Advanced Tax Considerations for Negotiating, Structuring and Documenting M&A Transactions

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Advanced Tax Considerations for Negotiating, Structuring and Documenting M&A Transactions Evaluating Taxable Versus Tax-Free Deals, Stock Sales Versus Asset Sales, Tax-Free Reorganizations, Earnouts and More TUESDAY, SEPTEMBER 12, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Jonathan Golub, Attorney, Royse Law Firm, Palo Alto, Calif. Roger Royse, Attorney, Royse Law Firm, Menlo Park, Calif. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

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5 M&A TAX CONSIDERATIONS FOR BUYERS AND SELLERS Jonathan Golub Royse Law Firm, PC Silicon Valley San Francisco Los Angeles Orange County Roger Royse Royse Law Firm, PC Silicon Valley San Francisco Los Angeles Orange County Skype: roger.royse IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.

6 OVERVIEW OF TRANSACTIONS Tax Free Reorganizations: Type A Merger Type B Stock for Stock Type C Stock for Assets Type D Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations Type E Recapitalizations Compensation Issues Taxable Transactions: Stock Sale Asset Sale S Corporation Strategies Use of LLCs Foreign Corporations 6

7 TAXABLE VS. TAX FREE Type of Acquisition Currency Stock Securities/Debt Deferred payments, earn out provisions Compensatory Nature of the Buyers and Seller Foreign Parties Tax Attributes of Parties Shareholder Level Considerations Tax Sensitivity of Shareholders Appetite for Complexity & Risk Some taxes subject to indemnification 7

8 CONTINUITY OF INTEREST IRS 50% Safe Harbor, Rev. Proc IRS 40% in Temp. Reg T(e)(2)(v), example (1) John A. Nelson 38% Stock Miller v. CIR 25% Stock Kass v. CIR 16% Stock is Insufficient 2011 Regulations address changes in value between the date of signing and close; if fixed consideration (Consideration is fixed if contract states exact number of shares and other cash or property to be exchanged) Consideration is valued as of last business day before the first day the contract is binding and If a portion of the fixed consideration is other property identified by value, then the specified value is used for that portion (see Reg (e)(2)) Proposed Regulations (Prop. Reg (e)(2)(vi)) consideration that varies as the value of issuing corporation stock changes prior to closing will not fall below (or above) contractual floor (or ceiling) markers for purposes of continuity of interest. If binding contract uses average value of issuing corporation stock that average value can be used for continuity of interest. Post transaction sales and redemptions 8

9 TAX FREE REORGANIZATIONS Type A Merger Type B Stock for Stock Type C Stock for Assets Type D Spin Off, Split Off, Split Up, and Type D Acquisitive Reorganizations Type E - Recapitalizations Ruling Guidelines Rev. Rul Rev. Proc Rev. Rul (terms) Rev. Proc Rev. Proc (Type D Checklist) 9

10 TYPE A REORGANIZATIONS SECTION 368(a)(1)(A) STATUTORY MERGER Shareholders Statutory Merger 2 or more corporations combined and only one survives (Rev. Rul ) Requires strict compliance with statute can be foreign; Reg (b)(1)(ii) No substantially all requirement No solely for voting stock requirement Acquiror Requirements: Necessary Continuity of Interest Business Purpose Continuity of Business Enterprise Plan of Reorganization Net Value Tax Effect: Shareholders Gain recognized to the extent of boot No gain recognition Acquiror takes s basis in assets plus gain recognized by Shareholders Busted Merger taxable asset sale followed by liquidation 10

11 TYPE B REORGANIZATIONS SECTION 368(a)(1)(B) STOCK FOR STOCK Shareholders Acquiror Acquisition of stock of, by Acquiror in exchange for Acquiror voting stock Acquiror needs control of immediately after the acquisition Control = 80% by vote and 80% of each class Acquiror s basis in stock is the same as the Shareholder s Solely for voting stock No Boot in a B Reorganization Expenses distinguish between expenses and Shareholder expenses (Rev. Rul ) Creeping B old and cold stock purchased for cash should not be integrated with stock exchange 11

12 TYPE C REORGANIZATIONS SECTION 368(a)(1)(C) STOCK FOR ASSETS Shareholders Acquiror Stock Acquiror Stock Assets Acquiror Acquisition of substantially all of the assets of, by Acquiror in exchange for Acquiror voting stock Substantially All at least 90% of FMV of Net Assets and at least 70% of FMV of Gross Assets must liquidate in the reorganization 20% Boot Exception Acquiror can pay boot (non-stock) for assets, up to 20% of total consideration; liabilities assumed are not considered boot unless other boot exists Reorganization Expenses Aquiror may assume expenses (Rev. Rul ) Assumption of stock options not boot Bridge loans by Acquiror are boot Redemptions and Dividends who pays and source of funds 12

