While the focus in mergers and acquisitions is often getting to the closing, before a purchase agreement is even signed there are key legal and financial issues to be considered. These issues can have important ramifications down the road, which may not be obvious to all parties. To achieve the best possible result, it is critical to consider potential transaction structures and the corresponding tax implications impacting the ultimate bottom line for each party.
Redpath’s Joe Hellman recently explored the legal side of M&A with Ryan Miske, a partner and chair of the private equity practice at Faegre Drinker, for an episode of The Transaction Abstract.
Listen to the episode below or keep reading for a full summary.
During the early stages of a transaction process, it is critical that lawyers work with tax advisors to help parties explore the ramifications of potential transaction structures. While in some cases, prior agreements used by the buyer can work as a starting point for documentation, the initial analysis should still be completed. Every deal is unique, and depending on the legal entity types and the parties’ objectives, there are a variety of transaction structures that may be appropriate under particular circumstances, including some which are relatively complex. However, transactions frequently take one of the following forms:
In an asset purchase, the buyer acquires specific assets and liabilities from the target business. After closing, the two entities continue to separately exist, although in some cases the selling entity may proceed with dissolution following closing.
Buyers often prefer asset purchases as they can more easily pick and choose among the target’s assets and liabilities based on the specific circumstances, leaving behind most (but not all) liabilities if mutually agreed. In addition to benefitting from an enhanced ability to manage risk related to inherited liabilities, buyers typically enjoy favorable tax treatment under this structure.
When a transaction is structured as an equity purchase, the buyer acquires the target company’s existing stock or other equity interests from existing equityholders, each of whom is a seller. Absent a specific carve out in the purchase agreement, the target company will retain all of its assets and liabilities, effectively transferring risk to the buyer(s). The target company retains its corporate identity, with only the identity of the equityholders changing. Equity transactions are often preferred by sellers, who typically benefit from favorable tax treatment and from few or no post-closing liabilities. However, equity transactions can become unwieldy if there are a large number of equityholders involved, each of whom are selling their interest as part of the transaction. In these instances, the parties may look to structure the transaction as a merger.
In a merger, two entities are combined together, with only one entity surviving the closing. Mergers are often more complex than asset and equity acquisitions, and are governed by the state laws applicable to both the merging entity and the surviving entity.
In a merger the surviving entity will wind up holding all the combined assets, rights, and liabilities of the parties to the merger, and only one entity will survive closing.
Resources:
Guide to buying a business
Guide to selling a business
When it comes to selecting a transaction structure, “get your legal and tax advisors involved early on,” advises Ryan, “so you can weigh those options. If you get too far down the path, it can become more time-consuming and, frankly, more expensive if you haven’t thought about the structure and the tax implications.”
While buyers want the best deal, and sellers do not want to find their proceeds unexpectedly diminished by taxes, the transaction structure analysis is not necessarily a competition, he notes. Often by working with tax and legal advisors from the beginning, the “tax cookies” can be divided so both buyer and seller come out winners.
Depending on the specifics of the deal, there may be ways to improve the buyer’s or seller’s (or both parties’) tax position before the purchase agreement is finalized. This is where you really need expertise from experienced legal and financial advisors.
Ryan notes that a lot of founder-owned companies will have made an S-election, which means a lot of the targets are S corporations. The election available under IRS 338(h)(10) enables an equity acquisition to be treated as an asset acquisition for tax purposes. This can result in a step-up in the tax basis of the assets, which in some cases can be very attractive to buyers. It is important that legal and tax advisors for each party determine whether this election is the best choice in a given situation.
Ryan notes that if a transaction involves a rollover, the 338(h)(10) election cannot be used. Instead, if the target entity is an S corporation, “there may be reasons to consider a dropdown of the target’s assets into a newly-formed LLC.” Or, an F-reorganization accomplishes a similar result via a multi-step process whereby the original S corporation effectively converts into an LLC. In this case, the buyer ends up holding equity interests in the new or as-converted LLC rather than the stock of the original S corporation.
Both of these strategies are becoming broadly accepted, and are especially valuable because they can be accomplished within the final few days before closing. However, “the one thing we like to remind buyers,” Ryan cautions, “is that with a 338(h)(10) or an F-reorganization, you’re inheriting any sort of legacy tax liabilities.”
To ensure that tax and structuring concerns don’t cause undue delay or expense, and that all parties are comfortable with the process, Ryan recommends creating a step chart at the beginning of a transaction. The step chart lays out the structure, including the relevant sections of the IRS code being relied on and the steps involved. This ensures that buyer, seller, and all advisors can visualize what needs to be done to execute the transaction, as well as the tax implications.
“You ought to be thinking about tax from the beginning,” repeats Ryan, and he is talking to both buyers and sellers. “As an M&A lawyer, if we’re the ones in control I will not circulate the purchase agreement until we have had this discussion because it is very inefficient. You don’t want to be drafting two different purchase agreements, it’s not good for anyone, and it’s more expensive.” Instead, he advises starting with the structure, and proceeding to documentation from there.