Top Tax Issues for Buyers and Sellers in Today’s M&A Market

Top Tax Issues for Buyers and Sellers in Today’s M&A Market

by Surbhi Bordia
January 10, 2024

In today’s less forgiving marketplace, buyers and sellers must examine taxation issues that can significantly impact a transaction’s value. Before moving forward with a deal, you should clearly understand what’s driving the current market and explore all the tax-related questions surrounding mergers and acquisitions (M&A).

Rising Costs and the Role of Tax Considerations in M&A

Following sky-high valuations and record M&A activity in 2021 and 2022, the pace of M&A has slowed across most industries. Persistent inflation and tight labor markets have introduced challenges for buyers and sellers to reach mutually acceptable agreements. And the highest interest rates in many years only intensify the problem.

Rising capital costs directly affect M&A trends; as debt becomes more expensive, companies often turn to alternative vehicles, venture capital or exchange listing and postpone or eliminate dividends. Tightening credit requirements and recent bank instability mean less liquidity, fewer successful deals and a more challenging environment for sellers.

At the same time, many public companies remain cash-rich and are once again enjoying high stock valuations, spurring them to pursue targeted capital investments in the so-called “Fourth Industrial Revolution” companies that provide cutting-edge technology in areas such as artificial intelligence, robotics, blockchain and genetic engineering.

What does this mean for purchase price, claw-backs, escrow provisions and overall value in upcoming deals?

More mature companies seeking to expand revenue are looking for new technology or product breakthroughs to add to their bottom line, so they are targeting younger companies with something new or different to offer the market. However, young companies may have fewer controls, smaller finance teams and minimal tax expertise. This mixture is certain to produce unrecorded liabilities, likely reducing the purchase price (decrease or escrow).

Protecting the cash runway is key in either consolidation or expansion. All parties often overlook the impacts of direct and indirect taxation during M&A, but this area requires proper time and consideration to accurately gauge net value and cash flow following the transaction.

Key Questions for Buyers

In general terms, buyers should conduct sufficient due diligence to answer the following questions about a target company:

  • What’s the company’s existing tax structure?
  • What’s the expected transaction structure?
  • What’s the target company’s historical tax compliance?
  • Are there any existing tax exposures?
  • How will current and projected tax liabilities be reflected in the M&A deal, including federal, state and local income tax, payroll tax and sales and use tax?

Specific taxation areas that often impact the value of a transaction include international tax and transfer pricing, quality of net operating losses (NOLs), state taxes, stock versus asset sales and research and development (R&D) tax credits. Buyers should pay close attention to these potential concerns during the due diligence period, while sellers should anticipate scrutiny and properly address each area before listing the business for sale.

International Tax and Transfer Pricing

M&A requires a thoughtful collaboration between various internal and external advisors, including legal, tax, accounting and finance. During the due diligence and negotiation phase, conducting a detailed review of various tax aspects of a target company’s global operations, tax attributes and jurisdiction-by-jurisdiction tax filing positions is essential.

Any significant risks the buyer discovers during due diligence provide an opportunity to negotiate and structure a robust indemnification clause for any subsequent liability arising from identified risk areas. If you’re a seller, the indemnification clause represents a price reduction that you may be able to resolve in pre-deal talks. Identifying and addressing tax risks before due diligence is a wise move that helps preserve your company's value.

Once a deal moves from the due diligence stage to the planning stage, devising a tax-efficient deal structure (asset acquisition, stock acquisition, etc.) that aligns with the combined company’s operations and supply chains is critical for all involved parties (the target shareholders, purchasing company and target company).

Before implementing the transaction, consider any foreign tax consequences from the planned tax structure (direct tax, indirect tax, stamp duties, etc.). Also, take care to plan intellectual property consolidation, legal entity integrations and employee/asset transfers in a way that aligns the final structure with overall business synergies — a common goal that drives many business combinations.

Transfer pricing — the pricing of goods, services and intangibles between related parties — is one of the most contentious areas of taxation between buyers and sellers and between taxpayers and governments. A company’s transfer pricing policy determines how income and expenses are allocated among the parent company and related entities located in other countries.

