Join Ellen Minnig, Tax Director at PKF Mueller, for an in-depth interview on primary considerations when determining taxability for a merger and acquisition (M&A) transaction. In this episode, Ellen provides insight on primary tax considerations, common challenges and tax consequences, and general benefits and detriments of M&A transactions.
[00:00:00] Ashley: Hi, I’m Ashley and you’re listening to the “Business Owner’s Guide Podcasts: Tips, Trends, and Talks From a CPA.” Today, we welcome Ellen Minnig from our Tax Department for a discussion on primary considerations when determining taxability for a merger and acquisition transaction.
[00:00:20] Ashley: But before we begin, let’s find out more about our guest.
[00:00:27] Ashley: Ellen Minnig is a Tax Director here at PKF Mueller. Ellen has over 20 years of tax experience in public accounting and industry work. She is also a key member of the Firm’s State and Local Tax Group.
[00:00:38] Ashley: Ellen, thank you so much for joining us today.
[00:00:40] Ellen: Nice to talk with you, Ashley.
[00:00:42] Ashley: Can you start off by telling us the first steps in determining taxability for an M&A transaction?
[00:00:47] Ellen: Sure. For a M&A transactions, the crucial factors are, what kind of entities are involved? How many entities are involved, and when I use the term entity, I mean an S-corp or a C Corp or a partnership, whether they intend to acquire another entity or whether they intend to merge, those are important considerations. Also it’s important for state and local tax to look at the seller and the buyer, whether they’re operating in more than one state in order to determine potential tax consequences and potential issues with the transaction.
[00:01:27] Ellen: Another consideration is where is the operating state, what will the new operating state be in terms of headquarters and what kind of activities will be occurring throughout the states? This is important in looking at tax ability in each state and how the company will continue to function after the transaction.
[00:01:51] Ashley: What are some other primary tax considerations?
[00:01:53] Ellen: One of the biggest considerations is how will the transaction be structured. So for instance, if you have, an S-corp selling its assets, then there will be a different tax ability scenario then if the S-corp is selling its stock.
[00:02:13] Ellen: In determining whether it’s a tax-free transaction or in looking at what due diligence and liabilities might attach to the transaction, it’s important to understand is it an asset sale or is it a stock sale or is it a hybrid of the two? Another issue is, is real estate involved because that tends to result in additional considerations and additional tax in terms of property tax.
[00:02:44] Ellen: Another consideration that’s important is once the transaction occurs, will the purchasing company control the company that sold, and this is really important because generally the internal revenue code allows for a tax-free transaction. If there is control by the purchasing company after the transaction.
[00:03:07] Ellen: So that’s an important consideration as to whether there will be gain recognized on the transaction or not. Another important consideration is just how is the transaction structured? Which companies will survive the transaction and which will basically be consumed during the transaction and restructured into other companies. That is, sometimes a very difficult, concept to look at and we often use an organizational chart before and after, or even as step transaction where, the lawyers will put together a step for each section of the transaction. So we understand which companies are selling, which companies are buying, who has control following, who owns who basically.
[00:03:58] Ellen: And that’s helpful in just getting a picture of what this transaction will do and long-term planning for these companies. Another important issue is if gain is recognized, who reports it and where do they report it? Generally the seller, if it is not a tax free transaction, they may have gain on the transaction and the consideration there is, where will they recognize that gain?
[00:04:28] Ellen: On their federal return obviously, but which state will they recognize it in while they apportionate among every state they’ve done business in or will it be in their home, our headquarters state. That’s another very important consideration that needs to be looked at before the transaction is entered into. Another issue that that often comes up is, are there international components or subsidiaries involved in the transaction, which obviously will complicate it, somewhat.
[00:05:00] Ellen: And in that light treaties and other international requirements will need to be looked at. And whether the transaction can be reported in other countries under standard accounting methods or whether, international standards will be used. So that’s an important consideration as well.
[00:05:22] Ellen: And that can also, change how gain is recognized and where it’s recognized. So, it’s important to include any international components. And, a final just general consideration that’s important for tax considerations is, are any of the companies publicly traded? Because if they are, they have additional reporting requirements and they’re under much closer scrutiny. So again, documenting all of the transaction, making sure everyone understands the consequences and making that clear as well in public reports, that need to be filed with the SEC publically traded companies is really important.
[00:06:07] Ashley: It seems there are quite a lot of considerations to keep in mind. Can you also describe some of the common challenges and tax consequences?
