Schrödinger’s Corporation

Schrödinger’s cat is a thought experiment, posited by physicist Erwin Schrödinger in reaction to the idea of quantum superposition. Quantum superposition is the concept that something can simultaneously exist in two different states until it is observed, at which point the two different states resolve into one state.  

In Schrödinger’s thought experiment, a cat is enclosed in a steel chamber along with a device that, if an atom exists in one state, releases something like iocaine powder (odorless, tasteless, dissolves instantly in liquid, and is one of the deadliest poisons known to man), which instantly kills the cat.  If, however, the atom exists in another state, the device does not release the poison and the cat is safe.  At some point, the steel chamber will be opened and the observation of the system will render one result: life or death.  But until that point, if this system is unobserved (and cats generally ignore everything anyway), quantum superposition requires that Schrödinger’s cat be both alive and dead simultaneously. 

Tax advisors often find themselves with Schrödinger’s corporations: corporations that made Subchapter S elections, but have engaged in behavior that terminated the S election.  Until the IRS observes those corporations, they exist in this precarious state, both as reporting S corporations and, potentially, as C corporations should the IRS audit and invalidate the corporation’s S election. It’s the retroactivity of the invalidation that makes the situation so interesting from an impact situation – an S corporation that was invalid as of 2010 could have been a C corporation since then and no one knew it until the IRS observed it. 

Strained physics analogies aside, we came across a fascinating implication of a Schrödinger’s corporation a few months back.  A client was contemplating the purchase of a corporation that had been formed in 2017 and had made a Subchapter S election at the time.  Unbeknownst to the shareholders of the corporation, the Subchapter S election had a fatal flaw.  The corporation reported consistently under Subchapter S and its shareholders reported their allocable share of corporate income.

Our client now wanted to purchase the assets of this corporation. In diligence, the S election flaw was discovered and the question arose – what is the potential exposure if the IRS audits the corporation and Schrödinger’s corporation is recharacterized as a C corporation? 

Generally speaking, this kind of recharacterization is a catastrophe that ranks among the deadliest poisons known to tax advisor – the seller now pays two levels of tax on any gain, potentially at both the federal and state level, resulting in an enormous additional tax liability.  But this case was different.  It turned out that if the S election was invalid as of the date of formation, the corporation otherwise met the definition of a qualified small business and the stock of the corporation was eligible for the 100% exclusion from tax allowed by Section 1202 of the Code.  When we ran the numbers, it turned out that the C corporation recharacterization actually resulted in less tax for the sellers.

In other words, in this case, Schrödinger’s cat had spent years building up an immunity to iocaine powder.

We tell this story not to make Princess Bride jokes (although that’s a nice side benefit), but to point out that every situation is different and minor details can have huge impacts on anticipated tax consequences.  Nothing beats having a friendly Acta tax professional by your side who can spot these details and direct you through the Fire Swamp safely.  

FAQs about the Tax Basis Step Up

The tax basis step-up is the most valuable attribute available in mergers and acquisitions taxation and is the lynchpin to most tax structuring in the middle market.  But it’s also complex, squishy, and potentially not worth anything at all. So…go figure.  We’re going to outline some of the fundamental concepts inherent in tax basis planning, but as always, every situation is different and there’s no substitute for the advice of your Friendly Acta Tax Advisor.

 What is tax basis?

Tax basis is an accounting mechanism designed to assist in calculating your gain or loss with respect to an investment.  Every time you buy an asset, you take a “cost basis” in that asset – meaning that whatever you paid for it becomes your tax basis.   Your tax basis in that asset is then adjusted upwards for additional cash investments you make in that asset (capital expenditures) and downwards for any wasting of the asset that Congress, in its infinite wisdom, has decided reflects a decline in value of the asset.  When you sell the asset, you realize tax gain or loss based upon the difference between what you receive for that asset and your tax basis in the asset. 

