Some Federal Income Tax Aspects of Acquiring a Distressed Company


Corporate & Finance Alert

February 3, 2009

Normally, in a rising economic climate, when a buyer acquires a business, there are several advantages to acquiring assets rather than the controlling equity interests of the business. The acquirer can step up its income tax basis of the assets acquired to the consideration paid rather than “inherit” what may be a relatively low historical cost basis. The acquirer may be able to pick and choose the assets acquired to avoid unwanted assets. Perhaps most importantly, by not buying stock, the buyer does not automatically assume the liabilities of the business, especially undisclosed liabilities, unless a third-party creditor can convince a court that the buyer should bear the risk of those liabilities under a transferee or successor liability theory.

In today’s market, if a potential buyer is paying a relatively low price in comparison to recent industry values, the buyer needs to carefully analyze the income tax implications of the proposed transaction structure, since, instead of an asset acquisition, a stock purchase may allow the acquisition of some valuable tax attributes. Currently, an asset purchase could result in an allocation of less federal income tax basis to the assets than currently exists within the target. Moreover, a troubled target may very well possess net operating losses (“NOLs”) which, even though subject to the limitations of the Internal Revenue Code (the “Code”), may be of interest to the buyer, but can only be obtained by buying stock.

A Hypothetical Acquisition
Suppose the acquirer is looking at the following fact pattern with respect to the potential acquisition of a relatively simply structured and distressed C corporation operating in the United States:

Gross fair market value of assets $15 million
Tax basis of assets 20 million
Bank debt of target 8 million
Old shareholder debt – cash advances 4 million
Trade debt 7 million
Net negative fair market of target – 4 million
Federal cumulative NOLs 6 million

Assume that the transaction is negotiated such that the old shareholders will give up their debt claims of $4 million. Assume also that the bank is willing to take a $2 million haircut (from $8 million to $6 million) as long as the buyer brings in new management and agrees to new loan documentation with some stricter covenants. And let’s assume that the bank and the buyer are willing to let the selling shareholders (perhaps a recalcitrant minority holder) get $2 million in cash out of the transaction. The trade debt stays in place.

For federal income tax purposes, if the transaction is structured as an asset acquisition, the consideration would amount to $15 million ($2 million in cash plus $13 million of assumed liabilities). As an asset transaction, this $15 million amount would be allocated among the acquired assets and would become the tax basis of the assets in the hands of the buyer’s acquisition vehicle. The buyer would not acquire any of the target’s NOLs.

The target would likely treat the forgiveness of the shareholder debt as a contribution to capital. It might realize cancellation of debt income (“COD”) of $2 million as a result of the partial release of the bank debt, but to the extent it was technically insolvent (counting the shareholder debt), it would not recognize that COD income, but would lose $2 million of tax attributes, probably NOLs. (Even if it did recognize the COD income, the NOLs could substantially offset that income.) The target would liquidate and would hopefully distribute out the $2 million cash after settling any other claims.

The Hypothetical as a Stock Acquisition
If the transaction is structured as a stock acquisition instead, and all other facts remain the same, $2 million would be paid to the shareholders for their stock of the target. Again, the target should be able to treat the forgiveness of the shareholder debt as a contribution to capital and it should be able to address the COD income. Let’s assume that $2 million of the target’s NOLs are lost because of the COD.

The buyers have now acquired the target with assets worth $15 million and subject to liabilities of $13 million, with $20 million of asset basis and $4 million of NOLs. Now, while this sounds interesting, unfortunately, it is also where things start to become complicated.

First, because the target has undergone a change of control, Code Section 382 will limit the annual usage of those NOLs. That is, although under current law, the NOLs can be carried over for twenty (20) years, the amount that can be actually used on an annual basis is subject to the “Section 382 limitation,” which equals the value of the target (assume $2 million) multiplied by the “long-term tax-exempt rate” promulgated by the IRS for the month of the ownership change. For February 2009, the long-term tax-exempt rate is 5.49%, which would result in a Section 382 limitation for our stock hypothetical of $109,800 ($2 million x 5.49%). In summary, although the buyer has acquired $4 million of NOLs, it can only use $109,800 of those NOLs in each of the subsequent twenty years.

