Taxes and Business Strategy, 30118Spring 2020
Problem Set #3
1. Computing Marginal Tax Rates, with NOLs
Assume that the current year is 2020. A few years ago, Congress and the Trump
administration passed a bill that made significant changes to corporate tax rates
and the treatment of Net Operating Losses (NOLs). This law was called the ‘Tax
Cuts and Jobs Act of 2017’.
Under that tax bill, the corporate tax rate was reduced from 35% down to 21%
starting in 2018. Assume that the tax reduction as part of that bill is set to expire in 2023.
You run a company called TaylorSwift Corp (a C-corp.), and you have
projected your income for the next few years.
Assume the following:
1. All income amounts below are before any NOL carryforwards or
carrybacks.
2. The maximum statutory rate for calendar year corporations was 35% up
through 2017, 21% in 2018 through 2022, but then increases back to 35% in 2023.
3. All amounts are in $ millions to avoid hassling with lower tax brackets.
4. The firm began operations in 2017, has an after tax discount rate of 10% per year, and you can
project the future with certainty.
5. Assume that corporations can carry forward unused NOLs, however, in any given year only 80%
of that year’s taxable income can be offset by NOL carryforwards. The remaining NOLs can be
carried forward to be used in future years. [NOTE: These are the NOL rules that were enacted as
part of the Tax Cuts and Jobs Act of 2017.]
a) Assume that Taylor Swift’s taxable income is as follows, and that we believe the projections to be
accurate. What is Taylor Swift’s Marginal Tax Rate in 2020 under the following projections?
tax rate
taxable income
2017
35%
+100
2018
21%
+100
2019
21%
+100
2020
21%
-70
2021
21%
+100
2022
21%
+100
2023
35%
+100
and beyond
35%
+100 per year
b) Instead, assume the following income and projections. What is the Marginal Tax Rate in 2020?
tax rate
taxable income
2017
35%
+100
2018
21%
+100
2019
21%
+100
2020
21%
-110
2021 2022 2023
21% 21% 35%
$100
+100 +100
and beyond
35%
+100 per year
c) Instead, assume the following income and projections. What is the Marginal Tax Rate in 2020?
tax rate
taxable income
2017
35%
+100
2018
21%
+100
2019
21%
-250
2020
21%
+100
2021
21%
+100
2022
21%
+100
2023
35%
+100
and beyond
35%
+100 per year
d) Instead, assume the following income and projections. What is the Marginal Tax Rate in 2020?
tax rate
taxable income
2017
35%
+100
2018
21%
-90
2019
21%
+100
2020
21%
-70
2021
21%
+100
2022
21%
+100
2023
35%
+100
and beyond
35%
+100 per year
2. Acquisition of free-standing C Corporation
Cavaliers is a privately-held C corporation that is organized in the state of Ohio, whereas the
Golden State Warriors is a publicly-held C Corporation organized in the state of California.
Cavaliers is interested in buying Warriors Corp., and would like to thoroughly liquidate
Warriors Corp. as well.
Warriors Corp has an inside basis of $350m (a tax basis of $650m less accumulated depreciation
of $300m), and does not have any liabilities.
Warriors is owned by two shareholders, Stephen Curry and Steve Kerr, who each own 50% of
Warriors Corp. Curry owns his shares in Warriors through a Roth IRA making any proceeds
nontaxable, and Kerr holds the shares in a taxable brokerage account. Both Stephen Curry and
Steve Kerr’s tax rates are 35% on ordinary income and 15% on long-term capital gains.
Stephen Curry has a tax basis in his shares of $125m, while Steve Kerr has a tax basis in his
shares of $110m. They have both owned their shares for more than 1 year.
Cavaliers Corp. and Warriors Corp. both have a corporate tax rate of 35% on both ordinary
income or on capital gains. Assume that if Cavaliers receive a step-up in basis, the benefits will
accrue over 10 years at the end of each year. Cavaliers Corp discounts future cash flows at 10%
per year.
Justify all your answers with appropriate calculations.
Part I. Cavaliers offers $600m in cash to purchase the assets of Warriors Corp. Warriors pays
taxes on the proceeds, and immediately distributes the remaining cash to Stephen Curry and Steve
err.
1) How much tax does Warriors Corp pay on the sale, and how much money will it distribute to its
shareholders?