Example 1: Let’s say that in 2023, you purchase one of those hot dog rollers for your convenience store and you get a screaming deal – it normally sells for $150, but you get it for $100. You still only have a $100 cost basis in the hot dog roller, regardless of how much it’s worth.  You then spend another $50 to have it installed and let’s assume that 100% of these expenditures must be capitalized into the equipment. That makes your basis in the equipment $150.  Congress decreed that in 2023, such equipment qualifies for 80% “bonus depreciation” where you got to depreciate 80% of your basis immediately.  That entitles you to a $120 deduction!  Additionally, the remaining $30 of tax basis is eligible for another $9.60 of depreciation in 2023 with the remaining $20.40 to be depreciated over the next 4 years (we’re going to spare you a discussion of the nuances of the Modified Accelerated Cost Recovery System).  That $129.60 of depreciation deductions reduce your tax basis in your hot dog roller to $20.40.  If you sold the roller for $100, you would recognize $79.60 of gain.

What is a tax basis step-up?

The tax basis step-up is just the way tax advisors describe the cost basis you take in assets purchased in an M&A transaction.

Cool story.  But if I always get a cost basis in whatever I purchase, why do I care about this?

Because what you purchase in the M&A context isn’t always depreciable and that’s where stuff gets weird. When you purchase depreciable assets, you take a cost basis in those assets and those assets can be depreciated or amortized, generating tax deductions.  When you purchase stock (for tax purposes), however, you take a cost basis in the stock you purchase.  Stock cannot be depreciated or amortized, and, more importantly, the corporation you just purchased cannot adjust its basis in its assets based on the purchase price.

Example 2a:  Let’s say you purchase 100% of the tangible and intangible assets of a business for $100.  You take a $100 basis in those assets. You’re required to allocate that basis among the assets in accordance with their relative value, so you allocate $10 to the tangible assets - net working capital and fixed assets - and the remaining $90 to intangible assets. The $90 allocated to intangible assets can be amortized on a straight-line basis over 15 years, resulting in $6 a year in amortization deductions for you.

Example 2b:  Let’s say that instead of purchasing the assets, that business is held by a corporation and you purchase the stock of that corporation for $100.  You take a $100 basis in the stock you purchase.  However, the corporation that you have purchased maintains its historical basis in the assets of the business.  So if, prior to the transaction, the corporation you purchased had $10 basis in its tangible assets – net working capital and fixed assets – but a $0 basis in its intangible assets, the corporation would continue, post-transaction, to have $10 basis in its tangible assets and $0 basis in its intangible assets.

The difference between Examples 2a and 2b are what people are talking about when they refer to a “tax basis step-up.” 

Why do I care? In either situation, I have a $100 basis in the business I’m eventually going to sell.

Because in year 1, if the business generates $6 of taxable income prior to considering amortization deductions, the business in Example 2a is going to use $6 of amortization deductions to pay $0 of tax, while the business in Example 2b is going to pay tax on $6 of income.  Assuming a 25% effective tax rate, that’s a cost of $1.50.  And it’s going to happen every year for the next 15 years. That’s what we call marginal gains, baby!

Sure, but I’m going to have to recapture those deductions at ordinary income rates when I sell the business anyway, so that’s just a time value of money benefit.

That’s a pretty sophisticated observation from someone we just had to explain cost basis to.  And it’s also both kind of true and kind of not true.  If we assume that you purchase assets like in Example 2a and hold them through a pass-through investment, it’s true that the depreciation deductions will reduce your outside basis in your investment, thus resulting in additional gain if that investment is ever sold.  It’s also true that additional gain will generally be “recaptured” at ordinary income rates.  However, if you purchase assets and hold them through a pass-through investment, you get all of the benefits we described here, including the ability to resell that tax basis step-up to the next buyer. And you can’t get any of those benefits if you buy stock in a corporation.

Second, if you purchase assets and hold them through a C corporation for whatever reason (you’re a publicly traded company, you have significant foreign investors, you like to antagonize your Friendly Acta Tax Advisor), those deductions are never recaptured because you’re (generally) never selling assets – you’re selling stock.  And your basis in your stock is never adjusted for deductions claimed at the corporate level.  In this situation, your deductions from the tax basis step-up become permanent.