13 TYPE D REORGANIZATIONS SECTION 368(a)(1)(D) DIVISIVE SPIN OFF, SPLIT OFF, Shareholders Transferor Transferee Stock SPLIT UP Transferee Stock Transferor Assets Control rules: Transfer by a corporation of all or part of its assets to another corporation if, immediately after the transfer, the transferor or its shareholders are in control of the transferee corporation. Distribution Rules: Stock or securities of the transferee must be distributed under the plan in a transaction that qualifies under Section 354, 355, or 356. Must satisfy business purpose, transfer long-lived business, and not fail numerous anti-abuse provisions. Precaution: Protectively file 336(e) election in case this fails to be a tax-free reorganization, to at least get inside basis step-up (see later slide) 13 Transferee

14 TYPE D REORGANIZATIONS SECTION 368(a)(1)(D) NON-DIVISIVE Merger Treated as Acquisitive D Shareholders with 20% Acquiror Stock Acquiror Stock If shareholders of Transferor stock receive Acquiror stock and own at least 50% of Acquiror stock, the transaction may be treated as a non-divisive D REORG even if it fails as an A REORG for lack of continuity Transferor Transferor Assets Merger Acquiror Failed Type C Treated as D Shareholders Liquidation / Reincorporation Shareholders Transferor Assets Acquiror Transferor Acquiror Cash & Stock 14

15 NON-QUALIFIED PREFERRED STOCK Preferred Stock limited and preferred as to dividends; and does not participate in corporate growth if: (1) shareholder has right to require issuer to redeem (2) issuer is required to redeem (3) issuer has right to redeem and is more likely than not to exercise that right; or (4) dividend rate varies based on interest rate, or commodity price or other index Redemption right exercisable within 20 years and not subject to contingency that renders likelihood remote Excludes stock compensation that may be repurchased on separation from service Conversion feature not enough to participate in growth Generally treated as boot to shareholders 15

16 TRIANGULAR OR SUBSIDIARY MERGERS 1. Forward Subsidiary Merger Acquiror Merger Sub 2. Reverse Subsidiary Merger Acquiror Merger Sub 16

17 TRIANGULAR OR SUBSIDIARY MERGERS Shareholders Acquiror 80% Merger Sub Tax Consequences Merger Sub takes s basis in assets increased by gain recognized by Acquiror takes drop down basis in stock of Merger Sub (same as asset basis) Section 368(a)(2)(D) Forward Triangular Merger A statutory merger of into Merger Sub (at least 80% owned by Merger Sub) Substantially all of s assets acquired by Merger Sub Would have been a good Type A merger if had merged into Merger Sub 17

18 TRIANGULAR OR SUBSIDIARY MERGERS Shareholders Acquiror 80% Merger Sub Tax Consequences Non-taxable to and carryover basis No gain to Acquiror and Merger Sub under Sections 1032 and 361 No gain to shareholders except to the extent of boot Acquiror s basis in stock generally is the asset basis, but Acquiror can choose to take shareholders basis in stock (if it is also a B) If transaction is also a 351, Acquiror can use shareholders basis plus gain Section 368(a)(2)(E) Reverse Triangular Merger Merger of Merger Sub into where (i) shareholders surrender control (80% of voting and nonvoting classes of stock) for Acquiror voting stock and (ii) holds substantially all the assets of and Merger Sub Shareholder loan issues 18

19 HORIZONTAL DOUBLE DUMMY Acquiror Shareholder Acquiror Acquiror Stock New Holdco Stock New Holdco Stock New Holdco Stock + $ Shareholder Merger Acquiror survives Merger Sub Employs with two interim ( dummy ) subsidiaries, which participate in reverse triangular mergers to create final structure. Each side potentially qualifies for 368(a)(1)(B) (due to subsidiary being ignored) or (a)(2)(e). Special feature: Shareholders of Acquiror and control Holdco under 368(c); overall transaction therefore generally a good Code 351 exchange, and even very high boot will generally not break transaction. 19 Merger Sub Merger Survives

20 DOUBLE MERGER REV. RUL Step 1: Reverse Triangular Merger Shareholders Step 2: A-type Forward Merger Shareholders Acquiror Acquiror 80% Merger Sub +Sub Merger Sub Survives Merger Sub Tax Benefit: A taxable reverse merger has just one tax on the shareholders, while a taxable forward merger has two taxes (one on shareholders and one on corporation). Intended that entire transaction be a tax-free A-type merger (where 20% boot limitation does not exist). Pairing the two reduces the risk of incurring the corporate level tax in the event the entire transaction is not treated as an A-type merger. 20