2) How much do each of the shareholders of Warriors Corp receive in proceeds from this transaction
after paying their own taxes?
3) What tax basis does Cavaliers Corp. take in the assets of Warriors Corp.?
4) If Cavaliers Corp. received a step-up in basis on the assets, how much is that step-up in basis
worth in present value to Cavaliers Corp?
Part II. Assume instead that Cavaliers offers $550m in cash to purchase the shares of Warriors
Corp. directly from the shareholders of Warriors Corp. After the transaction, Warriors Corp is
owned by Cavaliers Corp.
1) How much tax does Warriors Corp pay on the sale, and how much money will it distribute to its
shareholders?
2) How much do each of the shareholders of Warriors Corp receive in proceeds from this transaction
after paying their own taxes?
3) What tax basis does Cavaliers Corp. take in the assets of Warriors Corp.?
4) If Cavaliers Corp. received a step-up in basis on the assets, how much is that step-up in basis worth in
present value to Cavaliers Corp?
5) Which do the shareholders of Warriors Corp. prefer, (i) receiving $600 in cash for the assets as in part
I, or (ii) receiving $550 in cash for the stock as in part II?
Part III. As in part II, assume that Cavaliers offers $550m in cash to purchase the shares of
Warriors Corp. directly from the shareholders of Warriors Corp. After the transaction, Warriors
Corp. is owned by Cavaliers. Assume that following the purchase, Cavaliers Corp makes a 338
election.
1) How much tax does Warriors Corp pay on the sale, and how much money will it distribute to its
shareholders?
2) How much do each of the shareholders of Warriors Corp receive in proceeds from this transaction
after paying their own taxes?
3) What tax basis does Cavaliers Corp. take in the assets of Warriors Corp.?
4) If Cavaliers Corp. received a step-up in basis on the assets, how much is that step-up in basis worth in
present value to Cavaliers Corp?
5) Does it make sense for Cavaliers Corp. to have made the optional 338 election?
Part IV. Using the same assumptions as in Part III, also assume that Warriors Corp, had $125m in
NOLs. Assume that the NOLs can be used to offset part of the gain in the case of a 338 election,
but assume that if Cavaliers did not make the election, then the NOLs would be worthless to
Cavaliers.
1) How much tax does Warriors Corp pay on the sale, and how much money will it distribute to its
shareholders?
2) How much do each of the shareholders of Warriors Corp receive in proceeds from this transaction
after paying their own taxes?
3) What tax basis does Cavaliers Corp. take in the assets of Warriors Corp.?
4) If Cavaliers Corp. received a step-up in basis on the assets, how much is that step-up in basis worth in
present value to Cavaliers Corp?
5) Does it make sense for Cavaliers Corp. to have made the optional 338 election?
Taxes and Business Strategy
Intro to Mergers & Acquisitions
and Taxable M&A
Session 6.0
Professor Ira Weiss
1
Topics for Today
Overview of M&A Issues
–
–
–
–
Taxable acquisitions of freestanding C corporations
–
Motivation and Structure (assets vs. stock)
Taxable or Non-taxable
Step-up in Basis, Inside vs. Outside Basis
Financial Accounting Issues for M&A
338 election
Acquisitions of conduit (flow-through) entities
–
–
S corporations, LLC, other conduits
Large tax benefits available through 338(h)(10) election.
2
1
Sample of M&A Issues
(which we will address)
How
do we make an acquisition (or merger) tax
efficient, while minimizing non-tax costs?
Taxable
vs. non-taxable structures?
When
do we make optional elections (338) to have
the basis of the assets stepped up to FMV?
Are
NOL carry-forwards useful to the seller or buyer?
What
is the value of NOLs to a potential buyer?
3
Connection to the framework
Parties (lots of them!). Which party should pay?
–
Non-tax issues. What are some non-tax issues?
