Recent trends in taxation favor substance over form. Congress recently codified the “substance over form” doctrine used by the courts. Many newly minted regulations issued by the U.S. Treasury Department eschew technical requirements and instead provide ambiguous anti-abuse warnings. However, there remain several areas where differences in form can have significant tax implications. One such area is the payment of deferred cash consideration in M&A transactions.
There can be several types of deferred cash payments in an M&A transaction. The most common form of deferred cash payment is deferred purchase price structured as a contractual obligation by buyer to seller to make additional cash payments pursuant to the underlying acquisition agreements (the “contractual promise”). The deferred consideration may be all or only a small portion of the overall purchase price. The amount of deferred consideration is usually or contingent and a function of earnings and performance.
Equity of the buyer is often considered an alternative form of consideration, rather than a type of deferred cash consideration. However, equity consideration may be utilized to accomplish the same objectives as deferred cash consideration with greater tax efficiency for the seller. For example, the main objective of many sellers is to avoid paying tax on any promise of further consideration until the consideration is actually received in cash. For such sellers equity of the buyer may be the best form of deferred consideration. As discussed below, certain redeemable equity of the buyer (the “buyer equity”) can be used to provide (i) tax-free results upon receipt and (ii) no current income accrual during the deferral period. Moreover, in many cases, the economic objective of a contractual promise may be easily mimicked in an equity instrument.
Tax Implications: Seller
(A) Seller Perspective: Contractual Promise: Sellers may elect to report deferred cash consideration on most sale transactions using the installment method, pursuant to Section 453 of the Internal Revenue Code of 1986, as amended. Under that method, the receipt of a promise to pay additional consideration is not taxable to the seller at closing. Instead, the tax is deferred until an actual payment is made. Each payment is then subdivided into return of capital (basis offset), interest and gain. The obligation must bear interest whether or not currently payable. Thus, the seller will be taxable on interest income over the course of the deferral period. The installment reporting rules do not apply to certain items such as dealer dispositions of real estate or sales of inventory. Moreover, the buyer’s promise to pay cannot be payable upon demand or readily tradable. For most sellers, there is a $5 million limit on the amount of installment obligations that may be outstanding at any time. If that limit is exceeded an interest charge is imposed on the deferred tax with respect to the excess installment obligations.
If a seller chooses to elect out of installment sale treatment, the seller will be taxed immediately upon closing and will determine its overall gain based upon the issue price of the obligation (in most cases, the principal amount of the obligation). There is an alternative theory that in some cases could defer the taxation of consideration where the value of that consideration is difficult to determine (the “open transaction doctrine”). However, that theory has been employed abusively by taxpayers and the IRS now maintains it is available only in “rare and unusual” circumstances.
(B) Seller Perspective: Buyer Equity:
If the buyer is a corporation and is willing to cooperate, in many cases, an acquisition with equity consideration can be structured to fall within the tax free exchange provisions of Sections 351 and 368 of the Code. However, in general, redeemable preferred stock may not be received tax -free under Section 351 or 368. Moreover, under Code Section 305, the legislative history suggests that accrued dividends never intended to be paid currently on redeemable preferred stock are currently taxable.
Fortunately, a tax efficient redeemable stock can be structured with limited brain damage. The key factor is that the stock must not function as preferred stock in the traditional sense for tax purposes. Nontraditional preferred stock includes common stock or preferred stock that participates in corporate growth to a significant extent. A popular form of participating preferred stock is a preferred stock that upon liquidation/redemption pays the greater of (i) its issue price plus a fixed yield and (ii) its common stock value on an as converted basis. If there is a real and meaningful likelihood that a seller will participate beyond the fixed yield, the seller may defer tax on the receipt of redeemable common stock or redeemable participating preferred stock under Sections 351 and 368 of the Code. Moreover, under Code Section 305, dividends that are not declared by the board but simply accrue to increase the liquidation price of redeemable stock are not currently taxable if the redeemable stock is common stock or participating preferred stock. Thus, buyer stock may be structured to provide (i) tax free results upon receipt and (ii) no current income accrual.