Second, based on the fact pattern, through the purchase of the stock of the target, the buyer has acquired assets with a tax basis of $20 million and a fair market value of $15 million. Without more, the difference between those items will be characterized as a “net unrealized built-in loss” under Code Section 382. Upon a disposition of those assets within the 5-year recognition period after the ownership change, the target will not be allowed to use the losses to offset other income, except, again, to the extent of the annual Section 382 limitation. Depending on the relative fair market value and historical tax basis of the target’s assets, built-in losses may be triggered on the collection of previously written-off accounts receivable, the amortization of intangible assets, or the disposition of unwanted assets. The buyer will need to run some projections to determine the impact if it disposes of acquired assets during the 5-year recognition period.

As this article went to print, Congress was passing legislation that would make NOLs somewhat more useable. Be sure that these changes in the law are taken into account when evaluating the value of any NOLs that you are evaluating.

Tax Attributes and Buying a Target from a Consolidated Group
When a buyer acquires the stock of a subsidiary from a consolidated group, it is important to specifically identify the asset tax basis that the acquirer will obtain, and the allocation of cumulative NOLs that will be made to the subsidiary as it leaves the consolidated group. Just because a target subsidiary may have generated significant losses in past years, that does not necessarily mean that the subsidiary will take significant NOLs with it. Those past losses could have been used by the consolidated group to offset income of other members of the group. The buyer may need to study the consolidated group’s past returns to see what the historical situation was, and the buyer will need to obtain (possibly months after closing) a copy of schedules submitted with the final return of the consolidated group that includes the activity of the target prior to its sale that actually detail the amount of the consolidated group’s NOLs allocated to the target when it left the consolidated group.

The Limited Usefulness of a Section 338(h)(10) Election
When asset prices are rising, Section 338(h)(10) elections can be advantageous (i) if either a selling corporation or a consolidated group possesses NOLs that can be used to offset the asset gain, or (ii) if long-term capital gains recognized in the deemed asset sale can be passed through to individual shareholders of an S corporation target. With a Section 338(h)(10) election, the transaction is a stock transaction for state corporate law purposes, but an asset transaction for federal income tax purposes. A Section 338(h)(10) election is only available when eighty percent (80%) or more of the stock of (i) a C corporation is acquired by a corporation from a selling corporation, or (ii) the stock of an S corporation is acquired by a corporation (it could be an S corporation) from its shareholders. With a distressed target, there may be loss recognized on the transaction so that the Section 338(h)(10) election is not necessary, or for the same reasons described above, the buyer may want the higher asset basis and a share in the corporate level NOLs available only through a straight stock transaction. In conclusion, the apparent advantages of a Section 338(h)(10) election may not prove out under the current market conditions.

When the Target is a Partnership or S Corporation for Tax Purposes
Pass-through entities such as partnerships, limited liability companies treated as partnerships for federal income tax purposes, and S corporations, don’t possess NOLs (an S corporation might for very unique situations) and are not subject to the built-in loss rules and other limitations of Section 382. This means that the tax planning for the acquisition of a troubled pass-through entity may be one step simpler. The treatment of COD income, on the other hand, may be more complicated, with individual selling members or shareholders potentially on the hook for phantom debt forgiveness income. Buyers still need to analyze the amount of asset basis that they will hold after the deal is signed.

Choice of Acquisition Entity
Once the buyer determines the type of acquisition that will best meet its corporate and tax goals, it will need to identify the type of entity, if any, that will be used to actually acquire the assets or stock of the target. If the beneficial owners or investors are U.S. individuals, then a pass-through entity, perhaps a limited liability company treated as a partnership, may well offer the most efficient holding company structure. If the acquirer is a C corporation, a simple C corporation acquisition entity may be fine. If the target is an S corporation, and the transaction is to be structured as an equity transaction, the buyer should look into setting up and qualifying the acquisition entity as an S corporation itself, and then make what is called a Q-Sub election for the target to result in an overall pass-through structure.

Buyers of distressed companies need to carefully evaluate the income tax implications of their acquisition structure to make sure they are maximizing the tax attributes of the target on a post-closing basis. This requires a careful and detailed analysis of a number of tax provisions which ultimately may have a substantial impact on the economics of the transaction.