–
Avoid liabilities (e.g., lawsuits), effect on earnings,
control issues, transaction costs, stock vs. cash
Structures
–
–
–
Acquirer, target, shareholders of each
Taxable (asset purchase, stock purchase with
338 election)
Non-taxable (368 “A”, “B”, “C”, 351, triangular)
Acquisitions of subsidiaries
Timing
–
Current vs. future taxes, one pocket to another
4
2
Example of M&A
Google’s purchase of YouTube, 2006
Note
6 (from Google’s 2006 Annual Report)
Acquisitions “In November 2006, we acquired all of the
voting interests of YouTube […] in a stock-for stock
transaction. The purchase price was $1.194 billion and
consisted of cash payments of $21.2 million, including
[…] the net issuance of 2,427,708 shares of our Class A
common stock”
Of
the purchase price, $1.134 billion was
allocated to goodwill
5
Example2 of M&A
Facebook purchase of WhatsApp, 2014
(based off FB announcement on Feb 19th, 2014)
In Feb 2014, Facebook entered into an agreement to acquire all the
outstanding shares of WhatsApp for $19B.
The $19B purchase price includes $12B of Facebook common
stock (183,865,778 shares), $4B in cash and $3B in restricted stock
to employees.
Upon consummation of the merger, at least 25% of the
consideration must be cash.
6
3
Example3 of M&A
JP Morgan purchase of Bear Stearns, 2008
Merger with The Bear Stearns Companies (5/30/08 10-Q)
Effective May 30, 2008, BSC Merger Corporation, a whollyowned subsidiary of JPMorgan Chase, merged with The
Bear Stearns Companies Inc. […] and Bear Stearns became
a wholly-owned subsidiary of JPMorgan Chase (the “Merger”)
The Merger provides the Firm with a leading global prime
brokerage platform; strengthens the Firm’s equities and asset
management businesses; enhances capabilities in mortgage
origination, securitization and servicing
The Merger is being accounted for under the purchase method
of accounting […]. The total purchase price to complete the
Merger was $1.5 billion
7
Taxes for Mergers and Acquisitions
Issues seem complicated, but principles hold
1
Transactions
taxable if cash
is received
2
No double tax
in the passthrough form
3
Losses can
offset gains of
a similar type
“Taxable” vs. “Tax-Free” M&A
M&A with C-corporations vs. S-corps
Target’s NOLs offset target’s gains,
acquirer’s use of target’s NOLs is limited
8
4
Types of Acquisitions and Divestitures
Acquisitions
of
Divestitures
Freestanding C Corporations
Conduit Entities (e.g., S Corporations)
Subsidiaries of C Corporations
Spin-offs
Equity Carve-outs
Derivative-Based (e.g., Tracking stock)
Creative structures: Morris Trust, cash-rich split off
9
Motivation for M&A
Why engage
in acquisitions?
Might we
want to
engage in
acquisitions
solely for tax
purposes?
1. Economies of scale and scope
2. Market power
3. Empire building
Not likely given today’s tax rules
10
5
Merger?
Acquisition?
Buying Part of a Company
Two ways to acquire part of a firm
1
Buy some of
the firm’s
stock
From whom is this purchase made?
What is the economic value of the stock?
Buy some of
the firm’s
assets
From whom is this purchase made?
What is the economic value of the assets?
2
12
6
Taxation of Stock Purchase
No
Buyer
tax consequences at purchase
Price
paid establishes tax basis of stock
Triggers
Seller
Tax
recognition of capital gain/loss
basis is seller’s purchase price
13
Taxation of Asset Purchase
No
Buyer
tax consequences at purchase
Price
paid establishes tax basis of assets
purchased (step-up in tax basis to purchase price)
Assets
are depreciated from price paid (FMV)
Triggers
Seller
recognition of capital gain/loss and
ordinary income (depreciation recapture)
Tax
basis = purchase price – depreciation +
capital improvement
14
7
Depreciation Recapture vs. Capital Gain
Tax Basis
Sale Price
Purchase
Price
Capital Gains
Depreciation
Recapture
(Ordinary)
Time
15
Scaling Up a Stock Purchase
What
if all shares are purchased?
Purchaser gets complete control
– All earnings, all assets, all liabilities
–
In
economic value, is this just a scaling up of
the value of a small stock purchase?
Does
purchase cost = share price*# shares?
16
8
Scaling Up an Asset Purchase
What if all
assets are
purchased?
Seller
chooses
whether or
not to
liquidate
Purchaser gets plant, property, equipment,
trademarks, patents, “goodwill,” etc.,
Key question – Who gets the liabilities?
