Architecture, Engineering & Construction Articles
Structuring a Merger for Architects & Engineers
By James A. DeLeo, CPA/MST
Gray, Gray & Gray, LLP
The level of merger activity in the architectural and engineering industry has picked up significantly in recent months, and promises to be even livelier in the coming year. If you are considering merging your firm or acquiring another, the way you structure the transaction can have far reaching consequences, particularly in the area of taxation.
There are several tax options available for structuring an acquisition. Prior to developing a successful tax structure for the transaction it is important to first determine whether the transaction will be the sale of assets or stock, and whether it is to be a taxable acquisition or a tax-free reorganization.
The parties to a transaction may agree on a taxable asset deal. In this instance an adjustment is usually negotiated in the purchase price to compensate the seller for incurring the tax. One form of taxable asset deal is a "direct asset sale" where the buyer purchases the assets directly from the seller for cash.1 This is the simplest of all transaction structures and results in the buyer receiving a "step-up" in the basis of the assets acquired up to the purchase price.
For example, if a buyer purchases a plotting printer for $900 that has a book value of $500 on the books of the seller, the buyer is allowed to "step-up" the basis of the acquired assets from $500 to $900. This step-up is preferable because it allows the buyer a larger depreciation and therefore a larger non-cash tax deduction. This structure benefits the buyer because it reduces taxes annually while having no impact on the cash flow of the business. The seller must report income on the transaction which could qualify for favorable capital gains treatment depending on the character of the assets being sold.
Another form of taxable asset deal involves a "cash merger." Under this deal structure the selling entity is merged into the buying entity or its parent company and the stockholders of the selling company are given cash in exchange for their stock.
Under either of the taxable asset deal structures, buyers must be aware of how the acquisition price is to be allocated in the transaction. For example, if the purchase price exceeds the fair market value of the assets acquired the buyer has created goodwill. This is an intangible asset to the buyer and must be amortized over a period of fifteen years. Although the buyer does obtain a tax benefit from such a transaction most buyers would prefer that the transaction be structured to minimize the amount of goodwill. This is due to tangible assets serving as better collateral for potential bank borrowing and being depreciated over shorter useful lives, therefore providing the buyer with a larger tax deduction.
From the seller's perspective a taxable asset deal generates gains and losses based on the nature of the assets sold. For example, the sale of inventory would be taxed at ordinary income rates. But the sale of depreciable assets would at least partially be taxed at the more favorable capital gains rates (assuming the seller is not a C-corporation).
The issue for the C-corporation seller is that it will not receive capital gain treatment on the asset transaction since C corporations do not have capital gains rates. A C-corporation will also be subject to double-taxation should the entity liquidate after the sale, so choice of entity is critical to maximizing after tax dollars in a taxable transaction. There are limited options available for C-Corporation owners to help take some of the sting out of the double tax at the corporate level.
In all taxable asset deals none of the seller's tax attributes, most notably net operating losses, can be carried over to the buyer. These tax attributes remain with the seller after sale and if the seller liquidates these tax attributes essentially are lost.
In a tax-free reorganization, both parties generally have the same tax consequences regardless of whether the reorganization is structured as an acquisition of assets or of stock. But the requirements for qualifying as a tax-free reorganization differ depending on whether an asset acquisition or stock acquisition is chosen. If the parties to a transaction agree to a tax-free asset acquisition there are three structures available for consideration. The first is called an "A Reorganization." Under this structure at least 80% of the stockholders of the seller's company exchange their stock for stock of the acquirer and the seller's company is then merged into the acquirer.
Another tax-free transaction structure is a "forward triangular merger." Under this structure the seller company is merged into a subsidiary of the buyer and the seller receives enough stock in the parent company to qualify for tax-free treatment.
A "C Reorganization" is another tax-free transaction structure. This structure has the seller company transferring its assets to the buyer or its subsidiary in return for enough stock in the parent company to qualify for this treatment and, once executed, the seller company liquidates and distributes the parent company stock to the stockholders of the seller.
Under all three tax-free scenarios the assets are transferred to the buyer at the book value amount carried over from the seller. As a result of the tax deferred nature of these transactions there is no "step-up" in basis of the acquired assets for the buyer.
There are also several tax structures available to apply to a stock deal. Assuming a taxable stock acquisition is planned and the seller is a closely held business, the simplest form of stock deal involves the purchase of stock for cash. This transaction is taxable to the stockholders of the seller at capital gain rates, which currently are at 15% for federal income tax purposes.
Another form of taxable stock transaction which is useful when the stock of the seller is widely held or includes restless minority owners is the "reverse subsidiary cash merger." This structure is helpful under these circumstances because a majority vote of the stockholders binds all stockholders to the agreement. Under this tax structure a newly formed subsidiary of the buyer is formed and merged into the seller. The stockholders of the seller receive cash for their shares of stock and the parent company buyer takes ownership.
If the parties to a stock transaction agree on a tax-free deal one method that may apply is the "B" reorganization, in which the stockholders of the seller transfer their stock to the buyer in exchange for only stock in the buyer.
Another means to structure a tax-free deal is through a "reverse triangular merger." Under this method the buyer establishes a subsidiary which is merged into the seller's company at which time the stockholders of the seller receive stock in the buyer sufficient to effect such a transaction (i.e. the buyer acquires at least 80% (control for tax purposes) of the seller's stock).
Under each of the tax-free scenarios mentioned above, unless a specific election is made to change the substance of the transaction, the basis the seller had in the assets and liabilities of the company carries over to the buyer. The buyer, therefore, receives no "step-up" in basis on the assets of the company and no additional depreciation deduction as is available in an asset deal.
However, in a stock deal, the tax attributes, including available net operating losses of the seller, carryover to the buyer. The losses however, are limited in the amount that can be deducted in any one year. This is designed to discourage potential buyers from making acquisitions solely to purchase net operating losses for use in offsetting income generated from the operations of the buyer.
In any form of stock transaction the buyer is not only responsible for any current or future liabilities of the acquired company but it is also liable for any pending or future IRS audits performed on the acquired company. In this regard it is imperative to review the three previously filed income tax returns of the seller during due diligence in order to gain an understanding as to the amount, if any, of exposure the buyer is undertaking by structuring the transaction as a stock deal.
Mergers and acquisitions are obviously complicated transactions. Your first step should be to seek qualified, experienced help in examining and structuring any deal.
James DeLeo, CPA is a partner with Gray, Gray & Gray, LLP, Certified Public Accountants, Westwood, MA. Gray, Gray & Gray serves the tax and accounting needs of businesses in the architecture, engineering and construction industries. Mr. DeLeo can be reached at (781) 407-0300, or via e-mail to:jdeleo@gggcpas.com
1. Doloboff and Wilcox, 771-2nd T.M., Corporate Acquisitions – (A), (B), and (C) Reorganizations