 percent "excess parachute" tax penalty. That problem becomeseven more costly for companies with "gross-up" provisions, in which thebusiness agrees to cover any excess income taxes that key executivesincur.

Privately held firms can mitigate excess taxation ofgolden parachutes if shareholders vote to approve the payouts. However,this requires the target company to fully disclose the names of allexecutives eligible for such payments, as well as the specificcompensation arrangements for each. It also requires each executive tosign a document waiving the right to any payments sparked by a changein control unless the shareholders approve the payments.

Tomanage this process, Shnider says it’s important to identify keyemployees at a target company with sizable change-in-controlcompensation packages. By taking this step before a deal closes, thebuyer and seller can review the list and identify creative ways torework existing compensation packages to meet executives’ needs.

"Ina perfect world, these things should be identified earlier rather thanlater, because the tax consequences can really affect how much a buyeris willing to pay for all the parachutes and gross-ups," Shnider says."Mergers and acquisitions is a strange and often unique world, and nomatter how smart a company’s executive team or in-house staff may be,they need to get the right outside help if they don’t have a lot ofM&A experience."