Can use cash (after taxes) to pay off liabilities
and distribute cash to shareholders
Can use cash (after taxes) to buy other assets
17
Five Parties, Two Types of Deals
Target
Company
Uncle Sam
Stock
Deal $
Asset
Deal $
Asset
Deal
Acquiring
Company
Asset
Deal $
Target
Company
Shareholders
Acquiring
Company
Shareholders
18
9
Non-Tax Costs
Transaction costs: stock vs. asset purchase?
Asset purchase is (usually) more costly. Why?
– Transfer of ownership rights may be complex
– Government contracts usually non-transferable
What is the benefit of asset purchase?
– The deal can be tailor-made: some assets and
liabilities may be left out
19
Inside and Outside Basis
Two ways to purchase gives two terms to
describe seller’s tax basis:
– Inside tax basis: firm’s basis in its own assets
– Outside tax basis: shareholders’ basis in firm’s
stock
shareholders
Outside basis
Corporation/firm
Inside basis
20
10
Step-up in Basis
In a taxable asset deal, the acquirer’s (inside) tax basis in
purchased assets is “stepped up” to fair market value
– Why is step-up in basis valuable to the acquirer?
future depreciation (and amortization)
– How is the purchase price allocated to the individual assets?
In a stock deal, the acquirer’s (outside) basis in the firm’s stock
= FMV, but firm’s (inside) basis in assets remains the same
– Special rules (338 election and 338(h)(10) election) allow for optional
step-up in inside tax basis in taxable stock deal
21
Deductibility of Intangibles Acquired when
Basis Stepped-up
IRS mandates 15 year useful life for purchased
intangibles (§197)
Applies only when assets are stepped up to FMV for
tax purposes (which is rare)
Prior to 1993, intangibles that had indefinite lives were
not deductible for tax purposes.
– This led to lots of games allocating goodwill to
depreciable intangibles
(e.g., patents & customer lists).
22
11
Financial Accounting Rules: Mergers &
Acquisitions
Financial accounting method for M&A called the ‘Acquisition
Method’, which replaced a method called ‘Purchase Accounting’
The acquirer assesses the fair value of the separate assets and
liabilities in the business it has acquired (& intangibles)
The value of all the assets & liabilities are stepped up to fair market
value for financial accounting purposes
If the acquisition price > FMV of T’s tangible and net monetary
assets then record GOODWILL on Acquirer’s books
For public companies, goodwill is not amortized, but instead is
tested for impairment once a year, and is written down if impaired.
For private companies, instead of being tested for impairment,
goodwill can be amortized over 10 years (reduces reporting burden).
23
Financial Accounting Rules for M&A as
compared to tax rules
Although goodwill is not amortized for financial reporting , in
some cases it is still amortized and deductible for tax purposes
Required disclosure of the amount of tax deductible goodwill:
– In the year of an acquisition, firms must publicly report the amount of
tax-deductible goodwill that was created by the acquisition (ASC 805)
(NOTE: Prior to 2001, tax-deductible goodwill had to be estimated)
24
12
Example 1 of Disclosures (in footnotes)
Salesforce acquisition of ExactTarget
Note 4 (from Salesforce 2014 Annual Report).
Acquisitions “On July 12th, 2013, the Company acquired for cash all
the outstanding stock of ExactTarget, a leading global provider crosschannel, digital marketing solutions… for $2.585 billion.
Of the purchase price, $1.849 billion was allocated to goodwill.
“The Goodwill balance is not deductible for tax purposes.”
25
Example 2 of Disclosures (in footnotes)
Google’s purchase of YouTube, 2006
Note 6 (from Google’s 2006 Annual Report).
Acquisitions “In November 2006, we acquired all of the voting
interests of YouTube […] in a stock-for stock transaction. The
purchase price was $1.194 billion and consisted of cash payments of
$21.2 million, including […] the net issuance of 2,427,708 shares of
our Class A common stock.”
Of the purchase price, $1.134 billion was allocated to goodwill
“Goodwill is not deductible for tax purposes. The developed
technology, customer contracts and other intangible assets have a
weighted-average useful life of 4.5 years from the date of acquisition.
The amortization of these intangibles is not deductible for tax
purposes. “
26
13
Example 3 of Disclosures (in footnotes)
Microsoft’s acquisitions during 2003
Footnote 18 (from 2003 Annual Report).
