23 annual health sciences tax conference - united · pdf file23rd annual health sciences tax...

23rd Annual Health Sciences Tax ConferenceAcquisitions of closely held businesses

December 11, 2013

Acquisitions of closely held businesses

Disclaimer

Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.


Disclaimer

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit ey.com.This presentation is © 2013 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party.Views expressed in this presentation are not necessarily those of Ernst & Young LLP.


Presenters

Laura MacDonough1101 New York Avenue N.W. Ernst & Young LLP Washington, DC+1 202 327 [email protected]

David MillerErnst & Young LLP1 Victory ParkSuite 20002323 Victory AvenueDallas, TX+1 214 969 [email protected]

Torsdon PoonErnst & Young LLP 1101 New York Avenue N.W.Washington, DC+1 202 327 [email protected]

Carole BelmarVice President, TaxationTeam Health, Inc.Knoxville, TN


Agenda

Mergers & acquisitions with:C corporations

Section 336(e) regulationsAcquisitions and personal goodwill

S corporationsQualification as an S corporationS corporation due diligencePost-acquisition restructuringOther planning considerations

PartnershipsAcquisition of a business owned in partnership solutionAcquisition of an interest in an existing partnershipAcquisition of a partial interest in a business: dealing with the anti-churning rules

Mergers & acquisitions with C corporations

Section 336(e) regulations


Background and benefits

Section 336(e)

What is it? To whom does it apply?

Sell-side deal optimization

Benefits

Provides that certain stock sales and dispositions may be treated as asset transfers for US federal income tax purposes

S corporationsPrivate equityCorporations

Operational benefitsFlexibility in structure Section 336(e) versus Section 338(h)(10)


Example 1: effect of forward cash merger

The tax effect of a forward cash merger and that of a 336(e) transaction are similar.Although Partnership owns the assets of Target directly in a forward cash merger, an even more similar result occurs if Partnership subsequently drops Target assets into a new corporation under Section 351.

Taxable forward merger results in a new entity owning Target’s assets.Licenses to Target may not be transferrable.

Stock purchase with 336(e) election offers same basis step-up in Target’s assets as that of the taxable forward merger, but Target continues to own all assets.336(e) election thereby offers same result but is less operationally invasive than a taxable forward merger.

Seller

Target

Taxable forward merger

Seller

TargetP’shp

P’shp

Stock purchase with 336(e) election


Example 2: private equity (PE) club deal

336(e) election offers an opportunity to separate wanted and unwanted businesses in typical private equity fund structure.Distribution of unwanted business and sale of wanted business are available, provided each fund is unrelated (owns less than 50% of Parent Holdco).

336(e) election is available for both the distribution of unwanted and the sale of wanted.

Parent Holdco

PE Fund 1 PE Fund 3PE

Fund 2

Holdco

Wanted Corp.

Unwanted Corp.

33.33% 33.33% 33.33%

Purchaser

Unwanted Corp. stock Unwanted

Corp. stock

Unwanted Corp. stock


Comparison of Section 336(e) to 338(h)(10)

Section 338(h)(10) Section 336(e)

Election maker Joint seller and purchaser election Seller and target election by agreement

Timing Election within 8.5 months Election on tax return(s)

Type of purchaser Corporate purchaser Corporate or noncorporate purchasers

Type of Seller and Target

US corporation seller and consolidated affiliate corporation target or nonconsolidated affiliate target; or S corporation target

US corporation seller and affiliated (but not necessarily consolidated) target; or S corporation target

Time frame 12-month acquisition period, limited creeping 12-month disposition period

Amount of stock disposed of

Sale of 80% vote and value (excluding Section 1504(a)(4) stock)

Sale and/or taxable distribution of 80% vote and value (excluding Section 1504(a)(4) stock)

Related parties Related-person restriction (Section 318(a) attribution)Note: 50% threshold for corporation attribution

Related-person restriction (Section 318(a) attribution but not between partnerships with < 5% partners)Note: 50% threshold for corporation attribution

Foreign Seller or Target

Not available if seller or target is foreign Not available if seller or target is foreign

Qualitative nature No carryover basis in whole or in part/no transfer of stock in a transaction to which Section 351, 354, 355 or 356 applies

No carryover basis in whole or in part/no transfer of stock in a transaction to which Section 351, 354, 355 or 356 applies


Flexibility of Section 336(e) vs Section 338(h)(10)

Section 336(e) offers flexibility regarding the type of business entity that can acquire a Target.