Non-Pro Rata Rollover for S Corporations

In order to qualify as an S corporation, an entity must satisfy a number of requirements, including that the corporation may only have one class of stock that entitles each shareholder to identical economic rights.  One result of this “single class of stock” requirement is that each shareholder is allocated gain or loss of the S corporation based on their relative ownership of S corporation shares.  Unlike a partnership, where partners can be allocated different shares of partnership items, S corporation allocations must be pro rata based on share ownership.

Thus, where an S corporation sells assets, but defers a portion of the tax gain therefrom by rolling over some of those assets into equity of the buyer in a tax-deferred manner, whatever gain is recognized must be allocated pro rata to the S corporation shareholders, regardless of how they will share the proceeds of the transaction.

Example 1:  Seller, an S corporation, is owned equally by A and B.  Seller enters into an agreement to sell 100% of its assets to Buyer in exchange for $100 of total consideration, consisting of $80 of cash and $20 of equity of Buyer (issued in a tax-deferred manner); however, A wants to stay invested in the business, while B wants to exit entirely. As a result, they have agreed that A will retain 100% of the equity of Seller, which will hold the $20 of equity of Buyer, while B’s shares of Seller will be completely redeemed in exchange for $50 of cash.  Seller has $10 of basis in its assets.

At the S corporation level, the Transaction will result in $72 of gain to the Seller (total gain realized of $90 ($100 of amount realized, less basis of $10), but only $72 recognized gain due to 20% deferral). That gain will be allocated equally to A and B, $36 each.  

That $36 allocation to B will increase her basis (assume it was $5 pre transaction) to $41.  The distribution of $50 cash to B in redemption of its Seller shares will trigger additional gain to B of $9 ($50 distribution in excess of $41 basis results in $9 of gain for a total of $45 of gain to B).

At the end of the day, A and B will recognize a collective $81 of gain on $80 of cash received.  Further, Seller will have a $2 basis in the $20 worth of equity it continues to hold, potentially resulting in $18 of additional gain either during the life of the investment or at exit.  Ultimately, if/when Seller is dissolved, the negative tax ramifications will work themselves out but timing and character differences may result in material economic changes.

The easy solution to the non-pro rata rollover dilemma is to shift to a stock deal (for tax purposes) rather than an asset deal.  There, because the transaction is occurring at the shareholder level, each shareholder can experience their own tax consequences without being bound by the tax choices of the other shareholders. Shifting from an asset to a stock deal, however, can have adverse consequences on a buyer who sees significant value in a tax basis step-up and operating through a pass-through entity, so the easy solution may not be the best solution.

Another solution is simply to recognize 100% of the gain in the current transaction.  There’s the potential for that structure to be economically beneficial regardless of the non-pro rata rollover dilemma.   

There is also a more complex solution to the non-pro rata rollover dilemma, but you’ll need to contact your friendly Acta professional to find out whether your transaction is a fit for this potential solution. 

Holding Period Issues

Pass-through entities elevate holding period concerns to a high level because they offer the option of exiting at either the asset level (sale by the entity of its assets, which may include equity interests in subsidiaries) or the equity level (sale by the owners of their shares in the S corporation or partnership interests in the partnership).  This decision generally does not impact the quantum of the gain recognized in the transaction (although it can be relevant when inside/outside basis differences exist), but can impact the character of the gain recognized.  

Example:  Company A is a portfolio company owned by Fund that is taxable as a partnership. Fund invested into Company A five years ago. Throughout its holding period, Company A has grown, in part, through acquisitions of the stock of two tuck-in businesses, including Business B, which was acquired two years ago and Business C, which was acquired six months ago. These acquisitions have been executed through additional leverage borrowed by Company A and Fund has not invested any additional capital into Company A since acquisition. 

If Fund exits through a sale of membership interests of Company A, its holding period for purposes of computing the nature of its capital gain will be determined by reference to the initial acquisition date. Because that date was five years ago, any capital gain will be long-term for both the limited partners and the carried interest.