We acquired Navision on July 12, 2002 for $1.465 billion consisting primarily
of $662 million in cash and the issuance of 29.1 million common shares of
Microsoft stock valued at $773 million. […]
The $1,197 million of goodwill was assigned to the Microsoft Business
Solutions segment. Of that total amount, approximately $900 million is
expected to be deductible for tax purposes
Rare is a video game developer located outside Leicestershire, England….
Rare was acquired on September 24, 2002 for $377 million consisting
primarily of $375 million in cash
The $281 million of goodwill was assigned to the Home and Entertainment
segment. Of that total amount, approximately $270 million is expected to
be deductible for tax purposes
27
Frequency of Step-up in TAX BASIS
(as compared to financial accy step-up)
The way many (most) people think it is:
Tax Status of the Transaction
Type of
consideration
Financial
Accounting
Treatment
Stock only
Acquisition
Accounting
Step-up to FMV
Cash
Acquisition
Accounting
Step-up to FMV
Cash/Stock
Acquisition
Accounting
Step-up to FMV
Nontaxable
Taxable
With step-up
28
14
Frequency of Step-up in TAX BASIS
(as compared to financial accy step-up)
The way it really is:
Tax Status of the Transaction
Taxable
Type of
consideration
Financial
Accounting
Treatment
Stock only
Acquisition
Accounting
Step-up to FMV
Cash
Acquisition
Accounting
Step-up to FMV
Cash/Stock
Acquisition
Accounting
Step-up to FMV
Nontaxable
w/o
step-up
with
step-up
29
Financial Accounting (cont.)
Therefore, in acquisitions of freestanding C
corporations, goodwill recorded on the acquirer financial
statements will only rarely be tax deductible.
In some types of transactions that we’ll discuss shortly,
the goodwill created in the acquisition will be tax
deductible
In next week’s class, we’ll go through how to estimate
how much goodwill is tax deductible
30
15
Taxable vs. Tax-Free M&A
In general, acquisitions purchased with cash are
“taxable” and those purchased with stock are “tax free”
– Follows principle: no cash, no taxes
Labels focus on tax consequences to the seller at the
time of sale
– “Tax-free” means no current taxes
31
32
16
First, start with Taxable M&A
Taxable acquisitions
– “Taxable” acquisitions of assets C-corps
– Taxable acquisition of stock & optional 338 election
– Acquisition of S-corps, 338(h)(10) election
Next sessions:
– “Tax-free” acquisitions
33
How can you acquire a C-Corp
in a Taxable Acquisition?
Optional tax election
that can be made by
acquirer
1.Asset acquisition
Possible
structures
2.Stock acquisition w/o 338 election
3.Stock acquisition with 338 election
Key question: When are each of these structures optimal?
34
17
Simplifying Assumptions
Acquisition is made entirely with cash
No taxes for acquiring corporation
shareholders, so we’ll ignore them
Target corporation liquidates after asset
sale and gives cash to shareholders
35
Taxable Asset Acquisition
T’s Shareholders
Liquidates
(cash)
Acquirer “A”
Cash
T assets
Target “T”
36
18
Taxable Asset Acquisition
T corp – Taxable ordinary/capital gain
–
T’s NOLs offset T’s gain but A cannot use NOLs to
offset their own income
T shareholders – Taxable capital gain
A corp: Step-up in Basis? Yes!
–
–
A Corp takes FMV basis in T assets (a step-up in basis)
If acquisition price > value of tangible assets, this will create
tax-deductible goodwill
Non-tax factors?
–
Transactions costs (costly to transfer assets), limited liability
for acquiring firm
37
Example: Toxico Acquires Happy Cows
Toxico Chemicals (A) is planning to acquire Happy Cows Ice Cream (T) in
expectation of significant synergies between the two operations
Toxico is a processor of hazardous chemicals and is currently under
investigation by the EPA
– Happy Cows is a maker of premium ice cream whose motto is “cows with selfesteem make better ice cream”
–
Happy Cows (T) has an extremely strong brand name and much
customer loyalty due to its progressive image.