21 DOUBLE MERGER WHOLLY OWNED LLC REV. RUL Step 1: Reverse Triangular Merger Shareholders Step 2: A-type Forward Merger Shareholders Acquiror Acquiror 80% Merger Sub +Sub Merger LLC Survives LLC Second step is merger into LLC under Reg (b)(1) (good forward merger) 21

22 TYPE E REORGANIZATIONS SECTION 368(a)(1)(E) RECAPITALIZATIONS Useful for single company restructuring Often used to transfer control of a company from one generation to the next Typical situation = founders of business want to pass on control to children. They engage in a Type E recapitalization to change their voting common stock to nonvoting common stock or preferred stock, leaving children with voting control of the company There may be estate and/or gift tax consequences to such a transaction An important requirement to qualify for tax free treatment under a Type E recapitalization is that the old stock/securities must have the same value as the new stock/securities for which they are exchanged A recent IRS Memo (Legal Advice Issued by Field Attorneys F) stated that where the value of the stock received was in excess of the value of the stock surrendered, there was no Type E recapitalization and therefore the excess amount of stock received was taxable 22

23 VOTING POWER Issues to consider in calculating voting power: Control relevant in sections 269, 304, 355(e), 368, 382, 957 and 1504 What sort of capital structure does the company have? For example: One or more classes of stock with the same voting rights; Separate classes of stock that vote for different directors; Separate classes with a different number votes per share; Supermajority provisions; Veto powers. How do you determine voting power when shareholders have agreement on voting? e.g. shareholders agree to abstain from voting, vote together, or transfer shares to a voting trust How do you determine voting power with regard to foreign entities that are treated as a corporation for U.S. tax purposes? 23

24 FINAL REGULATIONS ON LOSS IMPORTATION General Rule: The acquirer s basis in assets acquired under Section 368 is usually the transferor s basis Section 362(e)(1) provides an exception for assets with built-in losses on the date of the transfer The IRS has issued Final Regulations explaining how these anti-loss importation rules apply (also applies to Section 334(b) transactions) Under the Final Regulations, if the aggregate basis of all Importation Property is greater than the aggregate value of such property then the basis of all the Importation Property is its value on the date of transfer Importation Property is property where: (1) the gain or loss is not subject to US tax in the hands of the transferor on a hypothetical sale immediately before the transfer; and (2) the gain or loss is subject to US tax in the hands of the transferee on a hypothetical sale immediately after the transfer 24

25 FINAL REGULATIONS ON LOSS IMPORTATION Issues to Consider Flow-through entities For flow-through entities such as a partnerships or S Corps, the importation property test is made by reference to the partners or shareholders, not the entity itself The hypothetical sale will consider allocations of gains and losses as per the organizing instrument The Final Regulations contain an anti-avoidance principal for REITs and RICs which applies the look-through principal above if the REIT/RIC acquired the property as part of a plan to avoid the anti-importation rules (same as Proposed Regulations) Controlled Foreign Companies (CFCs) and Passive Foreign Investment Companies (PFICs) Under the Importation Property test, a gain or loss on the sale of an asset by a PFIC or CFC is not considered subject to US tax even though it may result in an inclusion under Section 951(a) or Section 1293(a) Comments were specifically requested on this approach It was adopted in the Final Regulations 25

26 TARGET DEBT SECURITIES Exchange of securities for Acquiror securities is tax free under Sections 354 and 356, to the extent that the principal amount of Acquiror debt is less than the principal amount of debt Portion attributable to cash basis accrued interest is taxable Possible COD income Example: bonds with an issue price (stated principal amount) of $1,000 exchanged for Acquiror stock or debt worth $900; has COD of $100 26

27 DIVIDEND EQUIVALENCY Section 356(a)(2) Boot as dividend or capital gain; postreorganization redemption test of Rev. Rul Clark hypothetical post-reorganization redemption reduced shareholder s interest from 1.32% to.92% - substantially disproportionate under Section 302(b)(2) Section 302(b)(1) redemption that results in meaningful reduction in voting power is redemption and not essentially equivalent to a dividend Section 302(b)(2) greater than 20% reduction is substantially disproportionate E&P Limitation on Dividend should be s E&P but unclear if Merger Sub s E&P counted; PLR , PLR , and PLR

28 CONTINGENT STOCK, ESCROWS, AND EARN-OUTS Escrows: shareholders usually treated as owner of escrowed Acquiror shares unless otherwise agreed Especially true if shareholders have right to vote and receive dividends Not clear who is owner if shareholders do not have right to vote or receive dividends Earn-Out Stock: shareholders not considered owners until Acquiror shares are issued Not treated as boot Imputed Interest Rev. Proc Ruling Guidelines use of escrow or contingent stock (1) stock must be distributed within 5 years, subject to escrow or contingency (2) valid business purpose (3) maximum number of shares cannot exceed 50% (4) trigger event not controlled by shareholders and not based on tax liability (5) Formula is objective and readily ascertainable (6) Restrictions on assignment and substitution (7) In the case of escrows, Acquiror shares shown as issued to shareholders, current voting and dividend rights, and vested 28