If Fund exits through a sale of assets by Company A (including the stock of Businesses B and C), any gain will be recognized at the Company A level (and will flow through to the Fund), necessitating a holding period computation at the Company A level.  In this situation, a purchase price allocation and gain computation will need to be performed with respect to each asset sold by Company A. Any gain attributable to Company C, which was acquired six months ago, would be short-term capital gain (taxable at ordinary income rates rather than the preferential 20% long-term capital gain rate) for both the limited partners and the carried interest.  Any gain attributable to Company B, which was acquired two years ago, would be long-term capital gain for the limited partners, but would be short-term capital gain for the carried interest. 

The reverse situation may exist where additional capital is contributed to a portfolio company taxable as a partnership to fund operations (a portion of the portfolio company’s holding period may be short-term, while the Portfolio Company may have a long-term holding period in all of its assets).  And in many situations, both an asset sale and an equity sale may result in a short-term holding period and it’s important to assess which situation results in the smallest allocation to such short-term assets. Regardless, your friendly Acta tax professional is available to discuss your situation and optimize your exit structure in order to minimize the impact of short-term holding periods on your tax position. 

Section 280G

The “golden parachute” rules of Sections 280G and 4999 come into play for certain individuals that receive compensation in connection with the transaction that equals or exceeds three times the individual’s average compensation for the portion of the past five years that they have worked for the corporation.  Those payments characterized as “golden parachute payments” are subject to a 20% excise tax and the target corporation is denied a deduction for such payments. Which individuals the provisions apply to, how is compensation determined, and what is considered average compensation is all subject to the vagaries of the Section 280G regulations. 

The goal of any transaction is to avoid the characterization of any payments as golden parachute payments and there are a number of ways to do that.  

• First, you can avoid the provisions being applicable to the target.  Partnerships, S corporations, and certain closely-held C corporations are all exempt from the provisions.     

• Second, you can exclude any amounts from compensation that are explicitly approved by a private company target’s shareholders. There are generally two problems that arise here:

  • The recipient of the payment has to be willing to waive all rights to the payments unless more than 75% of the target company’s shareholders approve of the payments. 

  • The recipient of the payment has to be willing to disclose to all of the target company’s shareholders exactly how much compensation they are receiving in the transaction. 

• Third, you can reduce the amount of the payment made to a recipient that is treated as made in connection with a change of control, generally by requiring that a non-compete with significant value be granted in exchange for a payment. 

Here at Acta, we have years of experience dealing with Section 280G issues ranging from valuations to disclosures, to calculations. For any C corporation undergoing a change in control, our professionals can help you work through the Section 280G analysis, whether it’s analyzing the potential individuals subject to Section 280G, calculating amounts for a shareholder vote disclosure, or structuring transactions in a way that minimizes the economic risk assumed by an executive from a waiver.  

Rollover Structuring

Generally speaking, the goal for any rollover investment should be tax-deferral.  However, there are two primary issues to consider: (1) the amount deferred, and (2) whether deferral is actually optimal.  

Amount deferred: Let’s say that you’ve agreed to sell your business for $50m.  You hold your business through an S corporation and you’ve agree to an asset deal and the buyer is requesting $5m of rollover investment.  Assume your S corporation has net tax basis of $10m in its assets.  Further assume that the buyer is using 50% leverage ($25m) to fund the acquisition. One would expect to defer 10% of your $40m of gain but it turns out that the actual deferral can vary significantly based upon the tax classification of the buyer and the amount of leverage incurred in the acquisition.  If, for instance, the buyer is a C corporation, your gain recognition would be approximately $36m, while if the buyer is a structured as a partnership for tax purposes, your gain recognition would be $32m. 

Is deferral optimal?  Here’s the thing about deferral – it’s temporary.  And while there’s a time value to money (any time you want to pay us in advance for a project, you’re welcome to do so), it rarely makes sense to trade deferral for a permanent cost.  Yet that’s what nearly every rollover investment of assets into a corporation does.  Why?   It’s likely a confluence of factors - everyone likes the idea of not paying taxes today and thus tend to undervalue the cost of future taxes. Additionally, due to the lack of understanding of tax consequences, there’s likely a disconnect between the seller, who gets all of the benefit of the deferral and none of the benefit of the basis step-up, and the buyer, who likely hasn’t priced the tax benefit into its financial model at all.

