Tax planning is an essential component of M&A strategy, and the complex web of hypotheticals that accompany every deal is difficult to unwind without the help of a tax professional. This article identifies some key tax issues in mergers and acquisitions. It’s not meant to be a comprehensive guide. Some key things to know before we start:
- An M&A transaction happens when two companies join to form a single entity through a merger or acquisition.
- The exchange or acquisition of assets or stock differentiates mergers and acquisitions from joint ventures, partnerships, or strategic alliances.
- Tax liability is a variable in an M&A deal’s net worth, making tax planning an essential part of any merger or acquisition.
What is an M&A Transaction?
An M&A transaction occurs when two companies combine to form a single entity through a merger or acquisition. This is typically done to grow operations, expand into new markets, or gain a competitive advantage. What that looks like depends on how the deal is structured. The terms and conditions of the agreement define what that means.
Acquiring a company is different than merging with one, but both are far more complex than forming a partnership or joint venture.
An acquisition transfers all assets and liabilities to the buyer, creating an income tax liability. A merger can trigger capital gains taxes, but there are several tax-efficient strategies to minimize them. These should be examined in the development stage when assessing potential M&A targets.
The exchange or acquisition of corporate stock differentiates mergers and acquisitions from joint ventures, partnerships, or strategic alliances. M&A transactions require the stock’s fair market value, due diligence on the target company, and negotiating favorable terms and conditions. The successful integration of the two companies is also a factor.
Tax planning is mandatory for M&A activities.
The first step in strategic tax planning is choosing how and when to acquire or merge with another company. “How” and “when” decisions are chock-full of tax considerations, so if we apply that truism to acquisitions and mergers, we’re talking about detailed planning on the structure and timing of the transaction.
Timelines are critical to tax-efficient M&As.
Timing is going to affect capital gains tax rates, depreciation schedules, and opportunities for deductions. Some tax years are more favorable than others, and in some cases, stretching a deal out over several years could reduce capital gains taxes.
Identifying and minimizing tax liability is a priority in structuring contracts.
I think it’s fair to say that in the traditional business owner’s approach to structuring contracts, there’s a false partition between business and tax. In actual fact, how a contract is structured is not just a process of coming to arrangements that lead to clear outcomes limited to the will of the parties. Tax burdens can arise independently of intent, which makes tax liability a slippery variable in the net worth of a deal and tax planning an essential part of any merger or acquisition.
Neglecting tax considerations can be costly. It’s not uncommon that a buyer closes a deal that looks good on paper, only to find out after closing that there’s a 35% tax liability. Anticipating the emergence of that future tax liability and structuring, or even restructuring, the contract is part of ensuring that an acquisition is going to be profitable, from all angles.
There are dozens of strategies, and many more sub-strategies, to preserve wealth during an M&A transaction. Each scenario is going to be slightly different with a lot of moving parts, so a tax and financial partner is essential. I’m happy to do the M&A tax planning and accounting portion for you. You’ll also need an independent assessor to determine fair market value and an attorney to draw up the contracts.
Should buyers pursue asset or stock purchases?
An acquiring company can purchase another company in two ways: either by purchasing the assets and liabilities or the stock of the company it intends to acquire.
Mergers and acquisitions come with tax issues for both buyers and sellers.
Buyers typically prefer asset purchases over stock purchases.
Buyers often prefer asset purchases. Buyers receive a step-up basis on the acquired assets, which increases depreciation deductions in the future. This also helps them avoid inheriting unknown or contingent liabilities, and they can choose which assets and liabilities to acquire. Stock purchases don’t offer those benefits.
Here’s an example of a scenario where an asset purchase makes sense.
Let’s look at a buyer looking to acquire a manufacturing company. Manufacturing requires machinery and equipment of significant value and equally attractive opportunities for deductions and depreciation, as I mentioned above. In this case, it would be advisable to pursue an asset purchase. The buyer acquires physical ownership of the equipment and liability for unpaid debt, but the buyer has room to negotiate for a set of assets and liabilities that are advantageous.
Stock purchases turn acquired companies into assets that are subject to capital gains tax.
Buying the stock of another company is also an acquisition, but the tax liability works differently.
The acquired company and its assets are not added to the buyer’s physical property, item-by-item, if you will. Instead, a stock acquisition shows up as an asset on the buyer’s balance sheet, while the seller’s portion is taxed as ordinary income on the asset purchase. A stock sale is also subject to capital gains tax.
Every acquisition should include plans for capital gains treatment and tax strategies to minimize associated tax liability.
Ordinary income tax rates range up to 37%. Long-term capital gains taxes are typically 15% to 20%.
That’s a significant difference in a multi-million dollar deal, but qualifying for capital gains treatment requires careful planning. It’s not something you want to do yourself. My team and I have the knowledge and experience to do it for you. Capital gains treatment requires:
- Holding periods (assets must be held for more than one year)
- Entity structure and transaction structure
- Allocation of purchase price among asset classes
- Treatment of seller financing or earnouts
Everyone has an exit plan. A smart buyer is going to consider the future capital gains associated with selling the company. Yours should include a tax strategy to minimize tax liability and preserve wealth. A thoughtful approach during initial structuring will make it easier to deal with late-stage tax issues in mergers and acquisitions.
Due diligence means knowing what you’re inheriting, from liabilities and accounting methods to potential tax exposure and compliance issues.
Acquiring a business means taking on its carryover liabilities. It’s important to conduct thorough due diligence so you know what you’re getting into. Carryover can include net operating losses, tax credits, depreciation schedules, and historical accounting methods. These can offer tax benefits, but IRS regulations may limit the scope of those benefits.
Tax due diligence for M&A can identify potential tax exposures, which include tax compliance issues, misidentification of employees or independent contractors, sales tax compliance, and international tax considerations. It’s also important to look for consistency between financial and tax accounting. Failing to uncover any of these could derail the M&A transaction.
The good news? The majority of small business entity structures are friendly to M&A transactions.
The structure of an M&A transaction can minimize capital gains in business sales. Partnerships and LLCs have flexibility in structuring buyouts, including the potential for tax-free distributions of appreciated property. S-Corps must pay attention to built-in gains taxes on appreciated assets sold after a C-Corp conversion. Some other structures to consider include:
- Tax-free reorganizations for certain qualifying transactions
- Installment sales to defer income recognition
- Earnouts that align the purchase price with business performance
- Entity conversions before the sale of the business to optimize tax treatment
- Section 1031 exchanges for qualifying real estate components
These are just a few solutions for dealing with tax issues in mergers and acquisitions.
Optimize M&A transactions with tax planning, CFO services, and business advisory support.
Getting a tax perspective is the obvious option. I think it makes sense to get tax planning from a firm that understands finance and business. Schedule a discovery call, and let’s discuss your situation.
Talk soon,
Jeremy A. Johnson, CPA