We have received articles from various professionals in and around the City of Aventura. In order to add to our business educational series, we requested an article from Barry Gurland, CPA of RSM McGladrey. Even after having an office in Aventura's Washington Mutual building for many years, he remains active in the City of Aventura and is a regular at Aventura Marketing Council events, lunches, and breakfasts. He is excited about this blog and the opportunity to contribute to our educational series.
How to avoid three common M&A tax traps
The record pace of mergers and acquisitions (M&As) during the past two years with the number of M&A deals in 2006 estimated at 25,000 dealmakers should plan carefully, because unforeseen tax issues can make an otherwise appealing merger much less palatable. According to a recent national survey on M&A activity, 70 percent of respondents said hidden or unrecorded financial liabilities threatened successful mergers or acquisitions. In that same study, nearly half of respondents cited incomplete tax planning as a significant risk in bringing two companies together.
Structure deals with an eye on taxes
To help minimize tax-related M&A headaches, experts say it's helpful to begin by thoughtfully analyzing how to structure a proposed transaction. In a taxable merger deal, a savvy buyer seeks to acquire only the assets of a target firm, largely because that's a good way to avoid assuming undisclosed tax or financial liabilities while gaining a sizable tax write-off against depreciated assets. Conversely, sellers often want to sell stock, because it's a straightforward transaction subject to taxation only once at a relatively low capital-gains rate.
Bridging gaps between the needs of buyers and sellers often requires creativity, says Bruce Shnider, a longtime M&A attorney and distinguished visiting professor at the University Of Minnesota Law School. For example, he says, parties can structure an M&A deal to allow the prospective seller to issue stock but enable the buyer to treat it as an asset acquisition for tax purposes. Under this arrangement, the buyer receives a "step up" in basis on acquired assets, providing a higher platform for depreciation and amortization deductions, as well as full disclosure on financial and tax liabilities. While the seller must treat any asset sale gains above the tax basis as ordinary income, the bulk of the transaction typically is taxed as capital gains.
In many situations, the amount of ordinary income is trivial, and the parties can adjust the purchase price to take that into account. In such a scenario, the seller enjoys the full benefits of selling stock, and the buyer enjoys the benefits of purchasing assets.
In a tax-deferred arrangement, a seller typically receives most or all of the sale's proceeds as stock in the purchasing company, and the seller will have no tax liability until selling the stock. Because the IRS has relaxed so-called "continuity of interest" regulations in recent years, sellers no longer have to hold stock in the new entity for an extended period. This choice, while complex, can work well in situations where the seller wants to cash out, and the buyer doesn't have a lot of cash for the purchase, Shnider says.
Address common tax traps
Once both parties approve the deal structure, key leaders can dig deeper into other potentially nasty tax traps. Some of these include:
State, local and transfer taxes. If the merging businesses have operational or sales presence in multiple states, this can raise significant issues. The United States alone has more than 7,500 taxing authorities in 45 states and the District of Columbia that impose sales-and-use taxes on the purchase of tangible goods. This means prospective buyers should look closely at how effectively the business has collected, reported and paid sales-and-use taxes to various jurisdictions. If the buyer cannot get good documentation that the seller has paid these liabilities in full, Shnider suggests reopening price negotiations to account for the potential cost or drafting an indemnification clause in the purchase agreement that makes the seller liable for all outstanding tax matters prior to close.
On property tax matters, experts say the buyer should verify any lien records and seek proof of payment for the most recent tax cycle. Even if payments are up-to-date, buyers may face a reassessment of property values after purchasing corporate property, which often leads to a tax increase.
Aggressive tax positions. In concert with a careful review of a target company's current tax liabilities, a prospective buyer should also take time to evaluate the target's overall tax posture. If questionable tax compliance practices go unchallenged, the buyer may risk failing future audits, leaving themselves open to potentially sizable tax liabilities. Note this major tell-tale warning sign: any existing target company correspondence with taxing authorities about unresolved payment issues.
While a seller may offer explanations of these unresolved payments, the buyer needs to recognize how that opens the door to potential tax liabilities, penalties and interest, which can add up to a material number, Shnider says.
Golden parachute provisions. Many companies offer executive pay agreements through which a change in control can accelerate vesting of deferred compensation or require the payout of a large severance package. Such "make-whole" provisions — if not properly managed — can deliver a nasty tax surprise.
For example, if a public company pays an executive $100,000 a year and awards that employee $299,000 in severance after a change in control, there is no tax liability. But, if the payout exceeds three times base pay, the company loses the ability to take a compensation deduction and faces a 20 percent "excess parachute" tax penalty. That problem becomes even more costly for companies with "gross-up" provisions, in which the business agrees to cover any excess income taxes that key executives incur.
Privately held firms can mitigate excess taxation of golden parachutes if shareholders vote to approve the payouts. However, this requires the target company to fully disclose the names of all executives eligible for such payments, as well as the specific compensation arrangements for each. It also requires each executive to sign a document waiving the right to any payments sparked by a change in control unless the shareholders approve the payments.
To manage this process, Shnider says it's important to identify key employees at a target company with sizable change-in-control compensation packages. By taking this step before a deal closes, the buyer and seller can review the list and identify creative ways to rework existing compensation packages to meet executives' needs.
"In a perfect world, these things should be identified earlier rather than later, because the tax consequences can really affect how much a buyer is willing to pay for all the parachutes and gross-ups," Shnider says. "Mergers and acquisitions is a strange and often unique world, and no matter how smart a company's executive team or in-house staff may be, they need to get the right outside help if they don't have a lot of M&A experience."
For More information contact
Barry T. Gurland
RSM McGladrey
100 NE 3rd Ave
Fort Lauderdale Florida 33301
954-356-5758