Speaking about the proposed acquisition of Happy Cows, Toxico’s CEO,
Billy Pilgrim, effuses:
–
“at Toxico, our core competency is processing. It doesn’t matter to us whether
we are processing Benzene or Butter Brickle. We can find ways to save money
and believe me, Happy Cows is a bloated operation”
Mr. Pilgrim has retained you to advise him how to structure the acquisition
38
19
Example of Taxable Asset Deal
Assume Tcorp=21% Tcapgain=15%, T has no NOLs
A pays $200 for T’s assets, inside basis (in its assets) is $100
T liquidates, outside basis (to shareholders) is $120
T corp: $100 + ($200-$100)*79% = $179
T shareholders: $120 + ($179-$120)*85% = $170.15
A corp: cost of acquisition = $187
PV of $100 depreciation is ~ $13 if we assume 10-year,
straight line, 10% discount rate, 21% tax
How does step-up in basis get allocated to assets?
39
AB2
Estimation of Tax Benefits from stepping-up the Tax
Basis of a Target’s Assets
Fact Pattern
Purchase Price
$200.00
Target’s Net Asset Basis
100.00
Step-up (1)
100.00
Amortization/Depreciation Period
10
Depreciation Method
Straight-line
Annual Incremental Amortization/Depreciation (2)
$10.00
tc =
21.00%
r=
10.00%
Period
Incremental Depreciation (2)
Tax Savings (3)
Present Value of Tax Savings (4)
1
$10.00
$2.10
$1.91
2
10.00
2.10
1.74
3
10.00
2.10
1.58
4
10.00
2.10
1.43
5
10.00
2.10
1.30
6
10.00
2.10
1.19
7
10.00
2.10
1.08
8
10.00
2.10
0.98
9
10.00
2.10
0.89
10
10.00
2.10
0.81
$100.00
$21.00
$12.90
Total
1
2
3
4
Step-up is the increase in the tax basis of the target’s assets computed as the purchase price less the net asset basis pre-acquisition
Incremental amortization/depreciation deductions is the step-up divided by the amortization period
Tax savings are incremental amortization/depreciation deductions multiplied by the corporate tax rate (tc)
Present value of tax savings discounted at the after-tax rate discount rate (r)
40
20
Slide 40
AB2
redid this too
Alexander Breinin, 3/5/2018
Taxable Stock Acquisition
(Without a Section 338 Election)
Cash
T’s Shareholders
Acquirer “A”
T stock
Target “T”
Subsidiary
(Target)
41
Taxable Stock Acquisition
(Without a 338 Election)
Tax implications for parties involved
T corp – No tax implications
T shareholders – taxable capital gain
A corp – Retains T’s inside basis in new
subsidiary’s (T’s) assets
– T’s NOLs survive but A cannot use
them to offset its own taxable income
42
21
Example of Taxable Stock Acquisition
(Without a 338 Election)
Assume Tcorp=21% Tcapgain=15%, T has no NOLs
A pays $179 for T’s stock, outside basis is $120
T corp: not involved in deal
T shareholders: $120 + ($179-$120)*85% = $170.15
A corp: cost of acquisition = $179
Why does A corp. pay only $179?
43
Taxable (Cash) Stock Acquisition
With a Section 338 Election
Cash
Shareholders
Acquirer
T stock
Target
Subsidiary
(Target)
338 Election
44
22
The 338 Election
Treats a taxable stock acquisition as if A acquires T’s assets for cash
(election made by A only)
Creates deemed sale and repurchase of T’s assets with hypothetical
third party
–
Price of deemed sale/buyback is called Aggregate Deemed Sale Price
(ADSP)
T (now a subsidiary of A) must pay taxes on “gain” from deemed sale
–
Effectively, the acquirer (A) is paying tax on the gain
–
T’s inside basis is stepped-up to ADSP, now in the hands of A
Acquirer must purchase 80% of target in a “qualified stock purchase”
Why would firms ever make a 338 election?
