Mark Lubin's article “Watch for Pitfalls Associated with Business Acquisitions" in CPA Now
Reprinted with permission from CPA Now, the blog of the Pennsylvania Institute of Certified Public Accountants.
Watch for Pitfalls Associated with Business Acquisitions
By Mark L. Lubin, CPA, JD, LLM
CPAs who do not regularly engage in merger and acquisition (M&A) work are occasionally asked to assist clients with business acquisitions. Business acquisitions can take different forms (e.g., stock vs. asset acquisition), and they often present significant risk exposure. The work is complex and highly time sensitive. Errors in planning and implementing these transactions can result in unnecessary taxes, increases to ongoing tax burdens for the buyer (due to loss or impairment of valuable tax attributes or otherwise), and buyer exposure to taxes attributable to pre-acquisition periods.
This blog highlights certain tax issues concerning transaction structure and due diligence that can arise in M&A transactions. Due to space limitations, I have focused on those issues typically presented from the buyer’s perspective.1
Business buyouts are typically structured as asset acquisitions, entity acquisitions, or a combination of both. Moreover, entity acquisitions are sometimes treated for federal income tax purposes as asset acquisitions.2 The ideal structure for an acquisition usually requires complex analysis, which should consider the following factors (among others that can depend on deal specifics):
- The target’s ownership structure and tax considerations concerning the target’s owners.3
- The tax character of target entities; in other words, whether the target’s business is conducted through a C corporation, S corporation, partnership (in legal form or an LLC taxable as such), disregarded entity LLC, or some combination of those types of entities.
- Whether the target/selling entity possesses substantial “unwanted” assets (such as a separate business or perhaps real property) that the purchaser does not wish to acquire, or the seller (or its owners) does not wish to transfer.
- Whether there is substantial “built-in” gain on the assets to be acquired.
- Whether the target possesses tax attributes that may be valuable to the buyer (taking into account any relevant limitations, such as the Section 382 limitation on use of net operating loss carryovers after an ownership change).4
- Whether the buyer wishes to retain and motivate target management by providing equity incentives.
- Financing considerations, such as favorable existing financing that could be compromised by an acquisition transaction.5
- Buyer exit considerations (discussed below).
Although a comprehensive discussion of these potential issues is beyond the scope of this article,6 a few general points should be noted.
In M&A transactions, sellers often prefer stock sales, whereas buyers often prefer asset purchases. This is generally because buyers seek to obtain an asset basis “step-up” and minimize exposure to seller liabilities (tax and nontax), whereas sellers prefer to avoid multiple taxation (e.g., tax at both corporate and shareholder levels for businesses conducted by C corporations), as well as limit ongoing exposure to tax and nontax liabilities relating to the business.7 Also, some businesses may hold intangible assets or have contractual, licensing, or other relationships that may make an asset transfer impractical. An early analysis of these issues can help parties and their advisers negotiate a favorable transaction structure.
Integration issues are sometimes overlooked in transactions where the buyer already has a complex structure. For example, where a buyer would benefit from holding various seller assets in different parts of its own structure, it may be most tax-effective for the buyer to separately acquire various assets through entities where they will ultimately reside, rather than initially having one entity acquire the target (or all its assets) and then moving the acquired assets around the buyer’s own structure.8
Considerations regarding the buyer’s potential exit can also influence acquisition structure. For example, a buyer that anticipates the eventual disposition of an acquired business to a private equity or similar fund may wish to acquire business assets through a disregarded LLC that can easily be transferred.
Due Diligence Considerations
Due diligence is critical for buyers and their advisers. Broadly speaking, due diligence involves a review of the target’s business to determine what risks are presented and to confirm the quality of the target’s assets and earnings. CPAs are often called on to handle tax-related aspects of due diligence.
Important buyer objectives of tax due diligence include the following:
- Determining (and to the extent possible, limiting) potential direct or indirect buyer liability for target taxes attributable to preacquisition periods.9
- Determining (and to the extent possible, mitigating) post-transaction constraints and potential tax liability attributable to prior target actions.10
- Corroborating the existence and ensuring the value and usability of tax attributes claimed by sellers.11
Businesses come in all shapes and sizes, so the potential issues and appropriate diligence procedures can vary substantially. In my experience, however, there are a few common elements to most successful tax diligence:
- The buyer and its advisers should understand certain fundamental aspects of the target’s business and overall transaction as early as possible. Those aspects include the target’s current and historic ownership structure (including the tax characterization of its entities), the types of business it conducts (and tax issues commonly associated with such businesses), the general parameters of the deal (what assets will be included, what pretransaction structuring, if any, is contemplated by the seller, etc.), and the broad tax planning objectives and constraints for all parties. Buyers and their advisers should review copies of recent target tax returns, financial statements, and ownership diagrams to highlight potential issues and quickly get up to speed on these matters.