Seller

Target

Corporate purchaser required for 338(h)(10)

Seller

Target

P’shp

Stock purchase/distribution with 336(e) election

Acquirer P’shp Individuals

Public


Summary of seller and purchaser considerations

Seller Purchaser

Benefits • Can market-basis step-up to purchaser if willing to make 336(e) election

• Ability to sell with step-up and without requiring intellectual property relicensing

• Opportunity to carve out unwanted subsidiaries

• Basis step-up• Don’t need corporate purchaser• Can liquidate target promptly

Traps • Loss limitation on distribution • No notice provisions• Creeping transactions• Consistency rules• Loss of net operating losses

Contractual provisions/considerations

• Breach of contract for failure to make 336(e) election

• Require or prohibit 336(e) election in stock purchase agreement

Reporting • File election jointly with target• Enter into binding agreement with target to

make election

• No participation in election• Reporting with respect to target

during creeping acquisition for consolidated and S corporation returns


Section 338(h)(10) with S corporationconsiderations

For 338(h)(10) election to be valid, target must have valid S election in effect.All shareholders (including non-selling) must consent.Incremental cost:

Potential ordinary income (cash-basis receivables, depreciation recapture, etc.)Built-in gains taxState and local income taxes


Section 338(h)(10) with S corporationconsiderations

Installment sale considerations:Corporate gain deferral, except for corporate level taxesShareholder gain acceleration (basis allocation issue)

Defer all payments to maximize gain deferral?Contingent installment sale rules

Basis allocation ruling for fixed-period contingent installment noteState tax planning

Involves deferral of all payments to avoid gain recognition at corporate levelQuestionable viability of planning


Reporting considerations

Election is joint between Seller and Target (or between S corporation target and its shareholders).

Target essentially represents the Purchaser(s) in the election because there may be many.

Seller(s) and Target must enter into binding agreement to make election.Election is made on the consolidated return of the Seller and Target or, otherwise, on both returns if they are not filing consolidated returns by filing a Section 336(e) election statement (contents described in Treas. Reg. §1.336-2(h)).For allocation of aggregate deemed asset disposition price and adjusted gross-up basis, Form 8883 should be used with appropriate adjustments made.Creeping acquisitions raise reporting issues

Consolidated groups: timing for inclusion on Seller’s consolidated return vs Purchaser’s consolidated return prior to completion of qualified disposition dateS corporations: K-1 obligation prior to qualified disposition date after selling shareholders have disposed of stock

Acquisitions and personal goodwill


Personal goodwill vs corporate goodwill

Personal goodwill (PG): individual’s personality, business acquaintances, character, reputation, skill and knowledgeCorporate goodwill: intangible assets of a business, including client lists and records, trained personnel and favorable leasesExistence of PG

Personal service corporations (e.g., doctors, dentists, etc.)Closely held corporations for which shareholder provides personal servicesCorporations for which a shareholder’s personality, business acquaintances, character, reputation, skill and knowledge have increased the value of the business enterprise


Taxable stock acquisitions and PG

Target

Individual A Public

Acquirer

$

Acquirer to acquire Target stock and Individual A’s PG from Individual A in exchange for cash in a taxable stock acquisitionTreatment of US federal income tax consequences to Individual A and Acquirer?Purchaser vs seller considerationsOther tax considerations:

Impact of covenant not to compete or long-term employment contractValuation issues

Impact of multiple shareholdersCharacter of PGApplicability of anti-churning rules


Taxable asset acquisitions and PG

Target

A Public

Acquirer

Acquirer to acquire assets from Target and PG from Individual A in exchange for cash in taxable asset acquisitionsTreatment of US federal income tax consequences to Individual A and Acquirer?Purchaser vs seller considerationsOther tax considerations:

Impact of covenant not to competeor long-term employment contractValuation issues

$

Target assets

$

$

Impact of multiple shareholdersCharacter of PGApplicability of anti-churning rules

Mergers & acquisitions with S corporations

Qualification as an S corporation


S corporation definition

An S corporation is a small business corporation that has filed a valid election to be treated as an S corporation.

