M&A: Navigating the Tax Implications

By July 18, 2019 December 11th, 2019 Tax
Railroad track merging into one | M&A Tax: Navigating the Tax Implications

Mergers and acquisitions (M&A) involves the combination of two entities into a single company.  M&A activities are on the rise in the United States. In the last two years, we have witnessed prominent American companies complete mega M&A deals. For instance, Amazon acquired grocery chain Whole Foods for $13.7 billion in 2017. AT&T purchased Time Warner for $85 billion in 2018. The Walt Disney Company acquired Twenty-First Century Fox, Inc. for $71.3 billion.

In line with recent action, 2019 reports on M&A trends continuously cite tax reform (such as the lowered federal corporate tax rate from 35% to 21%), a more relaxed U.S. regulatory climate and growing cash reserves as reasons for M&A optimism. In fact, surveys and reports reveal an increasing optimism among executives about the nature and future of M&A activities.

With M&A deals continuing to become more common in the business world, it is helpful to understand the M&A tax implications and how to avoid the scrutiny of the IRS.

Merger vs. Acquisition

Mergers and acquisitions generally attempt to achieve the same goal: increase the strength or profitability of the dominant company. In other words, it is a strategic play to maximize shareholder wealth. So how does a merger differ from an acquisition?

Acquisitions

An acquisition entails one company purchasing a major stake in another business entity. In the deal, the acquired company either retains its own name and identity or assumes the name of the purchasing company.

An acquisition tends to rely on the cooperation and consent of a Board of Directors and sometimes management as well. This varies from a tender which, although similar to an acquisition, is arranged directly between shareholders to avoid the involvement of the Board of Directors.

Mergers

A merger results in the creation of a new, previously nonexistent business entity when two companies join forces. These companies are usually similar in size and act as equal partners in the newly formed venture.

A consolidation is very comparable to a merger. A current example is Citigroup. Citigroup emerged from the consolidation of two companies, Citicorp and Travelers Insurance Group.

How does the M&A structure affect taxes?

Determining the structure of the M&A transaction is a critical aspect of the process. One of the most basic structuring decisions is deciding whether the company is buying/selling stock or assets. Each option yields notable tax implications.

1. Stock (or ownership interest)

Buyers can directly purchase a seller’s ownership interest if the target business is operated as a C or S corporation, a partnership or a limited liability company (LLC) that is treated as a partnership for tax reasons.

2. Assets

In some M&A deals, buyers purchase the assets of a business. This may occur if the purchaser only desires specific assets or product lines. Furthermore, this is the only option if the target business is a sole proprietorship or a single-member LLC treated as a sole proprietorship.

Note that under some circumstances, a corporate stock purchase is treated as an asset purchase by making a “Section 338 election.”

What are the buyer vs. seller preferences in regards to stock vs. assets?

Buyers

For a number of reasons, buyers typically prefer an asset purchase over ownership interests. Generally, the purchasing company’s main goal is to generate sufficient cash flow from the acquired business to cover any acquisition debt and provide an acceptable return on investment. Thus, purchasers seek to limit exposure to undisclosed and unknown liabilities, as well as minimize taxes after the deal.

Furthermore, the acquisition of assets provides the buyer with a tax basis step-up of the purchased assets to reflect the purchase price. These particular assets commonly include goodwill and other intangibles. Stepped-up basis lowers taxable gains when certain assets, such as receivables and inventory, are converted into cash. This also increases depreciation and amortization deductions for qualifying assets.

Sellers

Conversely, sellers typically prefer stock sales for both tax and nontax reasons. The acquired company aims to minimize the tax bill. This is usually accomplished by selling ownership interests in a business (corporate stock or partnership or LLC interests) as opposed to selling business assets.

Additionally, selling stock results in a higher tax basis in the stock of the entity in relation to assets, qualification for long-term capital gain tax rates, and/or avoiding double taxation. Generally, selling stock also transfers liabilities to the buyer.

Please note: other issues, such as employee benefits, can cause unexpected tax issues when buying or selling a business.

If I am participating in M&A, what does the IRS need from me?

First and foremost, it is highly important that both parties involved report the transaction to the IRS in the same fashion. Failure to do so elevates the likelihood of an audit.

If the sale involves business assets (as opposed to stock or other ownership interests), both the buyer and seller must report the purchase price allocations to the IRS. Each company must attach IRS Form 8594, “Asset Acquisition Statement,” to their respective federal income tax returns for the tax year of the transaction.

What is reported in M&A tax?

The buyer must allocate the total purchase price to the specific acquired assets. The amount allocated to each asset becomes its initial tax basis. For depreciable and amortizable assets, the initial tax basis determines the depreciation and amortization deductions for that asset following acquisition. Depreciable and amortizable assets include:

  • Equipment
  • Buildings and improvements
  • Software
  • Furniture and fixtures
  • Intangibles (including customer lists, licenses, patents, copyrights and goodwill)

In addition to reporting the items listed above, the parties must disclose whether they entered into a non-compete agreement, management contract or similar agreement and any monetary consideration. This is indicated on Form 8594, as well.

How can Squar Milner help you with M&A Tax?

We at Squar Milner are well-versed in M&A transactions. In 2017, we merged in San Francisco-based firm DZH Phillips LLP to form one of the top four largest accounting firms based in California, top five firms based in the West, and top 50 firms in the entire country. We have continued on this path with acquisitions of other California-based accounting firms such as Boas & Boas and Louie & Wong LLP.

The combination of a highly technical and knowledgeable M&A service team and invaluable firsthand experience of the step-by-step process of M&A, we are well-prepared to serve your M&A tax needs.

Buying or selling a business may be one of the most significant transactions you make during your lifetime. Therefore, it is vital to have the right tax professionals to advise and guide you through the process. Squar Milner can help. Find out more today!

Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner.  All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.

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