TAX ASPECTS OF BUYING OR SELLING A BUSINESS

1. TAX ASPECTS OF BUYING OR SELLING A BUSINESS Jim Browne

2. Topics • Transaction considerations • Taxable asset acquisition • Taxable stock acquisition • Tax-free reorganizations • Acquisitions using disregarded entities

3. Topics • Transaction considerations • Taxable asset acquisition • Taxable stock acquisition • Tax-free reorganizations • Acquisitions using disregarded entities

4. Transaction Considerations • Form of transaction • Asset purchase: specified assets/liabilities • Stock purchase or merger: all assets/liabilities • Hybrid – merger by division (TBOC §10.003) • Form can impact tax consequences • Income tax considerations: entity level tax; Buyer’s tax basis; Seller’s amount and character of gain/loss • Sec. 338 election to treat a stock sale as an asset sale • Transfer tax considerations

5. Transaction Considerations • Form and timing of consideration • Buyer equity versus cash or other property • Like-kind exchange • Deferred, contingent, or escrowed payments • Employment/consulting agreements and covenants not to compete • Shareholder assets, including goodwill • Purchase price allocation • Etc.

6. Topics • Transaction considerations • Taxable asset acquisition • Taxable stock acquisition • Tax-free reorganizations • Acquisitions using disregarded entities

7. Taxable Asset Acquisition • Purchase of assets Result Transaction TargetShareholders Buyer Shareholders TargetShareholders Buyer Shareholders Cash? Cash Buyer Target Buyer Target Assets Assets and Assumed Liabilities RetainedAssets and Liabilities

8. Taxable Asset Acquisition • Target = C corporation • Target recognizes gain or loss on asset sales • Ordinary income to extent of ordinary assets • Can use NOLs and other tax attributes to mitigate • Target Shareholders recognize gain on distribution of sale proceeds by Target • Buyer has FMV basis in assets acquired

9. Taxable Asset Acquisition • Target = S corporation • Target recognizes gain or loss on asset sales, but passed through to Target Shareholders • Target Shareholders increase basis in their Target stock by gain passed through. • Distributed cash taxable only if > stock basis • Buyer has FMV basis in assets acquired • Target = LLC/Psp • Same as S corporation

10. Taxable Asset Acquisition • Merger by division Result Transaction Buyer Shareholders Buyer Shareholders Target Shareholders Target Shareholders Cash Target Target Buyer Buyer Merger AcquiredTarget assetsand liabilities Cash;Retained assetsand liabilities

11. Buyer Target and Buyer Assets and Liabilities Taxable Asset Acquisition • Forward merger Result Transaction BuyerShareholders Target Shareholders Buyer Shareholders Target Shareholders Cash Target Buyer Merger Cash

12. Taxable Asset Acquisition • Forward subsidiary merger Result Transaction Buyer Shareholders Target Shareholders Buyer Shareholders Target Shareholders Cash Target Buyer Buyer Cash Merger Buyer Sub Buyer sub Target assetsand liabilities

13. Taxable Asset Acquisition • Merger by division • Same tax consequences as asset acquisition • Selected assets/liabilities transfer by operation of law • Target survives and retains unwanted assets/liabilities • Forward merger • Same as merger by division, except all assets/liabilities transfer and Target terminates • Forward subsidiary merger • Similar to forward merger, but Buyer treated as dropping Target’s assets/liabilities into Buyer sub

14. Topics • Transaction considerations • Taxable asset acquisition • Taxable stock acquisition • Tax-free reorganizations • Acquisitions using disregarded entities

15. Taxable Stock Acquisition • Purchase of stock Result Transaction TargetShareholders Buyer Shareholders TargetShareholders Buyer Shareholders Cash Stock Cash Buyer Target Buyer Target

16. Taxable Stock Acquisition • Target = C corporation • Target has no gain or loss • Target shareholders recognize gain on receipt of sale proceeds from Buyer • Gain generally all capital gain • Buyer has FMV basis in Target stock, but Target has carryover basis in assets • Target tax attributes (NOLs) generally eliminated

17. Taxable Stock Acquisition • Target = C corporation (con’t) • Section 338(g) election • Available if Buyer = corporation and meets other requirements (e.g., 80% stock purchase) • Rarely advisable due to double tax • Seller has stock sale gain • Target has deemed asset sale gain • Consider only if Target has large NOL carryforward

18. Taxable Stock Acquisition • Target = C corporation (con’t) • Section 338(h)(10) election • Available if Buyer is a corporation and Seller and Target file a consolidated federal income tax return • No double tax • Seller recognizes asset sale gain • Deemed liquidation of Target is tax free • Target has FMV tax basis • Rarely inadvisable