The election is made on Form 2553.The election must be signed by a duly authorized officer of the corporation.In addition, each shareholder owning stock on the date the election is filed must consent to the election.If the election is to be effective retroactive to the beginning of the tax year, any person owning stock during the pre-election must also consent.

If an S election is missing an officer or shareholder’s consent, then the election is invalid.


Small business corporation

A small business corporation is a corporation that:Is a domestic corporationIs not an ineligible corporationHas only individuals (other than nonresident aliens), certain trusts and certain tax-exempt organizations as shareholdersHas no more than 100 shareholdersHas only one class of stock


Qualified Subchapter S subsidiary (QSub)

A parent S corporation may elect to treat a qualifying subsidiary as a Qsub.

A qualifying subsidiary is a domestic corporation (other than an ineligible corporation) that is wholly owned by a parent S corporation for US federal income tax purposes.

When a valid QSub election is made for a subsidiary, the subsidiary is disregarded for US federal income tax purposes.

Accordingly, its assets, liabilities and items of income, gain, loss, deduction and credit are treated as those of its parent S corporation.


Failing to qualify as a small business corporation

If corporation is not a small business corporation at the time its S election is filed, the election is invalid.If a corporation ceases to be a small business corporation subsequent to the filing of a valid S election, its S election terminates.

A corporation’s S election will also terminate if it has excessive passive investment income for three consecutive tax years and Subchapter C earnings and profits at the close of each of these tax years.


Failing to qualify as a small business corporation

If a corporation’s S election is invalid or subsequently terminated, it is a C corporation.

The QSub elections made for subsidiaries would be invalid or terminated; thus, the QSubs would also be C corporations.The corporation would be liable for corporate-level taxes.A Section 338(h)(10) election would be unavailable.

Note that the IRS may grant relief for an inadvertently invalid or terminated S election or QSub election (see Section 1362(f)).

S corporation due diligence


S corporation due diligence

Confirm S corporation status of targetConfirm QSub status of relevant subsidiary corporationsEvaluate exposure for corporate-level taxes applicable to S corporations

Last-in, first-out recapture taxBuilt-in gains taxPassive investment income taxState, local and foreign taxesPayroll taxes


Common S corporation due diligence issues

Unable to locate copy of S election and/or QSub electionsMissing spousal consentImpermissible trust shareholder (or unable to locate election to treat as permissible shareholder)More than one class of stock

Disproportionate distributionsPersonal expenses paid by corporationUnreasonably high shareholder compensationNon-arm’s-length related-party transactions

Unreasonably low compensationBuilt-in gains tax (note differing recognition periods)


Use of limited liability company (LLC) to address diligence issues

FactsBuyer wants to acquire Oldco, a purported S corporation, in a transaction that results in basis step-up. For legal and other business reasons, the transaction cannot be structured as actual asset acquisition.Buyer has concerns about validity of Oldco’s S election.

Current structure

Shareholders

Oldco


Use of LLC to address diligence issues

Possible restructuring:Oldco shareholders form Newco; an S election is made for Newco.Oldco shareholders contribute stock of Oldco to Newco in exchange for Newco stock.Immediately following the contribution, Oldco is converted to an LLC under state law conversion statute.

A check-the-box election is NOT made.

Buyer acquires LLC.

Revised structure

OldcoLLC

Shareholders

Newco


Use of LLC to address diligence issues

Results:Buyer is treated as having acquired assets of Oldco in a taxable asset acquisition.

Treatment provides buyer with certainty regarding basis step-up.Newco should be liable for any built-in gains (or other corporate level) tax resulting from sale transaction.

Oldco LLC should have successor liability for any corporate-level taxes incurred pre-restructuring.

Post-acquisition restructuring


(1) S Corporation transfers operating assets (and related liabilities) to LLC in exchange for LLC interests.

(2) S Corporation sells LLC interests to buyer.

New LLC

(1) Assets and

liabilities

(1) LLC interests

S Corporation

Buyer

(2) Cash

(2) LLC interests

Use of LLC to avoid termination of S election

Flow-through status is maintained because ineligible investor is a partner, not a shareholder.

Anti-churning rules should be considered.

If money is to be used in business, funds could be contributed to LLC.

Disguised-sale rules should be considered.


