Tax Implications Of Your M&A Deal: An Overview For Business Owners

When working out the different aspects of the collaboration, don’t overlook the tax implications of your M&A deal. Mergers and acquisitions have strategic benefits and successfully add value to the legacy company. However, buyers and sellers should also understand their tax obligations.

Working with an expert M&A advisor is advisable since the professional will guide you on the various aspects. You’ll also have an attorney, CPA, and tax consultant on board for regulatory compliance and understanding the applicable taxes.

M&As typically involve significant federal and state tax liabilities. When structuring the transaction, you’ll work out how to model the deal after analyzing the tax dues. To put it simply, merger and acquisition deals can be taxable or non-taxable.

This categorization relies on how the dealmakers handle the stock and assets of both companies and how payments are made. Read ahead to understand in detail the tax implications of your M&A deal.

Merger Categories for Tax Considerations

When two companies enter into a strategic merger, they must pay taxes on the gains from the assets they acquire. These assets can be in the form of capital, stock, and other fixed assets pooled during the merger. Taxable mergers according to IRC §1001 can be standard and triangle.

• In a standard merger, the acquirer absorbs the purchased company into their own company. The legacy company continues offering products and services that the two companies provided before the merger.
• A triangle merger is a collaboration between two smaller companies. In this case, one company is the subsidiary of a parent company which assumes the tax liability and financial responsibility.

How Mergers Qualify as Reorganizations

A third form of mergers is a reorganization and does not attract any tax liability under IRC § 368. However, for the deal to be tax-exempt, it must comply with stringent criteria that the IRS lays down. These criteria include several statutory and common law requirements for the dealmakers.

• When one corporation acquires the assets and stock of another corporation
• When one corporation splits and creates two or more independent entities
• The corporation restructures its capital composition internally.

How Tax Exemptions Work

Essentially, merging corporations needn’t pay taxes under reorganization if they swap their assets and equity and create a new company.

The transaction can also be considered non-taxable if the acquirer pays for the purchase with stock or equity. If no cash or debt changes hands, the deal is tax-free.

However, the transaction must comply with certain conditions:

• The acquirer pays at least 50% of the targeted company’s value in stock from their own company. This strategy is called continuity of ownership interest.
• The targeted company distributes the stock and securities from the deal to its shareholders.
• The targeted company continues operations just as before the merger. Or, the acquirer uses a significant portion of the targeted company’s assets to run its own business. The buyer must maintain ownership of the assets for at least two years after the deal is complete. This strategy is called continuity of business enterprise.
• The acquirer assumes any outstanding liabilities of the targeted company. Since cash is not a part of the transaction, tax is not payable.
• Dealmakers must execute the transaction as a standalone M&A deal. It cannot be a part of a series of transactions that would otherwise attract a tax liability.
• The acquirer issues stock to the targeted company in exchange for its property.

If the seller receives property other than stock and equity from the sale, this consideration is called “boot.” The boot attracts tax dues. But if the seller distributes some portion of the boot to their shareholders, the distributed portion is not taxable.

Remember that the IRS comes down hard on M&As conducted for the sole purpose of avoiding tax obligations. The agency uses the step-transaction doctrine to determine if the transactions have been made to avoid taxes. If that happens, the IRS denies the tax-free status.

Tax Implications of Your M&A Deal – Assets or Stock Consideration

Consideration Paid in Stock

When negotiating the terms of the sale, sellers can enter into a stock sale or an asset sale. If the acquirer purchases stock, they are essentially buying the seller’s ownership stake in their company. This strategy attracts less tax under the 2018 Tax Cuts and Jobs Act (TCJA).

The TCJA has set a 21% corporate federal income tax rate for purchasing stock in a C Corporation. As a rule, C Corporations generate more after-tax income since they pay lower taxes. Any corporate assets that appreciate in value will attract lower taxes if the acquirer sells them at a later date.

Sellers may prefer to get stock in the acquirer’s company because they can get the company’s full sale price. They can also avoid any possible liabilities after the sale.

Most importantly, any gains on the stock are long-term capital gains and will attract a lower tax rate than short-term capital gains. As a result, the seller can avoid paying high taxes.

Consideration Paid in Assets

At times, acquirers prefer to purchase only the assets of the targeted company to avoid taking on unknown liabilities. Purchasing the ownership stake in a company could come with business-related liabilities that transfer with the sale.

Purchasing fixed assets has another advantage. The acquirer can take advantage of the stepped-up basis rule and lower their tax liability. According to this rule, the buyer is liable to pay taxes on the assets’ market value at the time of the purchase. And not at the value the seller purchased them.

This provision allows them to leverage deductions based on depreciation and value the assets at a lower price. Then again, if the buyer purchases receivables and inventory as part of the deal, they can sell the assets. Or, the receivables convert into cash.

As a result, the buyer can claim lower gains and have a lower tax liability. Rules under the TCJA have expanded the depreciation deductions within the first year, making asset purchases a better deal. Particularly from the tax liability perspective.