One caveat on the tax-free exchange rules in Sections 351 and 368: Where both equity and cash are provided as consideration the equity may be wholly or partially taxable depending in part on the tax basis of the assets being sold and the mix of equity and non equity consideration. In short, the realized gain is measured by subtracting to the tax basis of the assets being acquired from the overall value of the consideration (including the stock value). The realized gain is recognized as income but only to the extent of the non equity consideration. Thus, some or all of the gain will likely be recognized when the tax basis is high and/or the amount of non equity consideration is high.
As discussed below, if the buyer is focused on achieving the highest post-acquisition tax basis as possible then the buyer may not be willing to cooperate in structuring the acquisition as a tax-free exchange for seller. In addition, the tax-free exchange rules may not be available in every transaction. When tax-free exchange treatment is not available the seller will be taxed immediately upon closing on the fair market value of the buyer equity, absent the unlikely application of the open transaction doctrine, mentioned above.
If the buyer is a partnership or limited liability company taxed as partnership, it is far easier to qualify for a tax free exchange with no tax due upon receipt of the buyer equity. Under Section 721 and 707 almost every transfer of property, in whole or in part, in exchange for partnership equity may qualify as a tax-free exchange. Moreover, there are no limitations on the terms of the redeemable preferred equity (e.g., participation) as described above. However, partnerships flow through income, gains and losses to their owners. Thus, sellers will be taxed currently on their share of income earned by the partnership prior to redemption and should be certain that they receive annual minimum distributions to cover their tax obligations.
Tax Implications: Buyer
Buyers are often focused on increasing the initial tax basis of the acquired assets or business. In a typical asset acquisition, the purchase price is allocated among the acquired assets and much of the purchase price ends up as amortizable goodwill. The amortizable goodwill is spread over 15 years and can provide significant tax deductions and shelter from tax. In a stock acquisition, disregarding a Section 338(h)(10) election, the tax basis of the acquired stock will not be amortizable and will matter much less to the buyer.
(A) Buyer Perspective: Contractual Promise:
The buyer’s tax treatment does not depend on the seller’s decision to elect installment sale treatment. Generally, the buyer will be unable to include the deferred cash consideration in the tax basis of the acquired assets until the deferred consideration is paid or at least fixed in amount. However, when the consideration is paid it may provide additional shelter from taxes. In the interim period, the buyer will earn income on the deferred cash and make deductible interest payments to the seller.
(B) Buyer Perspective: Buyer Equity:
If the transaction is structured as a tax free acquisition then no adjustment to tax basis will be available to buyer with respect to the tax free portion of the buyer equity either upon closing or upon redemption of the buyer stock. In the interim, the buyer will earn income on the cash but no deduction will be provided for the accrued dividends or redemption payments. When tax-free treatment is not available then the buyer will have an immediate tax basis adjustment at closing with respect to the fair market value of the buyer equity. Again, in the interim, the buyer has the use of the cash but no deduction will be provided for the accrued dividends or redemption payments.
How Long is Too Long?
Both structures outlined above can be used to provide deferral for several years. However, the maximum length for deferred cash consideration raises some interesting questions. First, depending upon the applicable yield negotiated by the parties the time value of money may make long term deferral costly to buyers. Second, as noted above, with a contractual promise scenario, the buyer may get a further basis increase only when the additional consideration is paid to the seller. If the payout is deferred until the end of the buyer’s holding period then the benefit of the increased basis and accompanying amortization deductions is of lesser value to the buyer. Finally, beginning 2013, the unearned income medicare contribution tax will take effect. Absent new legislation, net investment income including interest and gain (other than gain on certain trades and businesses) resulting from an installment sale will be subject to an additional 3.8 percent tax. Thus, deferral after 2012 may subject sellers to an additional tax cost.
The life lesson for general partners is that there are infinite paths to any single destination. Deferred cash consideration is no exception. With an open mind, deferred consideration may be structured using buyer equity to provide optimal results that cater to the individual objectives of the parties.
Isaac Grossman is the head of the tax department at Morrison Cohen LLP, a law firm located in New York City. He can be reached by email at firstname.lastname@example.org.