19. Taxable Stock Acquisition • Target = S corporation (SC) • Generally: same tax consequences as C corp. • Section 338(h)(10) election • Available if Buyer = corporation and other requirements are met (e.g., 80% stock purchase) • No double tax • Target’s deemed asset sale produces stock basis adjustment that generally eliminates Sellers’ stock gain • Target gets stepped up tax basis • Rarely inadvisable

20. Taxable Stock Acquisition • Target = LLC/Psp • Target shareholders have capital gain except to extent of Target’s “hot assets” • Target has stepped up tax basis if Section 754 election is made by Target • Better than a 338(h)(10) election because no 80% purchase requirement or 100% gain recognition requirement

21. Taxable Stock Acquisition • Section 338(h)(10) election Result Transaction Buyer shareholders Buyer shareholders TargetShareholders TargetShareholders Cash Cash Buyer Target Cash Buyer New Target Assetsand Liabilities New Target

22. Taxable Stock Acquisition • Reverse subsidiary merger Result Transaction Buyer Shareholders Target Shareholders Buyer Shareholders Target Shareholders Cash Target Buyer Buyer Cash Merger Buyer Sub Target

23. Taxable Asset Acquisition • Reverse subsidiary merger • Treated same as stock purchase • Used to “squeeze out” minority shareholders • Most common form for acquiring the business of a publicly traded company

24. Topics • Transaction considerations • Taxable asset acquisition • Taxable stock acquisition • Tax-free reorganizations • Acquisitions using disregarded entities

25. Tax-Free Reorganizations • General considerations • Involves only corporations and requires issuance of qualifying consideration (stock) • Tax effects • Generally no entity level taxes • Target Shareholders recognize gain to extent of non-qualifying consideration (a/k/a “boot”) • Acquiror forgoes FMV tax basis

26. Tax-Free Reorganizations • Evaluation • Generally not a tax efficient acquisition structure • Seller’s gain is recognized to the extent of boot • Unrecognized gain is merely deferred • Buyer generally suffers a total and permanent loss of tax step up • Application • Target = C corporation; low stock basis; high asset basis • Internal reorganization of consolidated subsidiaries • Public company spin-off (divisive D reorganization)

27. Tax-Free Reorganizations • Types of tax-free reorganizations • A: statutory merger • B: stock for stock • C: assets for stock • D: assets for stock • E: recapitalization • F: change of identity, form, or place organized • G: bankruptcy reorganization

28. Target Tax-Free Reorganizations • “A” reorganization (statutory merger) Result Transaction TargetShareholders Acquiror Stock Target and Acquiror Shareholders Acquiror Acquiror Merger Acquiror Assets Target Assets Target Assets Acquiror Assets

29. Tax-Free Reorganizations • “A” reorganization (statutory merger) • Voting or nonvoting stock (other than nonqualified preferred stock) can be used • “Boot” (cash or other property) is permissible for approximately 60% of consideration • Each Target Shareholder recognizes gain to the extent of boot received

30. Acquiror Merger Sub Acquiror Target Tax-Free Reorganizations • Triangular “A” reorganizations Reverse or“(a)(2)(E)” Forward or“(a)(2)(D)” Acquiror Target Merger Sub Target Merger Merger Target and Acquiror Shareholders Target and Acquiror Shareholders Result Result Acquiror Merger Sub

31. Tax-Free Reorganizations • Triangular “A” reorganizations • Purpose • Avoid board/shhr approval of Acquiror • Avoid exposing Acquiror business to Target liabiltiies • Reverse subsidiary merger – Target survives • Treated as stock purchase • Requires ≥ 80% voting stock consideration • Forward subsidiary merger – Target terminates • Treated as asset purchase • Requires ≥ ~40% stock consideration

32. Tax-Free Reorganizations • Triangular “A” reorganizations • Strategies to avoid boot limitations • Horizontal double dummy merger • National Starch rollover • Stock repurchase transactions • Partnership Acquiror

33. Acquiror Tax-Free Reorganizations • “B” reorganization (stock for stock) Result Transaction Acquiror and TargetShareholders Target Shareholders Acquiror Stock Target Target Stock Acquiror Target

34. Tax-Free Reorganizations • “B” reorganization (stock for stock) • Must acquire control of Target • Control = stock having ≥ 80% of total voting power, plus ≥ 80% of total number of each class of non-voting stock (“vote and value”) • Consideration is solely voting stock of Acquiror • Reverse subsidiary merger • Same effect without “solely voting stock” limit • If solely voting stock is used, qualifies as B reorg.