However, if the buyer purchases stock, they cannot use the stepped-up basis rule and pay lower taxes. Unless they make a Section 338 election under the Internal Revenue Code (IRC). This rule allows the corporate buyer to execute a “qualified stock purchase” of another corporation.

In that case, the buyer can treat the acquisition as an asset purchase. And not a stock acquisition to claim a lower tax liability. Since several conditions and criteria apply to such purchases, it’s advisable to check with a qualified CPA.

Make sure to understand the tax implications of your M&A deal before moving forward.

Balancing the Purchase Price Against Tax Considerations

Invariably, dealmakers in an M&A transaction may have conflicts of interest when allocating the price against stock and assets. Tax implications play an important role since both parties will want to minimize their tax liabilities.

For instance, buyers will want to allocate a lesser portion of the purchase price toward assets like real estate. Properties carrying mortgage will need the buyer to make payments through the amortization period. Intangible assets and equipment will need depreciation calculations.

Moreover, any land that the company owns will attract capital gains as it appreciates over time. From the seller’s perspective, allocating a larger portion of the purchase price to these assets results in lower tax liabilities.

When both parties want to lower their respective tax obligations, they’ll have to work out a middle ground. Typically, a higher purchase price may compensate for the tax considerations.

Keep in mind that in fundraising, storytelling is everything. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Timing the Merger Completion for Tax Liabilities

Merger and acquisition deals can take a few months to several years to close and this can influence tax liabilities. Over the last decade, the average closing time has increased by 30%. However, this interval varies according to several different factors.

The size of the deal is a significant variable and larger deals valued at over $250B can take 279 days on average.

Mid-sized deals valued between $500M and $5B extend to an average of 279 days. Cross-border and cross-country deals typically involve regulatory compliance in different jurisdictions.

The higher the deal value, the more meticulous is the due diligence and exchange of technology and assets. When deals take over a year and extend across multiple assessment years, calculating taxes during the straddle period becomes complicated.

The straddle period is the interval from the time when the companies file the articles of the merger. And ends with the final deal closing. As a result, dealmakers must negotiate which parties will assume the tax liability since both companies will continue conducting business.

Both parties must also determine the exact date when the acquired company’s tax year will end. Or when it ceases to exist as an independent entity from the taxation perspective. Handling tax refunds and post-closing tax audits is also an issue if the pre-closing tax periods come under scrutiny.

This can happen if the target company has been underreporting its income and revenue. Or has accrued taxes that are unpaid at the time of the transaction.

Pre-Closing Tax Liabilities Issues

Even though the acquired company ceases to exist as an independent entity, the seller is subject to audit assessments. These assessments and pre-closing liabilities can extend for up to four years after the merger’s final closing date.

For this reason, the buyer may conduct thorough due diligence to examine the targeted company’s financials. The objective is to examine its pre-closing tax status and uncover any discrepancies and liabilities. These issues can have serious tax implications for the buyer.

This is why, both parties negotiate the terms of the purchase and sale agreement to include various tax provisions. These terms shift the burden of the pre-closing tax liabilities to the seller.

The agreement will also include provisions for tax covenants, tax representations and warranties, and tax indemnity and survival clauses. Working out these issues at the onset helps you understand the tax implications of your M&A deal. And, eliminate any disagreements that can derail the deal.

Additional Tax Concerns to Be Aware Of

Several other issues can arise when calculating the tax liabilities both parties must assume.

Calculating the transfer pricing for goods and services can become a problem. When the parties in an M&A deal transfer such assets between the two companies, they may set prices. However, since the entities are now related, calculating the appropriate pricing can become a challenge.

The IRS will likely meticulously examine the pricing to ensure that it is reasonable and there are no tax liabilities. If that happens, both parties may attract tax audits and penalties.

Since M&A deals take extended periods for completion, there’s the possibility of changes in the tax laws. Changing governments and regulations can significantly influence the final taxes both parties must pay. They may also have to renegotiate the purchase and sale agreement for tax compliance.

Tax calculation methods can vary between the parties to the M&A deal. If they use entirely distinct methods, several accounting challenges can arise leading to unexpected tax liabilities. Aligning the financials for both companies and adjusting for tax compliance can be a complicated process.

Retaining the services of expert credential CPAs is always advisable to stay on top of the dues.

The Takeaway!

Taxation laws and compliance issues can be complicated, particularly in the case of mergers and acquisition deals. Transferring assets, stock, IP, receivables, real estate, and inventory and calculating the tax implications is a highly complex exercise.

Even as you negotiate the terms and conditions, be aware of the tax implications of your M&A deal. Have an expert CPA at the table to direct you on the taxes the deal will incur and the parties liable for payment. Don’t overlook the financials from previous years and scrutinize them for discrepancies.

Non-compliance can result in significant penalties and fines and possibly, even audits that you want to avoid.

You may find interesting as well our free library of business templates. There you will find every single template you will need when building and scaling your business completely for free. See it here.