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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.
Anti-Churning Rules
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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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