Helping clients avoid big tax bills after a mergers or acquisition

Mergers and acquisitions are filled with tax traps – and opportunities – for all parties.

For instance, few financial developments make a client happier than a big jump in the value of their stock. These clients have probably all heard of recent headline biz marriages: In 2018, deals valued at $1 billion-plus increased 25 percent year over year, with more than twice as many megadeals over $25 billion, according to research cited by Barclays.

Ballooning stock values can happen after mergers or acquisitions – and clients might not realize that their new shares in one of the companies might someday create a hefty tax bill.

Let’s say Company A acquires Company B, and the shareholders of B must exchange their shares for those of A. If the fair market value of Company B’s shares is higher than the basis in the shares of Company A’s (that is, the original purchase price of the shares of Company A), the shareholders must recognize a taxable gain at sale. If Company B’s share price is lower in fair market value than their basis in the forfeited shares of Company A, their basis remains the same.

Type of deal is important

The structure of the transaction can determine tax questions for almost everyone involved in an M&A, so recognizing the characteristics of various deals for clients as early as possible is important.

Alternatives mergers can be for cash, or for cash and some form of securities (private companies often use these types of transactions.) Tax-deferred or tax-free deals involve shares exchanged for new shares and the basis moved to the new shares received. Such stock transactions don’t involve the sale of assets, and, again in the above example, Company B remains intact after the deal. Straight stock swaps are also generally not taxable events.

Shareholders often like stock deals not only for the apparent immediate gain in their portfolios but because they result in one layer of taxation (unlike some asset sales by C corps). The gain recognized is also generally long-term capital gain, taxed more favorably than short-term.

Helping clients look ahead

Key questions include whether the gain be deferred or reduced, and any holding periods involved. Also important: Does the stock qualify for 1202 treatment, which allows exclusion of capital gains from select small-business stock from federal tax?

Steps to help clients who either face or might face these tax situations in an M&A include keeping tax basis computations up to date for quick decision-making if a deal does pop up, and pinpointing what shares have the least-advantageous basis if/when a taxpayer can sell only a portion of their shares.

Can an election be made to treat the transaction as an asset sale? This could happen under IRC Sections 338, 336, and 754, depending on various criteria – and should be investigated before a letter of intent is signed. Generally, asset purchases provide better tax results for the purchaser, such as accelerating amortization of the assets.

In asset transactions, the target company can liquidate, dissolve, or otherwise cease to exist, or can choose to remain in existence. The target company recognizes gain or loss on the difference between the sales price allocated to the assets [generally negotiated in the asset-purchase agreement] and the tax basis of the assets.

Your clients who are involved in the decision-making of the deal should ask such additional questions as:

  • Does either company have undisclosed liabilities and or unsure tax situations or positions? State and local and payroll tax issues? How will the new combined entity affect state and local taxes – including sales and use taxes – in the future of both companies? Buyers typically negotiate representations, indemnifications, and similar matters in the stock purchase agreement to protect against undisclosed liabilities.
  • Where could acquired liabilities go within the combined entity to maximize tax benefits?
  • Net operating losses or other tax attributes of the acquired company can be tax benefits only if they survive the transaction. To what extent will the target company’s tax attributes survive the deal?
  • Would any credits or incentives from federal, state, and local tax authorities benefit either company in the deal? What activities – such as job creation or capital investment – does either company engage in that might qualify for these credits? (Companies can sometimes negotiate for custom incentives, too.)

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