45
Aggregate Deemed Sale Price
ADSP estimates the value of T’s gross assets
ADSP = P + L + tcorp*(ADSP – Binside)
–
P is price paid for T’s stock
–
L is the book value of T’s liabilities (assumed by A)
– tc
–
is the corporate tax rate
Binside is the inside basis of T’s assets
Solving gives ADSP = (P + L – tcorp*Binside)/(1– tcorp)
46
23
Taxable Stock Acquisition with
Section 338 election
Tax implications for parties involved:
T Corp (not subsidiary): not involved
T shareholders: taxable gain
A corp: T (subsidiary) assets stepped up to
FMV, but T must pay taxes
– T’s NOLs can offset taxes due on the deemed gain on
338 election
47
Example of Taxable Stock Acquisition
With a 338 Election
Assume Tc=21% Tcg=15%, T has no NOLs
T’s inside basis is $100, no liabilities
A pays $179 for T’s stock, outside basis is $120
T shareholders: $120 + ($179-$120)*85% = $170.15
T corp (sub): deemed gain of $100
ADSP = ($179 + $0 – 21%*$100)/(1-21%) = $200
A corp: cost of acquisition = $179 + $21 –$13 = $187
$21 tax paid by subsidiary, $13 is PV of step-up
48
24
Taxable C Corporation Acquisitions
Summary Table
Type of Deal
Asset
Deal ($)
Stock Deal
w/o 338 ($)
Stock Deal
w/ 338 ($)
After-Tax Benefit
to Shareholders
$170.15
$170.15
$170.15
After-Tax Cost to
Acquiring Firm
$187
$179
$187
49
The Bottom Line
Why
is stock acquisition without a 338 election
less costly in this example?
Avoids corporate tax
– Gives up step-up in basis, but step-up less
valuable b/c depreciation takes time
–
What
–
would make the other deals less costly?
Tax reason: If target company had NOLs
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25
When would you want to make a 338
election?
1
T has NOLCFs
2
T foreign corporation
3
T is subsidiary of another company 338(h)(10)
4
T is an S corporation 338(h)(10)
51
How would you adjust ADSP calculation in
case of NOLs?
ADSP
= P + L + tcorp*(ADSP – Binside)
Add NOLs:
ADSP
= P + L + tc*(ADSP – Binside-NOLs)
Solve: ADSP = (P + L – tc*Binside- tc *NOLs) / (1– tc)
If
the target has NOLs, will the ADSP be higher
or lower than without NOLs?
(assuming the sales price is the same)
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26
Tax Implications of Basic Structures Employed
in Acquisition of Freestanding C Corporations
Tax-free Acquisitions
Taxable Acquisitions
Asset
Acquisition
Stock
Acquisition
with a § 338
Election (1)
Stock
Acquisition
without a § 338
Election
Asset
Acquisition
Stock
Acquisition
Typical Form of Consideration
Cash
Cash
Cash
Stock
Stock
Taxable to Target Shareholders (2)
Yes
Yes
Yes
No
No
Target Corporation Level Taxable Gain
Yes
Yes
No
No
No
Step-up in the Tax Basis of the Target’s Assets
Yes
Yes
No
No
No
Target’s Tax Attributes Survive (3)
No
No
Yes
Yes
Yes
Structural and Tax Factors
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Acquisitions of Conduit Entities
(e.g., S-corporations, LLCs)
Rules are similar to C-corporations
–
–
Assets or stock can be purchased
Step-up in basis available in stock deal w/ 338(h)(10)
What’s different for conduits?
–
–
–
Flow-through eliminates double taxation for asset
acquisition; step-up in basis is “free”
Rates differ between capital and ordinary income;
recaptured depreciation is ordinary income
Seller must agree to step-up in basis for stock deal
(when S corp being acquired, but not for LLC)
Did 338 election make sense for C corp?
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27
Acquisition of Conduits (S Corporations):
Types of Structures
1
Taxable asset acquisition
2
Taxable stock acquisition without 338(h)(10)
election
3
Taxable stock acquisition with 338(h)(10)
election
55
Taxable Asset Acquisition of
S-Corporation (or an LLC)
T’s Shareholders
Acquirer “A”
Cash
Liquidates
(cash)
Taxable
Gain
T assets
Target “T” S-corp
T is a flow-through entity
56
28
Taxable Asset Acquisition of S-Corp (or LLC)
T corporation
T
shareholders
A corporation
Not taxable on asset sale
Passes though gain to shareholders
Taxable on gain from asset sale;
Gain retains character (e.g., ordinary vs. capital)
as passed through
Gain creates step-up in basis
Cash only received if liquidation occurs, but gain
passes through regardless
Takes FMV basis in T assets (stepped-up basis!)
