Taxable Acquisitions Course Materials

Taxable acquisitions � Acquire stock or assets? � Assume that Buyer Corporation wants to acquire the business of Target Corporation � Target's assets have appreciated and are worth more than their tax basis � Assume the acquisition will be a taxable purchase • purchase price will be cash or notes rather than the buyer's stock Why use a taxable purchase? � seller wants cash � buyer wants seller out of the continuing entity � buyer wants "step-up" in tax basis of acquired assets � seller has losses that can be used to offset taxable gain Transaction structure � The transaction can be structured in one of three ways • methods 1, 2, and 3 on page 324 � all referred to as "taxable" methods because Target's shareholders will have a taxable gain from the transaction Transaction structures 1. Buyer purchases all of the assets from Target ! Target liquidates and pays cash out to its shareholders 2. Buyer purchases all of the Target stock from Target shareholders ! Target is liquidated ! Buyer ends up with all of Target's assets 3. Buyer purchases all of the Target stock from Target shareholders ! Target is maintained as a subsidiary of Buyer Buyer's considerations � Buying Target stock results in Buyer having a tax basis in the stock equal to the purchase price • However, Target (as a subsidiary of Buyer) keeps its old (lower) tax basis in its assets � Therefore, Buyer gets no tax deductions (e.g., depreciation, amortization) for the excess of the purchase price paid over the basis of Target's assets � Buying Target assets results in "step-up" in tax basis • higher future depreciation/amortization deductions • less future income tax Limits of asset purchases � Sometimes there are valuable intangible assets that cannot be transferred • examples: licenses, exclusive rights, franchises, cable tv, oil leases, cell phones, season tickets � To obtain these assets Buyer needs to buy the stock of the corporation owning the assets � If Target has valuable tax attributes such as NOL carryforwards these are lost if assets are purchased Target's shareholders' considerations � If stock is sold, there is only a single level of tax to the shareholders (lower capital gains rates usually apply) � If assets are sold there are two levels of tax • Target is taxed on the (ordinary) gain from selling the assets • Target's shareholders are taxed on the gain from liquidating Target # excess of what shareholders receive on the liquidation over their basis in their stock is a gain # usually taxed at lower capital gains rates � For an asset sale, Target NOLs or capital loss carryforwards, can be used to offset gain at Target's level � If Target's shareholder is a corporation owning 80% or more of Target's stock, gain or loss on liquidation of Target is generally avoided under special rules Section 338 � Suppose Buyer acquires Target stock � Special tax rule (section 338) allows Buyer to elect to "step up" basis of Target's assets to equal the purchase price Buyer paid for the stock � Should asset basis be stepped up? • To step up the tax basis Target has to recognize gain as though the assets had been sold • Tax issue: Will the present value of the future tax savings resulting from the step-up (that is, higher future depreciation and/or amortization) be more than the additional tax currently due on the additional gain? • Usually only optimal when Target has NOLs that can offset gain generated by step up Section 338 � Note that under the Section 338 election the liability for the tax on the gain to Target rests with Buyer • Target's old shareholders have sold their stock • Target is now a subsidiary of Buyer � To make the Section 338 election Buyer must purchase at least 80% of Target's stock • Special rule allows a basis step up to the total of the following: # cash paid by Buyer for stock of Target # liabilities of Target # tax liability arising from section 338 step up transaction Allocation of purchase price among assets � In an asset purchase, the lump-sum purchase price must be allocated among all of the assets acquired from Target � This is extremely important as the costs of different assets are recovered over different time periods • Some assets can be expensed as used (e.g., supplies, inventory) • Some assets must be depreciated (e.g., machinery, buildings) • Purchased intangibles must be amortized over 15 years (e.g., goodwill) • The cost of some assets may not be deducted until they are sold (e.g., land) Survival of NOLs and other tax attributes � One of the reasons to purchase stock rather than assets is that tax attributes like NOL carryforwards may survive and be utilized by Target in the future � To prevent people from simply purchasing net operating loss benefits ("trafficking"), the tax law puts limitations on the use of NOLs in cases where there has been a change of ownership � This limitation applies whenever there has been a greater than 50% change in the ownership of the loss corporation � The limitation applies to carryforwards of all tax attributes, such as tax credits, capital losses, as well as net operating losses §382 limitation for NOL carryforwards � Multiply the market value of Target by the long term tax exempt interest rate � This is the amount of the NOL that may be used each year in the future � Why this rule? • Congress did not want investors buying corporations with loss carryforwards, putting profitable businesses into them, and using the loss carryforwards to shield the taxable income of the profitable busi • Under the rules investors may only earn a "tax free" return on their investment equal to the tax exempt interest rate, in other words, what they could have earned by investing in municipal bonds • Any return in excess of the tax exempt rate will be subject to tax A’s Taxable Purchase of T’s Stock � T has assets with a basis of $100 (inside basis) and FMV of $200. � A pays T shareholders $165 for their stock ($200 FMV of T assets less built in tax liability of $35 {($200-$100) x 35%}). � T’s shareholders have a basis (outside basis) in T stock = $80. A’s Taxable Purchase of T’s Stock � T Corp • No gain or loss on the sale of its stock • T’s basis in its assets remain the same ($100) • Tax attributes generally not affected (ability to use in • the future may be limited) � A Corp • Basis in stock purchased $165 � T’s Shareholders • Amount realized • Basis • Gain (capital) $165 80 $85 A’s Taxable Purchase of T’s Stock � Nontax Factors: • An acquisition of T’s stock will protect A from T’s liabilities but will leave T’s assets subject to it’s liabilities. • Stock transactions may be necessary if T has licenses or other agreements that are not transferable. A’s Taxable Purchase of T’s Assets � T has assets with a basis of $100 (inside basis) and FMV of $200. � A pays T $200 for the assets. • Why won’t A pay $165 like before? � T’s shareholders have a basis (outside basis) in T stock = $80. A’s Taxable Purchase of T’s Assets � T Corp • Amount realized $200 • Basis • Gain (capital) # 100 $100 Tax attributes are not affected (NOLs may be available to offset gain) � A Corp • Basis in assets equal to purchase price $200 • Stepped-up basis generates deductions (depreciation, amortization, etc.) � T’s Shareholders • No gain or loss unless company liquidated A’s Taxable Purchase of T’s Assets � Nontax Factors: • An acquisition of T’s assets will allow A to avoid all of T’s liabilities. • Must transfer title in all assets sold (may be costly)