As previously discussed, a buyer of assets gets a (generally) amortizable tax basis step-up.  That leads to deductions that reduce tax liability in the future for the buyer and has significant value.  However, when assets are transferred to a buyer in a tax-deferred manner, the buyer foregoes a tax basis step-up – that’s the cost of the seller’s tax deferral.  If the buyer is a pass-through entity, that’s not a big deal; any deductions generated by a tax basis step-up are temporary in nature and will be recaptured on exit, meaning that you’re trading tax deferral for tax deferral. However, if the buyer is a C corporation, amortization deductions lead to permanent tax reduction and you’re trading tax deferral for a permanent cost. 

 Example 1

C corporation Buyer agrees to acquire 100% of the assets of Company A (an S corporation) for $50,000x, but has asked the sole owner of Company A to rollover $10,000x of value.  Assume no acquisition indebtedness is incurred in the transaction and that Company A has $5,000x of net tax basis in its assets.  Buyer will be treated as purchasing 80% of Company A’s assets for $40,000X, resulting in a tax basis step-up of 80% of the $45,000x of built-in gain ($36,000x).  With respect to the remaining $10,000x of assets, Buyer will take a carryover basis of $1,000x.  Company A will defer $9,000x of taxable gain in connection with the rollover. 

Assuming the gain deferred is all long-term capital gain and ignoring state tax, the benefit obtained by Company A’s shareholder is deferral of $1,800x of tax, which will be recognized when Company A disposes of the shares of the Buyer.   If that’s 5 years and you apply a 6% discount rate, the benefit of deferral is about $455x (less if the shareholder of Company A is active in the business and would avoid the net investment income impact on the initial sale).

Conservatively, the cost to a corporate buyer under those facts is the loss of approximately $600x of deductions per year for the next 15 years.  If we assume that the buyer can fully utilize those deductions, the value of those deductions, assuming a federal corporate tax rate of 21% and ignoring state tax, is approximately $1,223x.

General Sell-Side Structuring Considerations – a Roadmap

Your sell-side considerations will vary significantly based on the tax status of the selling company you are selling, the tax status of the buyer entity, and the amount of any rollover equity you’re taking as consideration in the transaction.  The following is intended as a guideline for considerations with links provided for more information on certain issues.  However, every situation is different and nuances matter in tax, so we recommend you consult with a tax professional (preferably an Acta tax professional) on the applicability of these issues to your facts.  

With respect to selling entities: 

• Partnerships will offer you the most exit flexibility, but holding period issues and rollover structuring will be critical to optimizing tax efficiency.

• S corporations are generally less flexible and require resolution of the asset or stock sale question. Once that path is determined, the decision tree gets more complicated because in an asset sale, you need to consider rollover issues, which can be challenging in an asset sale through an S corporation, as well as the legal structure of a tax asset sale should be considered, and whether any disguised sale benefits can be obtained. Stock sales are simpler from a structuring perspective, but you’ll still want to think about things like minimizing your net investment income tax impact, and work through any cash-to-accrual issues that may exist. 

• C corporations offer one tax-efficient path and that’s the sale of stock. If you’ve agreed to sell assets out of a C corporation before talking to an Acta professional, there may be options to minimize the adverse impact created by this agreement.  Additional structuring considerations exist, including net investment income tax opportunities.  Additionally, Section 280G rears its ugly head and, in the private company context, sellers should evaluate the shareholder vote exception.  Finally, because the Section 1202 income exclusion is so meaningful, make sure that your planning takes into consideration the timing and continuation (to the extent possible) of this opportunity.

If you’re receiving rollover equity in the transaction and the potential buyer is:

• A partnership, you’ll want to consider the treatment of acquisition debt in the transaction, as that will impact your gain recognition.  Additionally, you’ll want to closely negotiate the Section 704(c) methodology adopted by the partnership as that can result in phantom income to you over the life of the partnership.  Finally, a partnership will offer you the most exit flexibility, but holding period issues and rollover structuring will be critical to optimizing tax efficiency.