57
Example of Taxable Asset Deal
A Corp (Illini) acquires and thoroughly liquidates Tarheels S-Corp
A Corp. pays $200 for T’s assets; T liquidates: PV of step-up is $13
Inside and outside basis is $100, no excess depreciation
Tcapgain=15% [NOTE: tax rate for individuals on capital gains]
T Shareholders: $200 – $15 (tax)= $185
T corp. passes through $100 CG $15 tax
A Corp: cost of acquisition = $187 = $200 – $13
$13 = PV of future depreciation of $100 step-up
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29
Depreciation Recapture vs. Capital Gain
Real Property (e.g., buildings) only
Tax Basis
Sale Price
Purchase
Price
Capital Gains
Depreciation
Recapture
(Ordinary)
Time
Note: recapture for buildings (Sec. 1245 assets) differs from shorter term assets (Sec. 1250)
59
Taxable Stock Acquisition (S Corp or LLC)
Without a 338(h)(10) Election
Cash
Shareholders
Acquirer
T stock
Target S-corp
Subsidiary –
C-corp (Target)
60
30
Example of Taxable Stock Acquisition w/o
338(h)(10) Election
Same as prior example, but A Corp. pays $200 for T’s stock
Assume Tcorp=21% Tcapgain=15%, T has no NOLs
T’s inside and outside basis $100
T corp: no tax at entity level
T shareholders: $200 – $15 (tax) = $185
A corp: cost of acquisition= $200
No step-up in basis of T’s assets!!
61
Taxable (Cash) Stock Acquisition with
Section 338 (h)(10) election (S corp)
Cash
Shareholders
Acquirer
T stock
Target S-corp
Subsidiary –
C-corp (Target)
338(h)(10)
Election
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31
Implications and Requirements for 338(h)(10)
Election
Acquirer must purchase 80% of target
Target shareholders must agree to election
Stock sale asset sale for tax purposes
– T shareholders taxed on capital/ordinary gain using
inside basis and depreciation (income passes
through)
– T corp steps up its basis before becoming a
subsidiary of A corporation
Step-up in basis is valuable to A corp because of
future depreciation
63
Example of Taxable Stock Acquisition
w/ 338(h)(10) Election
A pays $200 for T’s stock;
Inside and outside basis are $100; no excess depreciation
T shareholders agree to and make 338(h)(10) election
T Shareholders: $200 – $15 (tax) = $185
$100 capital gain to T shareholders
Passed through from T corp. due to 338(h)(10)
election
A corporation: cost of acquisition = $187 = $200 – $13
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32
Taxable S Corporaton Acquisitions
Summary Table
Type of Deal
Asset
w/o 338
Stock Deal
Deal ($) (h) (10) ($) w/ 338 (h) (10) ($)
After-Tax Benefit
to Shareholders
$185
$185
$185
After-Tax Cost to
Acquiring Firm
$187
$200
$187
65
The Bottom Line
Stock acquisition without a 338(h)(10) election is
more costly for conduit entities
– S-corporation never pays taxes
– Step-up in basis from asset deal or election is “free”
What would make the asset deal and the 338(h)(10)
election more costly?
– If target had depreciation that needed to be recaptured
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33
Example of S-corporation
Acquisition w/ Excess Depreciation
A pays $200 for T’s assets; inside basis is $100
$40 in excess depreciation (Cost basis of $140- accum depr 40 = 100 basis)
T liquidates, outside basis $100
Assume: Individuals => Tordinary=35%, Tcapgain=15%; Corp => Tcorp=21%
T shareholders:
– Total gain = $200 – 100 = 100
– Ordinary income = $40
– Capital gain = $60
– After-tax cash to shareholders = $200 – $40*35% – 60*15% = $177
– T shareholders will demand more cash $$ to agree to 338(h)(10)
election
A Corp: cost = $200 – $13 = $187
67
Example #2 (continuation of prior example)
A pays $200 for T’s stock; inside basis is $100
$40 in excess depreciation (Cost basis of $140accum depr 40 = 100 basis)
T liquidates, outside basis $100
(i) Assume that A has offered $200 in cash to purchase the stock of the target.
What price (P*) would the acquirer have to offer T shareholders so that the
shareholders are indifferent between receiving $200 in cash versus P* whereby
T shareholders would agree to make a 338(h)(10) election?
(ii) Would the buyer be willing to pay the amount calculated above to induce the
selling shareholders to make the election?
Assume: 10% discount rate, 10 yr useful life for assets, corporate tax rate 21%
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