[00:06:13] Ellen: I’ve hopefully conveyed that it’s very important to document and show the transaction, give a visual aspect to it.
[00:06:22] Ellen: So everyone understands the consequences and that can be quite challenging, but it’s certainly possible. And the better it’s done, the more the transaction is likely to be successful. One of the issues is at the end of the transaction who continues to operate? Generally with a stock sale, the company selling may continue to operate.
[00:06:46] Ellen: And because of that, it’s important to look at how will they operate, who will file their returns, who will manage them, will their employees stay on or leave, and make sure any appropriate documents are filed with the IRS, as well as with state regulatory authorities, so that it’s very clear in the end, who will continue to operate and all the registrations are in order.
[00:07:12] Ellen: The next issue that I see a lot is employees, is will they continue to work for the entity that’s being purchased, will they work for the buyer, will they not work, will they, you know, basically be let go as part of the transaction, these considerations are really important obviously to continuing good morale, to making sure that the transaction is successful because the employees are obviously very key to companies. So that is a very important challenge to consider prior to the transaction.
[00:07:49] Ellen: Another issue that kind of goes hand in hand with that is what kind of future operating agreements will the entity that continues to exist have, and in those agreements, a lot of these issues can be ironed out.
[00:08:05] Ellen: So, there are general purchase and sale agreements that all have to be drafted, just for the transaction itself, but the continuing existence of whichever entities we’ll continue to do business. They need operating agreements too, and they need to make sure they cover some of the issues we’ve been talking about.
[00:08:26] Ellen: So I think that’s another, very important challenge and important area to cover in planning a transaction and executing it. Another issue will be, how is the management of the new company structured? And this goes along with the two considerations, I just mentioned which employees will continue, what will their duties be, how will they be integrated into the company, who will be in charge, who will handle various aspects of operations. And so that again, can be addressed in operating agreements, and that can be very helpful.
[00:09:03] Ellen: Another issue that comes up and is important to consider is mainly for the purchaser, are there a lot of costs associated with the transaction? Who’s responsible for the costs, for instance, due diligence, to make sure that companies don’t have significant liabilities, their reporting is consistent and correct, and those kinds of issues are really important as far as how much is it going to cost to document these transactions?
[00:09:34] Ellen: So the transactional costs, which include attorneys and registration fees and accounting, and a variety of costs, they can be beneficial, to the company paying the bulk of them, which is often the purchaser. And if those costs are structured correctly, they can be deducted in the first, either the first year of operations as a new company or over an amortizable period such as 10 years.
[00:10:03] Ellen: And if that’s true, that’s a huge benefit often to the purchaser in reducing tax in the future. So it’s important to consider what those costs are and how can we classify them and, and maximize deductibility to minimize tax. That’s very important because if they are capital costs, they tend to be absorbed into the stock and are not deductible. So that that’s a big issue, that it’s a great area to help the parties minimize their tax consequences.
[00:10:37] Ellen: Hand in hand with that, due diligence is required to look at what are potential liabilities, with an asset sale there tends to be much more significant liabilities and that’s because the assets carry with them liabilities and those are transferred to the buyer.
[00:10:56] Ellen: So in that case, if they do have, for instance, sales, tax liability for equipment purchase, for instance, that sales tax liability will basically be the buyer’s liability at the end of the transaction. So it’s very important to make sure that the seller has properly paid their taxes, registered assets, taken care of important costs associated with assets, and that loans are also addressed on those assets.
[00:11:29] Ellen: So that at the end of the transaction, the buyer doesn’t have significant liabilities that it, must deal with and could even make the transaction, something that you, don’t want to enter into. That’s a huge consideration and that’s often fairly expensive, and again, the buyer tends to absorb that cost.
[00:11:48] Ellen: So it’s important to make sure you have a great firm that’s going to take care of that due diligence and then another consideration is, just who will file the tax returns. And it’s a, smaller consideration, but it’s important to tax departments. That’s written up well in the agreement and it’s clear so that, all the, all the parties know who will be filing returns, what periods will be involved, will there be short period returns? When are those returns due? and you have to remember that it’ll be a federal return and potentially multiple state returns as well. So it sounds a bit more administrative, but that’s a very, important documentation consideration so that everybody’s clear on future tax filings and things get done on time and amounts that are due get paid on time.