29 UNVESTED STOCK RECEIVED IN A TAXABLE OR NON-TAXABLE DEAL Rev. Rul The revenue ruling addresses: (1) the exchange of fully vested stock for unvested stock of an acquiring corporation in a tax-free reorganization, and (2) the exchange of fully vested stock for unvested stock of an acquiring corporation in a taxable exchange Under either (1) or (2), the Rev. Rul. provides that the exchange constitutes a transfer of property subject to Section 83. The service provider would need to file an 83(b) election to avoid the recognition of compensation income in the future as the shares vest. The Rev. Rul. also provides that the spread will be zero, so there is no downside to the service provider s 83(b) election. 29

30 OPTIONS Assumption or Substitution No tax on substitution of NSO No tax on substitution of ISO, so long as the substitution is not a modification. There is no modification so long as: (1) the aggregate spread in new option does not exceed the spread in the old; and (2) the new option does not have more favorable terms than the old; see Sections 424(a) and 424(h)(3) 30

31 OPTIONS CASH OUT Cancel options for cash payment NSO ISO Ordinary income compensation withholding or 1099 Deduction to or Acquiror? FICA TAM employer deducts based on method of accounting; not clear if cash out at close is pre-acquisition deduction or post-close Acquiror deduction in absence of scripting the timing Under the cash method, the deduction generally arises when the employer has paid the property to the employee. See Regs (a)(1). Under the accrual method, the deduction arises when the employer's obligation to make the property transfer becomes fixed, the property's value is determinable and economic performance occurs. See Regs (a)(2) and -4(d)(2)(iii)(B) Exercise and disqualifying disposition treated differently 31

32 SECTION 409A Deferred compensation A deferral of compensation occurs whenever the service provider (employee) has a legally binding right during a taxable year to compensation that will be paid to such person in a later year. Treasury Regulation Section 1.409A-1(b) Consequences of violating 409A Amounts which were to be deferred are subject to immediate taxation Additional 20% penalty on such amounts Interest penalty CA state tax penalty Bonus or Carve Out Plans Participation in Earn Outs (Reg A-3(i)(5)(iv)) Payments of compensation in this context may be treated as paid at a designated date or pursuant to a schedule that complies with 409A if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally pursuant to the change in control event 32

33 EARN OUT PROVISIONS Bridge a valuation gap between seller and buyer Additional financing option Payment/tax deferral Reduce risk of overpaying Earn outs usually based on Financial s Earnings before interest, tax, depreciation and amortization (EBITDA); Revenue; Net income; Earnings per share Non-Financial s Regulatory approval; Increase in customer base/sales; Product development milestones Key Considerations: Terms, time period, payout structure, security for payments, allocation of control of the acquired business, level of support (if any) committed 33

34 280G GOLDEN PARACHUTE RULES 20% excise tax and loss of deduction on Excess Parachute Payment Excess Parachute Payment means the amount by which the Parachute Payment exceeds the Base Amount Parachute Payment means a payment, the present value of which, exceeds three times the Base Amount Base Amount means the average annual compensation for past 5 years Must be paid to a disqualified individual (meaning employee, officer, shareholder, or highly compensated individual) As compensation, AND Contingent on a change in control (50% change ownership or effective control, or ownership change in a substantial portion of the company s assets) Reduce Excess for reasonable compensation Exclude reasonable compensation for future services Exception for small business corporation and non publicly traded corporation that has 75% uninterested shareholder approval Withholding requirement 34

35 280G OTHER ISSUES Non-Publicly Traded Stock Approval of 75% of shareholders after adequate disclosure Vote determines the right of the shareholder to the payment Ignore shares held by persons receiving the payment Reduction for Excess (299% of payments) Reduction for Reasonable Compensation Reduction for Future Services 35

36 TAXABLE STOCK PURCHASES Shareholders Acquiror Merger Sub Cash Reverse Triangular Merger Treated as Stock Sale Shareholders have gain or loss Acquiror takes cost basis in shares 36

37 PERSONAL GOODWILL Key questions: (1) Who owns the goodwill (individual or company)? And (2) Was that goodwill ever transferred? Two key cases: Bross Trucking, Inc. goodwill may be transferred to a company via an employment contract if that employment contract grants the company a right to future services (e.g., through a non-compete provision) Note: non-compete provisions are generally invalid in California absent the sale of a business Martin Ice Cream the court held that customer relationships and distribution lists were an asset of the shareholder because they were never transferred to the company (the business began as a sole proprietorship and then part of the business was specifically transferred to a new company) 37