35. Acquiror Tax-Free Reorganizations • “C” reorganization (assets for stock) Result Transaction Acquiror and TargetShareholders Target Shareholders Acquiror Stock Target Acquiror TargetAssets Acquiror and TargetAssets

36. Acquiror Tax-Free Reorganizations • Triangular “C” reorganization Result Transaction Acquiror and TargetShareholders Target Shareholders Acquiror Stock Target Acquiror TargetAssets Sub Sub TargetAssets

37. Tax-Free Reorganizations • “C” reorganization (assets for stock) • Must acquire “substantially all” Target’s assets • IRS definition = 70% of Target’s gross asset value or 90% of Target’s net asset value • Generally “solely for voting stock” • Boot relaxation rule: At least 80 percent of Target’s gross asset value (including retained assets) is acquired for voting stock; assumed liabilities = cash • Target must liquidate

38. Tax-Free Reorganizations • “C” reorganization (con’t) • “D” reorganization overlap • “C” reorganization applies if Acquiror stock received by Target does not constitute control of Acquiror • “D” reorganization applies if Target obtains control • Forward merger or forward subsidiary merger • Same general effect as C reorg. or triangular C reorg. • “C” reorg. used if Target has minor unwanted assets or has unwanted liabilities (NB: merger by division available in Texas)

39. Tax-Free Reorganizations • “D” reorganization (assets for stock) • Non-Divisive D reorganization • Substantially all Target assets transferred to Acquiror • Target receives 50% control of Acquiror • Target liquidates • Divisive D reorganization • Less than substantially all assets transferred • Target receives 80% control of Acquiror • Target generally does not liquidate

40. Tax-Free Reorganizations • Non-Divisive “D” reorganization Result Transaction Target Shareholders TargetShareholders≥ 50% AcquirorShareholders≤ 50% Acquiror Stock Target Acquiror Acquiror TargetAssets Acquiror and TargetAssets

41. Tax-Free Reorganizations • Divisive “D” reorganization – SPIN-OFF Result Transaction Target Shareholders TargetShareholders Acquiror Stock Target Acquiror Target Acquiror TransferredAssets RetainedAssets TransferredAssets

42. Tax-Free Reorganizations • Divisive “D” reorganization – SPLIT-OFF Result Transaction Target Shareholders TargetShareholders TargetShareholders Acquiror Stock Target Acquiror Target Acquiror TransferredAssets RetainedAssets TransferredAssets

43. Tax-Free Reorganizations • Divisive “D” reorganization – SPLIT-UP Result Transaction Target Shareholders TargetShareholdersf TargetShareholders Acquiror Stock Acquiror 1 Acquiror 1 Acquiror 2 Target TransferredAssets Acquiror 2 TransferredAssets TransferredAssets

44. Tax-Free Reorganizations • “E” reorganization (recapitalization) • Exchange of stock or securities of a corporation for other stock or securities of the corporation • “F” reorganizations (change in form, etc.) • A mere change in identity, form, or place or organization of one corporation • “G” reorganizations (bankruptcy) • Transfers of assets under bankruptcy plan

45. Tax-Free Reorganizations • Alternative: LLC/Psp Acquiror • Exchange of Target assets for LLC Acquiror “stock” • Treated as non-taxable contribution to capital • Generally no limitations on type or quantity of stock • Acquiror generally can’t be publicly traded • Exchange of Target assets for “boot” • Seller basis allocated between stock and boot • Contrast to “gain recognized to the extent of boot” rule • Acquiror obtains FMV tax basis to the extent of Seller gain, including gain on subsequent sale of Acquiror stock • Seller may be able to borrow against Acquiror stock to “monetize” the nontaxable sale consideration

46. Topics • Transaction considerations • Taxable asset acquisition • Taxable stock acquisition • Tax-free reorganizations • Acquisitions using disregarded entities

47. Acquisitions Using Disregarded Entities • Common Types of Disregarded Entities • Corporate form • Qualified subchapter S subsidiary (QSUB) • Qualified REIT subsidiary (QRS) • Non-corporate form • Single member limited liability company (SMLLC) • Certain wholly-owned partnerships

48. Acquisitions Using Disregarded Entities • Forward subsidiary merger into DE (A reorg?) Result Transaction Stock Acquiror and Target Shareholders TargetShareholders Acquiror Acquiror Target SMLLC Merger SMLLC

49. Acquisitions Using Disregarded Entities • Reverse subsidiary merger into DE (B reorg.?) Result Transaction Stock Acquiror and Target Shareholders TargetShareholders Acquiror Acquiror Target SMLLC Merger Target

50. Acquisitions Using Disregarded Entities • Asset acquisition by DE (= 721/331) Result Transaction AcquirorShareholders TargetShareholders TargetShareholders Acquiror Stock Acquiror Target SMLLC Merger LLC Tax treatment = Target contribution of assets to LLC followed by Target liquidationCf. Rev. Rul. 99-5 (situation 2).