Careful attention to tax considerations during the course of acquisition transactions can help secure opportunities to protect and enhance value for private equity funds. While there are numerous tax issues to consider in any transaction, below are some key considerations.
Identifying Structuring Opportunities Through Tax Elections
338(h)(10) Elections for Qualified Targets
An election under Section 338(h)(10) of the Internal Revenue Code allows a corporate buyer to acquire stock while realizing the tax benefits of an asset purchase if the target is (i) a member of a consolidated group (or a non-consolidated selling affiliate) or (ii) an S corporation, and the private equity fund’s corporate buyer acquires a minimum percentage of the target’s stock by vote and value (after excluding any non-voting, non-convertible preferred stock) within a defined acquisition period. However, in certain circumstances a Section 338(h)(10) election may cause the seller to incur additional taxes due to the difference between the inside and outside bases in its shares. As a result, to secure cooperation from the seller, it is important for private equity funds and their counsel to identify such opportunities early in a transaction—often at the letter of intent phase—to secure the benefits of a 338(h)(10) election without having to agree to concessions later in the transaction.
Section 754 Elections for Tax Partnerships
A buyer of less than all of the equity in a target taxed as a partnership can realize the tax benefits of an asset purchase through a Section 754 election made by the target. A Section 754 election allows the partnership to adjust the basis of its assets to reflect the difference between the private equity fund’s basis for the purchased equity and the private equity fund’s proportionate share of the adjusted basis of all target partnership property. If a Section 754 election for the target partnership is not already in place, then it should be made on the federal tax return of the target partnership (i.e., Form 1065) for the tax year of the acquisition.
Structuring Rollover Equity
To ensure that management incentives are properly aligned, attention should be given to the value attributed to the management rollover amount when the target owners are to receive “rollover equity” in the post-acquisition tax partnership. The contribution value (if any) attributed to the rollover amount can have unexpected tax consequences. If the private equity fund is entitled to return of its investment before rollover equity participates, attributing contribution value to the rollover equity may have the unintended consequence of causing tax losses to be allocated to the rollover equity owners rather than to the private equity fund.
Transaction Tax Benefits
Many transactions present the opportunity for the target company to recognize tax savings as a result of the costs, incurred compensation-related deductions (including from option cancellation payments, deferred compensation, and stay and bonus plans) and payment of professional fees. However, the allocation of the benefits between the buyer and seller of the business is not always intuitive. With the advice of tax counsel, attention should be given to structuring payments in a tax-efficient manner and to allocating transaction tax benefits in the purchase agreement.
Attention should be paid to “anti-churning” rules in order to avoid potentially significant and often needless reductions in the buyer’s after-tax cash flow. If the target business was in existence on or before August 10, 1993, and after the transaction the target owners own (or a related party owns) more than 20 percent of the equity of the buyer, goodwill and going concern value of the target may not be amortizable by the buyer as a result of the “anti-churning rules.” Moreover, if the buyer is a limited liability company or the corporate acquirer is owned by a limited liability company, the anti-churning rules can be an issue even where the target owners hold, after the transaction, 20 percent or less of the limited liability company