38 PERSONAL GOODWILL Issues: Is a buy/sell non-compete sufficient to satisfy the right to future services? What does the scope of the non-compete need to be? (geographic area, time, etc.) Is a fiduciary obligation not to compete sufficient? Is a non-solicitation and/or non-use of trade secrets provision sufficient? Best practice = shareholders should sell their personal goodwill separate from the stock/asset sale 38

39 PERSONAL GOODWILL CASES Estate of Franklin Z. Adell v. Comm r (Tax Court 2014) Case about the treatment of the goodwill provided by the son of decedent s company The son did not transfer his goodwill through an employment or noncompete agreement The Court held that the IRS s value for the son s goodwill was not high enough Kennedy v. Comm r (Tax Court 2010) Kennedy sold his corporation; 25% of the purchase price was payment for consulting services and 75% was payment for Kennedy s goodwill The Court held that the identification of personal goodwill is not enough to conclude that the goodwill was sold The Court found the payments to Kennedy were consideration for services because the contractual allocation did not genuinely reflect the relative value of his customer relationships compared to the value of the his ongoing personal services Solomon v. Comm r (Tax Court 2008) Solomon sold its corporate division; the purchase agreement included a customer list and a covenant not to compete Nothing in the agreement made reference to the sale of personal goodwill and the acquiring party continued to do business under its own name The Court held that the proceeds paid directly to the shareholders were actually attributable to their covenant not to compete rather than for a customer list or personal goodwill 39

40 Qualified Small Business Stock (QSBS) Benefits Reduced federal income tax for non-corporate stockholders on capital gains from QSBS held for more than five years Gain exclusion is limited to $10 million or 10x the taxpayer s aggregate adjusted bases in the stock Potential to roll QSBS proceeds into new QSBS and tack holding period Eligibility Stock in a C-corporation originally issued to the taxpayer after August 10, 1993 in exchange for money or property (not stock) or as compensation for services Corporation is a qualified small business Original issuance exceptions Acquired on conversion of other stock in the same corporation Certain carryover basis transactions 40

41 QSBS ISSUE FOR CASH FREE STOCK SALES companies may be acquired on a cash free/debt free basis, however this often necessitates a cash dividend to shareholders immediately prior to the sale During negotiations, both Acquiror and shareholders typically treat this dividend as part of the acquisition price, however the form of the transaction is a dividend This pre-sale dividend can create problems for shareholders QSBS relief: Under the QSBS rules, the maximum taxable gain considered available for relief is the higher of $10 million or ten times stock basis If the dividend payment is treated as a pre-sale distribution then it will reduce the basis of the stock and may therefore reduce the amount of gain available for QSBS relief Taxpayer may choose to file on the basis that the dividend is, in substance, part of the sale proceeds, however this could be subject to challenge by the tax authorities 41

42 CASH FORWARD MERGER Shareholders Shareholders Merger Acquiror Survives Variation with Merger Sub: Acquiror Acquiror Merger Sub Asset Sale Followed by Liquidation of has gain on sale shareholders have gain on liquidation (unless 332 applies) Acquiror takes cost basis in assets S corporations with no h10 election 42

43 SECTION 382 LIMITATION ON LOSSES AFTER CHANGE IN OWNERSHIP Section 381 Survival of Tax Attributes Section 382 When there has been an ownership change of a corporation with loss carry forwards, use of Net Operating Losses (NOLs) against future income is limited to the product of the value of the and the long term interest rate. Ownership Change occurs if, within a 3 year testing period, the percentage of stock of held by 5 Percent Shareholders increases by more than 50% over lowest percentage held by such shareholders during the test period. 43

44 BUSTED 351 Shareholders Acquiror Stock Shareholder Business Stock Acquiror Merger Rev. Ruling Weikel v CIR, 51 TCM 432 (1986) Substantial business purpose Step 1: Incorporate Step 2: Merge into Acquiror 44

45 USE OF WHOLLY OWNED LLC T Shareholders Acquiror LLC Merger of Corporation into LLC Reg (b)(1) by operation of law, all assets and liabilities of become those of LLC, and ceases legal existence A Type Reorganization 45