Your transfer pricing strategy creates multiple areas for risk exposure: foreign taxes and book and taxable income, leading to cash tax expense and foreign tax credits or even NOLs. It’s important to have the correct economic analysis behind these related party transactions. Full and contemporaneous reports under IRC 6662, along with foreign transfer pricing reports, would benefit anyone contemplating an acquisition.

Lastly, both sides need to pay close attention to legal and regulatory changes. For example, how does the Altera court decision impact share-based compensation for cost-sharing arrangements and intercompany services?

Quality of NOLs and R&D Tax Credits

As companies grow and expand, they often experience net operating losses. NOLs can be carried forward to future years, and, with recent tax law changes, can be carried forward indefinitely on federal tax returns. Many states have similar NOL arrangements. Recorded as deferred tax assets, NOLs can offset future tax liabilities, and they can be enticing to the buyer, increasing the purchase price significantly.

Unfortunately, the tax code limits how valuable NOLs will be post-acquisition. When an ownership change occurs (greater than 50% change), IRC Section 382 may restrict the use of the NOLs. Also, now that companies must capitalize and amortize R&D expenses over a longer time (five to 15 years as of 2022), NOLs may no longer offer benefit.

By conducting a Section 382 analysis, the seller can help the buyer validate the quality of the target entity’s NOLs so they can assign appropriate value. Performing this analysis will also help validate any corporate tax credits (such as R&D tax credits), as these are also subject to the Section 382 limitations.

State Taxes

Buyers and sellers need to understand the unique taxes in each state where a business is active, including those on income, property, sales and use, gross receipts, inheritance and payroll. Buyers will look at these state and local tax issues before entering a transaction:

  • Nexus: Nexus, or the minimum connection required for a business to file taxes in a particular jurisdiction, varies between states. And in the wake of South Dakota v. Wayfair, economic nexus provisions apply to income taxes, gross receipts taxes and sales/use tax. These rules are especially applicable to out-of-state sellers that exceed a certain monetary threshold or number of transactions in various states, regardless of payroll and/or property in that state. One misunderstood law could mean thousands of dollars in penalties and interest.
  • Apportionment: Allocating an entity’s sales among its active jurisdictions can be trickier than it sounds. One state may source sales using a market-based approach, while another delineates revenue based on where the work is performed. Mistakes in apportionment can generate penalties and interest and create ripple effects for tax and reporting for other states.
  • State-specific adjustments: States do not universally mimic the federal government’s choices, so state-specific tax return adjustments are required. Since the Tax Cuts and Jobs Act (TCJA) of 2017, states have been more restrictive in what federal tax deductions they allow.

Buyers may have a different risk tolerance than their targets, so sellers should prepare for questions about their state tax practices and positions.

Stock vs. Asset Sales

Sellers usually prefer stock sales for tax purposes, while buyers tend to favor asset sales. That’s because stock sales are generally treated as long-term capital gains (assuming the seller has held their interest in the company for more than one year). As such, they’re taxed at a top tax rate of 20%, plus a potential additional 3.8% net investment income tax. Asset sales can generate a combination of ordinary income (currently taxed at a top rate of 37%) and capital gains. However, step-up elections can unlock significant tax advantages for both parties.

Types of step-up elections

Codified under Section 338(g), Section 338(h)(10) and Section 336(e), step-up elections are powerful instruments that can reduce taxable income and enhance tax benefits by shaping the depreciation and amortization of newly acquired assets during the post-transaction period.

  • Section 338(g) is a unilateral election initiated exclusively by the buyer corporation. This election is especially valuable in the context of domestic target companies. It empowers the buyer to harness the target company's tax attributes, notably NOLs, to offset entity-level taxes without any restrictive limitations.

    Section 338(g) has the potential to substantially reduce the buyer's overall tax liability, but buyers should exercise caution when considering elections for domestic companies. Though it offers substantial tax benefits, a Section 338(g) election can trigger double taxation — first at the target company level and subsequently at the shareholder level.