Contribute unwanted assets to LLC and distribute to shareholders (or distribute outright)

Taxable gain

Form new S corporation; contribute stock of existing S corporation and make QSub election (or convert to LLC); distribute unwanted assets to S corporation; sell QSub stock (or LLC interests)Contribute desired assets to new QSub (or LLC) and sell QSub stock (or LLC interests)

Structuring alternatives for unwanted assets


(1) Non-big assets

(1) Cash

Built-in gains tax planning: bifurcated asset/stock sale

Buyer

(2) Cash

(3) Cash

(3) Stock

(1) S Corporation sells non-big assets to Buyer for cash; Buyer gets step-up in basis.

(2) S Corporation distributes proceeds from sale to shareholders (or Buyer increases purchase price for stock).

(3) Shareholders sell S Corporation stock to Buyer; no §338(h)(10) election is made.

Shareholders

S Corporation

Other planning considerations


Taxable income planning

Eliminate indebtedness of QSub to parent prior to termination of S electionPlanning for income and expense recognition

Pre- or post-acquisitionTiming of compensatory deductions


Contract considerations

Gross-up for incremental cost associated with Section 338 (h)(10)

Should be addressed in letter of intent

Section 1362(f) reliefResponsibility for filing final S corporation returnSigning of final S corporation returnRefund of Section 7519 deposit (and making of deposit if necessary)ElectionsIndemnificationsWorking-capital considerations

Mergers & acquisitions with partnerships


Partnership transactions

Acquisition of a business owned in partnership solution:Taxpayer does not own an interest in the existing partnership.Taxpayer does own an interest in the existing partnership.

Acquisition of a partial interest in a business:Acquisition is of an interest in an existing partnership.Acquisition is of a partial interest in a business (forming a new partnership and dealing with the anti-churning rules).

Acquisition of a business owned in partnership solution


Acquisition of a partnership (no pre-existing ownership)

Target

Assets

Partner A Partner B

Buyer


Acquisition of a partnership (pre-existing ownership)

Target

Assets

Partner A Buyer


Acquisition of a partnership (pre-existing ownership)

Target

Partner A Buyer

Partial liquidation

From whom does Buyer acquire the purchased assets? Does it matter?

Acquisition of an interest in an existing partnership


Basic considerations and traps for the unwary

Amendment to partnership agreementInheriting your predecessor’s economic and tax attributes

Capital account, operating and liquidating distribution waterfallTax allocations: catch-up allocations, minimum gain, Section 704(c) built-in gain (and method)

Section 754 electionMechanics of Section 743 adjustment/interaction with Section 704(c)Built-in loss and mandatory adjustments

Partnership terminations Restart depreciationShort-period returns and new electionsConsequences to lower-tier partnerships


Basic considerations and traps for the unwary

Section 706Intra-year allocations and permissible methodsPartnership year end change?

Section 706 — rules governing partnership year end based on year end of partnersMajority interest/principal partners/lease aggregate deferralSpecial rules for certain foreign and tax-exempt partners

Required change from cash to accrual method?Partnership generally prevented by Section 448 from using cash method of accounting if a C corporation is a partnerException for certain “small partnerships” meeting $5M gross receipts test

Entity-level taxes (withholding, employment, state, etc.)Tax protection agreementsCash contributions and related distributions

If newly admitted partner contributing cash and if related cash distribution to one or more existing partners, consider application of disguised-sale rules

Acquisition of a partial interest in a business: dealing with the anti-churning rules


Step 1: partnership formation

Seller

Seller Sub

5% interest in Target

$600m assets

Buyer

LLC


Step 2: interest purchase

Seller Sub

LLC

70% interest in Target*

$420m cash

* Seller and Seller Sub own 30% combined going forward. $600m assets

Seller

Buyer


Step 2a: partnership borrowing

Seller

Seller Sub

5%

95%

Note

$400m

$600m assets

Buyer

LLCBank


Step 3a: debt-financed distribution

Seller

Seller Sub

5%

LLC Bank

95%

$400m note

$20m cash

$380m cash

$600m assets

Buyer


Step 4a: interest purchase

Seller Sub

LLC Bank$400m note

70% interest in Target*

$140m cash

$380m cash*

$20m cash*

* Seller and Seller Sub own 30% combined going forward. $600m assets

Seller

Buyer


Resulting structure

30%*

$400m note

70%

$520m cash*

$20m cash*

$600m assets* Seller and Seller Sub own

30% combined going forward.

Seller

Seller Sub

Buyer

LLC Bank

Questions?

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