46 CHECK AND MERGE TRANSACTION The Code provides for tax-free mergers of corporations into other corporations and partnerships into other partnerships, but there is no provision for a tax free merger of a partnership (or an LLC taxable as a partnership) into a corporation However, an LLC taxable as a partnership can merge directly into a corporation on a tax free basis if adopts a two-step process: (1) the LLC elects to change its entity classification from a partnership to a corporation; and (2) the LLC (now taxable as a corporation) merges into another corporation Will the step-transaction doctrine merge the two steps? An entity classification does not need a business purpose and applies to all parts of the Code including the step transaction doctrine (Reg (g)(2)(i)) Courts will presumably respect the entity classification election and therefore the two steps 46

47 SECTION 351 / 721 ROLLOVER Shareholders PEG 80% vote & value Taxation of boot Debt + non-qualified voting stock Assumption of liabilities Cash out some and rollover Shareholders Shares Cash NewCo Cash PEG Shareholders Cash Assets Cash NewCo Cash PEG Assets 47

48 LLC TECHNIQUES Step 1 Step 2 T Shareholders Former Shareholders Corp. LLC $ Acquiror LLC 48

49 INSTALLMENT METHOD Gain on each payment = gross profit ratio times payment Gross profit ratio = ratio of total gain to purchase price Pre-transaction planning opportunities to utilize basis Section 453A interest charge to the extent taxpayer holds more than $5 million face amount of Section 453 obligations Section 453 Limits Not available for publicly held stock or securities, or inventory Not available for sales for demand notes or readily tradable notes Not available for instruments secured by cash or cash equivalents Obligor must be purchaser (cannot use parent debt) Section 453 applies unless taxpayer affirmatively elects out Section 453(h) shareholders who receive Acquiror debt in liquidation of allowed to use installment reporting 49

50 CONTINGENT PAYMENTS AND EARN-OUTS Distinguish Equity vs. Debt 3 Issues (1) allocation between interest and sales proceeds; (2) timing of realization of sales proceeds; and (3) timing of basis recovery Interest (b) Contingent payment debt for cash or publicly traded property use non-contingent bond method; projected non-contingent and contingent payments (c) Contingent debt instrument issued for non-publicly traded property bifurcate into non-contingent debt instrument and contingent debt instrument; contingent payment treated as principal based on present value, excess is interest Buyer s basis is non-contingent portion plus contingent payments treated as principal 50

51 CONTINGENT PAYMENTS AND GAIN RECOGNITION Reg. 15A.453-1(c) If capped by maximum amounts, assume maximum for purposes of gross profit percentage (accelerates gain, backloads basis) If no cap, but term, basis recovered ratably over term If neither time nor amount is capped, basis recovered ratably over 15 years Election out of Section 453 FMV of contingent obligation is amount realized Open transaction treatment rare and extraordinary situations only 51

52 SECTION 338 ELECTION Section 338(g) in stock sale treated as selling all its assets followed by liquidation post close (soaks up NOLs) Section 338(h)(10) Sale and liquidation deemed to occur pre-close; joint election; S corporation or sale out of a consolidated group Adjusted Grossed-Up Basis New Asset basis is basis in recently purchased stock (last 12 months) grossed up to reflect minority shareholder s basis + liabilities of (including taxes in 338(g)) Adjusted Deemed Sale Price grossed up amount realized of recently purchased stock plus liabilities of old T (on day after acquisition date) 52

53 Partnership Structure with Profits Interest Acquisition Structure: Post Acquisition: Acquiror Acquiror 100% Shareholders 100% less profits interest Shareholders $$ Hold Co, LLC Issuance of unvested profits interest Hold Co, LLC 100% 100% 100% Merger Merger Co, LLC converts to wholly-owned LLC - treated as a taxfree liquidation into Hold Co, LLC if a single member LLC 53

54 338(g) ELECTIONS If there is a US Buyer of a foreign owned foreign target, then 338(g) election steps up basis and eliminates E&P and foreign tax credits may be able to offset 338(g) gains with NOLs 54

55 PURCHASE PRICE ALLOCATION Asset Sale or 338 Election Sections 1060 and 338 classes based on FMV Class I cash and equivalents Class II actively traded personal property under 1092 Class III debt instruments and marked to market Class IV inventory Class V assets other than those in I-IV or VI Class VI goodwill and going concern Agreement Allocations Danielson Rule Parties bound by agreement unless IRS determines that the allocation is NOT appropriate SFAS 141R Purchase Price Allocations Assets booked at FMV as of closing date (not signing date) Bargain purchase results in accounting gain Earn Outs estimated and recorded Deferred tax assets for excess tax deductible goodwill over book value Transaction related costs recognized (expensed) 55

56 S CORPORATIONS AND 338(h)(10) Shareholders T (S Corp) Acquiror Merger Sub Character difference ordinary income assets California 1.5% tax on S corporations New York gain from 338(h)(10) sale of New York S corporation is New York-source income All shareholders must consent on Form 8023 Deemed 338 election for subsidiaries 1374 BIG Tax Minority shareholders in rollover Hidden tax in liquidation or deemed liquidation in installment sale. 3.8% NIIT Tax 56