    Applying Section 338(g) to foreign target companies results in a step-up in the basis of the foreign company's assets, effectively wiping the slate clean of historical tax attributes like earnings and profits. This election can also reduce subpart F income or global intangible low-taxed income during the post-transaction period.

  • Section 338(h)(10) is a joint election that requires cooperation between sellers and buyers. This election presents the opportunity for a step-up in the basis of a domestic corporation or S corporation, streamlining the tax structure. With Section 338(h)(10), the target company faces only one taxation level when selling its assets, effectively rendering the stock sale irrelevant for U.S. federal income tax purposes.
  • Section 336(e) is a seller-initiated election that can simplify the seller’s tax implications and help them maximize their outcomes. Under this provision, the target company recognizes the federal income tax consequences of a deemed asset disposition while it remains under the seller’s ownership. The result is a single taxation level, as with Section 338(h)(10).

Step-up elections can be a game-changer that optimizes M&A for buyers and sellers. However, these tax provisions require expert analysis to determine their nuanced impacts on the post-transaction financial landscape. Engaging a qualified M&A specialist is crucial to navigate these complex tax strategies effectively.

R&D Tax Credits

Research credits are valuable tax assets with a federal carryover life of 20 years, but acquisitions and dispositions of trades or businesses require adjustments to the credit year and base year computations. The TCJA made the research and development (R&D) tax credit available to more taxpayers than ever before. However, new expensing rules related to Section 174 (effective from tax year 2022 forward) severely limit your ability to use R&D dollars to offset tax exposure.

Potential buyers will want to know that their target can support its R&D credit claims. Buyers will need to evaluate whether the target’s research credits are sufficiently documented both in terms of detailed qualified research expense computations and of qualified research activity. Without this documentation, the research credits are at high risk for disallowance by the IRS and state taxing authorities. Buyers will also want to verify that the target has set aside reserves in case the IRS uncovers an issue or disallows part of the credit. Sellers should be aware that targets with dedicated reserves for these tax credits will look more attractive.

Buyers can acquire a target’s unused payroll credits (for qualified small businesses) and use them to offset payroll taxes (the employer portion of FICA) for quarters after the transaction date for up to 20 years. R&D credits elected to be used as payroll tax credits are not subject to Section 383 limitation and can be a significant cash windfall for the buyer. Both buyers and sellers should understand how the credits impact cash flow and value and craft a precise sales agreement to clearly address this issue.

Beyond Direct Taxes

If stock is part of an acquisition, the burden of due diligence includes an inquiry into the life-to-date company operations. That means sellers need to look at much more than direct taxes before selling their business. Here are several considerations sellers should address before the due diligence period begins:

  • Sales tax: Review economic nexus and collection of reseller certificates, as well as border adjustment tax (BAT) and property tax.
  • Payroll tax exposure: Document required withholdings for stock compensation and ISO/NQSO classification.
  • Golden parachute under Section 280G: Confirm compliance of all executive compensation arrangements that will occur with the transaction. Identify excess payments that could trigger penalties and non-deductibility issues so you can implement strategies to avoid the problem and protect future cash flow.
  • Section 162(m): Confirm compliance with this recently modified portion of the tax code; limits on the deductibility of compensation now cover an expanded range of employees.
  • Other matters: Closely examine potential issues around compensation and benefits, post-closing purchase price allocation, transaction costs, FATCA/FIRPTA tax withholding and reporting, asset step-up elections, section 1202 and equity incentives.

Sellers should also evaluate their financial reporting team, consider an audit, address contract noncompliance — and perhaps most importantly, consider the timing of the transaction. Taking an objectively attractive deal may not be your best path if the timing doesn’t align with personal transition plans, company goals or the company’s business lifecycle position.

Don’t Let Tax Surprises Derail Your M&A Success

Tax-related surprises aren’t good for buyers or sellers, especially in a challenging market. Without proper tax planning, M&A often wastes effort and resources instead of delivering the expected benefits for both sides. Help ensure a successful transaction. Reach out to our tax consultants today to get clarity on the tax issues you need to consider before and after the deal closes.

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Surbhi Bordia, Tax
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