• A corporation, the biggest issue will be whether you can achieve tax-deferred treatment on your rollover equity. In many circumstances, you can structure into a tax-deferred contribution (whether directly or through a parent Holdco structure).  Alternatively, for selling corporations, reorganization structures may be available to defer taxation on the rollover component; however, care should be taken to meet both the statutory and non-statutory requirements of these provisions.

FAQ on F Reorganizations

If you’ve hung out in middle market M&A long enough, you’ve heard of a Section 368(a)(1)(F) reorganization transaction (the cool kids just call them F Reorgs).  It’s not important that you understand the legal and tax steps involved in an F Reorg, but it is important that you understand their benefits and risks.

What is an F Reorg? 
An F Reorg, in the M&A context, generally refers to a transaction effected to treat a sale of the stock of an S corporation as the sale of assets of the S corporation for tax purposes. 

Can you F Reorg an entity other than an S corporation? 
You can – technically, C corporations can undergo F reorganizations and practitioners will occasionally refer to “F reorging” partnerships when what they really mean is a partnership continuation transaction, but the main usage is with S corporations. 

If I’m a Buyer, why do I want to do an F Reorg? 
The F reorg enables you to buy stock of the S corporation (which is much simpler legally and allows you to avoid certain regulatory hassles) while still getting a basis step-up for tax purposes. 

If I’m a Seller, why do I want to do an F Reorg? 
Well, you might not want to.  There are some risks inherent in the F reorg structure for the Seller and asset sales are sometimes adverse for the Seller. However, assuming that you’ve agreed to ensure the Buyer gets a basis step-up for their money, an F reorg is generally the most efficient way to do that.

Any other benefits to an F Reorg? 
Why yes, thanks for asking.  An F reorg allows the Buyer to switch the investment vehicle from a corporation to a pass-through, thus enabling the Buyer to enhance its return through pass-through investing.

Why wouldn’t I just make a Section 338(h)(10) election? 
Oh, look who’s the tax expert now.  A Section 338(h)(10) election has the benefit of treating a stock purchase of an S corporation like an asset purchase for tax purposes, but with one major drawback – assuming you qualify for a Section 338(h)(10) (generally, the transaction must be a purchase of 80% or more of the S corp), any seller rollover would be fully taxed in a Section 338(h)(10) election, whereas an F Reorg transaction can generally defer tax on the rollover portion. 

Section 163(j)

No one paid a lot of attention to Section 163(j) when it was passed back in 2017.  The limitation it applied to interest expense deductions – 30% of a taxpayer’s EBITDA – just didn’t come into play very often.  Interest rates were low and the addback of tax depreciation and amortization resulted in a threshold that only rarely impacted a taxpayer’s interest expense deduction.

Things are very different today.  The provision automatically adjusted in 2022 to reduce the interest expense limitation to 30% of EBIT and the Fed started playing with interest rates in an effort to slow down inflation.

As a result, taxpayers across the country are getting hit with additional tax liability in a time of reduced cash flow. 

At Acta Consulting, we can’t do a whole lot about borrowing costs, but we can do something about the non-deductibility of your interest expense.  Specifically, we structure acquisitions in such a way that any newly acquired amortization and depreciation can be excluded from the calculation of EBIT, effectively returning to the pre-2022 limit of 30% of EBIT.   For many of our clients, that added cash flow can be the make or break factor in a deal. 

Pass-through Investing for Funds

Why invest through a pass-through (generally limited liability company taxable as a partnership), when the effective federal income tax rate (29.6%-37%) is higher than the effective federal income tax rate for corporations (21%)?  Why make your investors go through the hassle of state income tax filings when you can block all of that income and only report at the corporate level?  

We have five reasons for you, with different levels of importance, depending on who’s considering the implications:

1. For income that will be distributed to owners, the additional shareholder level tax on distributions (20% federal, plus state) results in an effective federal income tax rate of about 37%, regardless. 

2. Funds are measured on pre-tax distributions to LPs – tax paid by a corporation reduces these distributions, while tax paid by an LP does not. 