57 S CORP 338(h)(10) ELECTION AND 453B(h) BASIS ALLOCATION ISSUE Shareholders $1 million basis $1 million cash $4 million 453 Note Stock Sale Acquiror Cash - $1 million / $1 million A/B Assets - $4 million / zero A/B Reg (h)(10) 1(e) Example 10 Gain to Shareholders in year of sale: $1 million x 80% = $800,000; A/B of Shareholder = $1.8 million No 331 liquidation: $1 million cash decreases A/B by $1 million to $800,000; $800,000 A/B in Note = $3.2 million gain 331 liquidation apportion basis: $1.8 million basis apportioned $360,000 to cash and $1,440,000 to Note; Gain in cash of $640,000 and gain in note of $2,560,000 for a total of $3.2 million gain (GP % on liquidation is 64%) Defer cash portion and include in installment obligation: gain on liquidation equal to zero; Shareholder A/B in note of $1 million; profit % is 80% 57

58 S CORP NO 338(h)(10) ELECTION DISAPPEARING BASIS T Shareholders T (S Corp) Acquiror Merger Sub Liquidate into Merger Sub or check the box Q-Sub Carryover Basis 58

59 S CORP INVESTMENT STRUCTURE Step One: Step Two: Step Three: T Shareholders T Shareholders T Shareholders $$ Holdings, Inc. (S Corp) Holdings, Inc. (S Corp) Holdings, Inc. (S Corp) Investor Membership interest, Inc. (QSSS), LLC (QSSS), LLC (QSSS) Step One: Shareholders of, Inc. transfer all, Inc. stock to Holdings, Inc. in exchange for Holdings, Inc. stock. Holdings, Inc. makes an S election and, Inc. elects to be treated as a qualified subchapter S subsidiary (QSSS). Step Two:, Inc. converts to an LLC for state law purposes (, LLC). Step Three: Investor purchases a membership interest in, LLC from Holdings, Inc. 59

60 Section 336(e) Basic Model (for stock sales): is treated as selling all of its assets to an unrelated person while owned by its former shareholders and then reacquiring same upon acquisition by Acquiror. Acquiror $ Shareholder Shareholder Acquiror Assets Stock 3 rd Party $ Assets Section 336(e) does not apply to sales to a related person. The attribution rules could give rise to an unexpected related person situation where the seller acquires at least 5% of the acquiring partnership as part of the transaction. For example, where an investment partnership acquires a target and provides a modest partnership interest to the selling shareholders. 60 $ = Deemed Component = Actual Component

61 SECTION 336(E) DETAILS Section 336(e) Basic Model Old target is treated as selling all of its assets to an unrelated person in exchange for the aggregate deemed asset disposition price (ADADP) New target is treated as acquiring all of the assets from an unrelated for an amount equal to the adjusted grossed up basis (AGUB) After the deemed asset disposition, but before the close of the disposition date, while owned by seller(s), old target is treated as transferring to seller all of the consideration deemed received from new target, generally in complete liquidation of old target For dispositions involving a distribution, seller is treated as acquiring the stock of new target from an unrelated person and distributing the new target stock, immediately after the deemed liquidation of old target Tax Consequences Old target recognizes gain or loss from the deemed asset and then is deemed to liquidate into seller New target is treated as a new corporation for federal income tax purposes but remains liable for the tax liabilities of old target Seller does not recognize gain or loss on the disposition of target stock No effect upon a purchaser No effect upon minority shareholders, or shareholders other than seller, except in the case of S corporation targets 61

62 FOREIGN CORPORATIONS Section 367(a) outbound transactions Foreign corporation not treated as a corporation except as provided in regulations Generally, gain recognized unless: No more than 50% of stock of foreign Acquiror received by US transferors, No more than 50% of stock of foreign Acquiror owned after the transfer by US persons that are officers or directors or 5% shareholders, Gain Recognition Agreement ("GRA") is entered into by 5% US transferee shareholders 36 month active trade or business test met, No intent to substantially dispose of or discontinue such trade or business, FMV of the assets of transferee must be at least equal to the FMV of the US target, and Tax reporting Section 367(b) inbound and foreign to foreign transfers US Acquiror and foreign can be treated as a corporation May be income to s US shareholders to extent of s accumulated E&P 62

63 FOREIGN GOODWILL REGULATIONS Intangible property under Section 936(h)(3)(B) does not include foreign goodwill or going concern Section 1.367(a)-1T(d)(5)(iii) Foreign goodwill or going concern value is the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued For purposes of section 367 and regulations thereunder the value of the right to use a corporate name in a foreign country shall be treated as foreign goodwill or going concern value Cross-border transactions Transfers of foreign goodwill and going concern value are taxable 63