- The scope and nature of the initial due diligence process should be agreed upon early between all relevant parties. Typically, buyers and their advisers will request a variety of documents and at least one call or videoconference with the target’s tax leadership and nontax personnel as appropriate.12 Flexibility should be preserved to change the due diligence scope and processes as potential issues become apparent.
- A detailed due diligence checklist should be prepared early in the process. That checklist should be organized by subject/potential issues, and it should describe in reasonable detail the review procedures to be undertaken.13
- A written due diligence report is good practice, and it is often required.14 A comprehensive diligence checklist (appropriately modified as diligence progresses) usually provides an ideal framework for such a report.15
A final takeaway is that forethought and good organization go a long way toward ensuring that transactions are appropriately structured and that tax due diligence is handled effectively and efficiently.
1 Specialized areas such as bankruptcy/workout acquisitions, cross-border (international) businesses, employment taxes, state and local taxes, and companies eligible for special tax incentives are generally beyond the scope of this article. For simplicity, references to targets and sellers are sometimes used interchangeably, depending on context.
2 For example, certain stock acquisitions can effectively be treated as asset acquisitions under IRC Section 338(h)(10), and acquisitions of disregarded LLCs are treated for such purposes as acquisitions of the LLCs’ assets.
3 It is common for a target to have multiple owners with varying tax objectives and concerns. For example, founders of a closely held business may wish to participate in future growth, avoid current taxation and obtain potential estate planning benefits by “rolling over” a portion of their investment in the target. On the other hand, other investors (such as private equity and venture funds) may wish to maximize their immediate cash proceeds.
4 In negotiating a purchase price, well-advised buyers should exercise caution to avoid paying for tax attributes not likely to be utilized.
5 For example, a target may have low-interest or other favorable long-term debt that would be repayable on an asset sale.
6 Resources that provide in-depth analyses of these issues include Mergers, Acquisitions, and Buyouts by Ginsburg, Levin, and Rocap (Wolters Kluwer) and Federal Income Taxation of Corporations and Shareholders by Bittker and Eustice (Thomson Reuters/Tax & Accounting).
7 Transaction parties and their advisers should generally do modeling to compare the relative value of an asset basis step-up to the buyer with related additional transaction tax costs to the seller. Such modeling should take into account corporate tax attributes such as loss carryovers, which can sometimes provide greater benefits by offsetting seller gains (including gains on dispositions of assets not wanted by the purchaser) in an overall stock transaction than they would on a post-transaction basis in the hands of a purchaser.
8 Although outside the scope of this article, sales and transfer taxes can often be minimized under the former approach.
9 This objective includes limiting tax audit and litigation risk for a variety of unreported and underreported taxes.
10 For example, entity purchasers may be required to continue using previously adopted target accounting methods.
11 Such attributes typically include loss and credit carryovers and adjusted asset basis.
12 Buyers and their advisers should ensure that adequate time is allotted for those discussions, and they should anticipate and be prepared to navigate legitimate confidentiality considerations that may be raised by the target (i.e., a target or its owners may not want its employees, customers, and competitors – and for public deals, financial markets – to know about a potential or pending acquisition before it is officially announced).
13 Such a checklist can help prevent issues from being overlooked as due diligence unfolds. Common tax due diligence subjects include the following: tax planning and significant transactions undertaken by the target; validity of tax elections made by target entities; tax audit exposure for open years concerning potential delinquencies; exposure regarding tax credits and incentives claimed; intercompany transactions, including potential transfer pricing risk; nexus exposure (i.e., risk of state, local, or foreign authorities asserting that target entities failed to file returns or make payments required as a result of their activity in the jurisdiction); employment tax issues, including worker misclassification and matters concerning retirement and benefit plans; potential liability for taxes of other entities (including under consolidated tax return rules); and exposure resulting from noncompliance with information reporting requirements (e.g., IRS Forms 1099). Specialists are often needed to assist in addressing these and other subjects.
14 That typically occurs where tax or representations and warranties insurance is obtained.
15 The spreadsheet format lends itself well to such a checklist, and it can also be useful for tracking diligence progress.
Mark L. Lubin, CPA, JD, LLM, is special counsel at the law firm Chamberlain Hrdlicka in Philadelphia, where his practice focuses on tax planning and complex business transactions. He can be reached at email@example.com.