3. Funds investing through partnerships can, by appropriately structuring acquisitions, minimize the impact of the decrease in 2022 of the interest expense limitation to 30% of EBITDA.

4. Funds investing through partnerships can, by appropriately structuring acquisitions and dispositions, minimize the impact of the 3-year rule on carried interest allocated to the GP.

5. Funds exiting from pass-through investments can pass-on an additional amortizable basis step-up to a buyer, potentially resulting in a higher sales price. 

What is the purpose of sell-side tax diligence?

Frequently, companies will forego a sell-side tax diligence process, reasoning that there’s no reason to pay for diligence of their own when a buyer is just going to discover any issues during their diligence process and the seller can respond to those issues if and when they arise. 

While this is a valid approach and works 100% of the time when material tax issues don’t exist, the primary purpose of sell-side tax diligence is not to raise tax issues, it’s to flip the resolution of tax issues from a tax analysis to a business decision. 

What do we mean by that?  Well, in any sale process, there’s a balance of power that shifts throughout the course of the process. When in a multi-party process, buyers tend to evaluate issues by risk adjusting exposure.  Once exclusivity occurs, however, the buyer views their price as what they’re willing to pay for the company as they know it and the seller should take the risk for any other issues.  

To illustrate the issue, consider a Company that potentially failed to collect and remit sales taxes in 20 different jurisdictions where they’ve established economic nexus.  The total potential exposure is about $1,000,000, but that exposure is spread pretty equally over the 20 identified jurisdictions.  If one assumes that the odds of the exposure being realized in any jurisdiction is approximately 10%, the true cost of the exposure is $100,000 and a rational buyer with full knowledge in a competitive process would price it accordingly. 

But if the issue is raised by the buyer when it has conducted diligence procedures, the buyer is not incentivized to act rationally and may ask for indemnification with a $1,000,000 escrow for a 4 to 5 year period, full payment of the $1,000,000 through voluntary disclosure agreements, or just a straight purchase price adjustment. While a seller is never obligated to agree to those terms, its negotiating position is weakened by exclusivity.  

At Acta Consulting, we’re focused on optimizing your negotiating position in any transaction. That’s why we offer our clients high-level sell-side tax diligence procedures designed to identify significant tax issues without the cost and logistical challenge of full tax procedures. These high-level procedures may not identify every potential tax issue, but do give you the best chance at maximizing your sale proceeds.

Taxation of Carried Interest

If you make your living from a carried interest in a fund, you’ve heard of the three-year rule…

Unlike normal investments, which have a one-year period in order to be taxed at favorable long-term capital gain rates (20%, federal), if you’ve held your investment for less than three years, you get taxed at the short-term capital gain rates (37%, federal). 

Kind of. 

It turns out that, like most things tax related, the devil is in the details.  Technically, the three-year rule keys off of the holding period of any capital assets sold in an exit transaction.

That leaves two rather large loopholes to plan into: 

1. If you can allocate gain recognized to assets other than capital assets, the three-year rule does not apply. 

2. If you invest into a pass-through entity with a greater than three year holding period in assets, when the entity sells the assets, the gain that flows through to you will not be subject to the three-year rule. 

These two loopholes provide opportunities for nearly any investor to avoid the three-year rule if they prepare for a disposition at the time of the initial investment.  Acta Consulting helps to structure acquisition transactions with an eye towards ultimate disposition, preparing for the possibility that that disposition will be within three years.  

Buy Side Structuring

There’s a lot of noise thrown around in discussing M&A structuring and the terms used – 338(h)(10), reverse triangular, double dummy, F reorganization – are all relevant and important…  

…to the lawyers.  

To the business people, there’s one primary issue: what are the tax attributes that I’m going to get out of this acquisition? 

And the answer to that question largely depends on whether you’re buying assets (for tax purposes) or stock (for tax purposes). The reason for the parentheticals is simple – a lot of those confusing terms are ways for lawyers to turn one legal structure into different treatment for tax purposes.  So ignore all of those terms – just ask whether it’s an asset deal or a stock deal for tax purposes. 

Because any transaction is a negotiation between buyer and seller, any structure should seek optimal tax results for both parties on an overall basis.