64 FOREIGN CORPORATIONS Anti-Inversion Rules tax outbound reorganization and/or tax foreign Acquiror as a U.S. taxpayer; Code Section 7874 If ownership of former U.S. shareholders in foreign Acquiror is 80% or more; foreign Acquiror is treated as a U.S. company If ownership continuity is between 60-80%; foreign Acquiror is NOT treated as a U.S. company, but U.S. tax attributes cannot be used to offset gains 20% excise tax on stock-based compensation upon certain corporate inversion transactions 7874 exception available for companies with substantial business activities in the foreign jurisdiction which exist when: (1) The number of employees and the amount of employee compensation in the foreign jurisdiction is at least 25% of the number of employees and amount of employee compensation in the total group; (2) The value of group assets (only tangible property held for use in the trade or business) located in the foreign jurisdiction is at least 25% of the total group assets; and (3) The income derived from the foreign jurisdiction is at least 25% of the group income 64

65 FOREIGN CORPORATIONS Controlled Foreign Corporations ( CFCs ) A foreign entity is classified as a CFC if it has United States Shareholders who collectively own more than 50% of the voting power or value of the company. For the purposes of the CFC rules, a United States Shareholder is defined as US persons holding at least a 10% interest in the foreign corporation. 65

66 1248 AMOUNT ON SALE OF CONTROLLED FOREIGN CORPORATION Section 1248 Seller of Controlled Foreign Corporation (CFC) must treat as dividend gain to extent of E&P 1248 inclusion carries foreign tax credits 1248 amount determined at year end and pro rated based on day count, so post closing events can have an effect on the 1248 amount 66

67 JOINT VENTURE STRUCTURES US Company Foreign Company LLC Section 367 Issues Disguised Sale Effect of assumed liabilities US & Foreign Assets 67

68 TRANSACTION COSTS Must capitalize Facilitative Costs that relate to a Categorized Transaction unless an exception applies Categorized Transactions (1) Acquisition of assets constituting a trade or business (2) Acquisition of an ownership interest in an entity if the acquirer and target are related after the transaction (3) Acquisition of an ownership interest in the taxpayer (4) Restructuring, recapitalization, or reorganization of the capital structure of the entity (5) A Section 351 transfer (6) Formation of a disregarded entity (7) Acquisition of capital (8) Stock issuance (9) A burrowing; and (10) Writing an option 68

69 TRANSACTION COSTS Facilitative Costs Costs incurred in the process of investigating or pursuing a Categorized Transaction Includes valuation costs and registrar and transfer agent fees Excludes consideration for the transaction (not a Facilitative Cost, but may be capitalized under other principles) and business integration costs Exceptions Does not include costs relating to a Covered Transaction Covered Transaction» Taxable acquisition by the taxpayer of assets constituting a trade or business» Taxable acquisition of ownership interest, regardless of whether taxpayer is the target or acquirer, if the two parties are related after the transaction» Type A, B, C, or Acquisitive D reorganizations 69

70 TRANSACTION COSTS Facilitative Costs cont. Exceptions cont. Bright Line Date Unless the cost is an Inherently Facilitative Cost then costs incurred before the Bright Line Date are not Facilitative Costs The Bright Line Date is the earlier of: (a) the execution of the letter of intent (or similar document); or (b) the authorization of the company s board of directors Inherently Facilitative Costs are: (1) valuation; (2) costs to structure the transaction; (3) draft and review of documents; (4) regulatory approval; (5) shareholder approval; and (6) conveyance of property Success-Based Fees Costs for which the obligation to pay is contingent upon a successful closing are presumed to be Facilitative Costs, however the taxpayer may overcome this presumption by maintaining sufficient documentation Rev. Proc provides a safe harbor permitting taxpayers to treat 70% of the success-based fees as being non-facilitative Costs and treating the remaining 30% as Facilitative Costs. 70

71 Key Provisions INDEMNITY What Taxes are subject to indemnification? Stock Sale pre-closing taxes, generally Asset Sale all of Seller s taxes Transfer Taxes Taxation of Escrow Release / Revision of Purchase Allocation Survival of Tax Representations and Warranties How long should they survive the closing? Tax Gross-up Characterization of Indemnification Payments 71

72 SILICON VALLEY 149 Commonwealth Dr Suite 1001 Menlo Park, CA SAN FRANCISCO 135 Main Street 12 th Floor San Francisco, CA LOS ANGELES Wilshire Blvd Suite 600 Los Angeles, CA ORANGE COUNTY 135 S. State College Blvd Suite 200 Brea, CA