[00:12:41] Ellen: And another consideration along with that is, if there are refunds due, who’s entitled to the refunds. So I’ve seen where that isn’t addressed clearly and, can cause some bickering. So it’s important to just document that upfront and then it doesn’t become a problem.
[00:12:59] Ashley: What are some general benefits and detriments of M&A transactions?
[00:13:02] Ellen: So we’d been talking about this throughout. But, one of the initial, issues is you need to be clear on how the transaction is structured, which companies will survive, which will not, how their management structure will be, basically integrated so that, generally the best approach is to have a centralized management following the transaction.
[00:13:27] Ellen: So how will that be achieved? And that can require quite a bit of forethought and, even documentation and operating agreements and planning so that employees and management are clear on their roles, following the transaction, and even down to, who’s going to prepare the tax returns at this new entity.
[00:13:48] Ellen: Those are the, those are some hurdles, especially integrating employees that may not have wanted to be part of this transaction. In other words, if the takeover is hostile or if, if the employees, if the firm has been operating for a long time independently, sometimes employees and management aren’t as happy to, you know, join the new entity, but that can be smoothed over in a variety of ways.
[00:14:17] Ellen: And it’s important to make sure and consider any acquired companies, how they will be integrated and just give that enough forethought that the the employees and management feel like their considerations have been addressed, and that can make a huge difference, in how successful the new entity is.
[00:14:37] Ellen: And then some obvious advantages are, we’ve talked about some tax savings. Hopefully, the combination, the merger or acquisition will result in a more efficient company, depending on what they do. And it will result in an increased competitive position in the marketplace, with increased revenues.
[00:14:59] Ellen: So, really M&A can be a great thing for companies to get involved with for all these reasons.
[00:15:06] Ashley: So Ellen, my last question for you is, is there a case study worth noting?
[00:15:11] Ellen: Yes, there is. There’s an Illinois case that I’d like to highlight. Just some of the benefits of making sure, that any client considers the effect of what they’re selling.
[00:15:23] Ellen: If they’re, if they’re engaged in a business sale and how they’re selling it. And the reason is because tax savings can be achieved if the sale is structured in the proper way. And in this case, the name of the case is, Texaco-Cities, it’s an Illinois case and it’s a pipeline case, and it’s basically dealing with only a subsidiary of Texaco.
[00:15:48] Ellen: So this particular subsidiary in the 1980s, ran pipelines in the Chicago area. And these ran two refineries in east Chicago and this particular activity, was crucial to the business. As time progressed, they became less needed and other types of energy were used to transport, and fuel refineries. So these pipelines became inactive. 90% of Texaco-Cities pipelines became completely inactive in Illinois and the surrounding states. The refineries were not operating and the pipelines weren’t needed. So the, the question here was this particular subsidiary sold 90% of its assets, which were these pipelines and at a gain of about $10 million in the eighties. So quite a bit.
[00:16:47] Ellen: And when they sold these pipelines, Illinois tried to tax the gain from the pipelines as business income, rather than non-business income. And it sounds odd to say that a business would ever have non-business income, but states define this as a type of income that is not in the ordinary course of business.
[00:17:09] Ellen: In other words, under a couple of tests, they use the main test being transactional, which looks at when we sell these pipelines, is this part of our normal course of businesses. Is this unusual? Is this infrequent, has this ever happened before? It looks at more, how businesses operate and timing.
[00:17:31] Ellen: And then the other test, which is the one that became more crucial in this case is, was the property selling assets that are essential to the business. So functionally is the gain from this essential to the business operations. And basically the important thing here and it’s a bit complex in terms of the business and non-business income allocations by state, but Texaco, because it was a pipeline company had to allocate its business income by a barrel of miles formula, which was a federal, you know, congressional, enacted formula.
[00:18:07] Ellen: And because of that barrel miles formula, their business income was tax by state, depending on the number of barrels generated by state. So when they use this particular formula, because of the state’s Texaco was operating, this subsidiary of Texaco was operating in, they found that each state the tax was higher overall than if the, gain had been taxed in just one state, for instance, Illinois, which was the domicile for Texaco-Cities.
[00:18:37] Ellen: So if they used a non-business income, if that was an appropriate approach for the scheme, then they could save nearly a half, a million dollars by, basically allocating this gain on their tax return as non-business income, as unusual infrequent and income not resolving from their regular operations.
[00:18:59] Ellen: So that’s what Texaco-Cities did and they felt they had a valid reason for that. And so this went to the Illinois Supreme court. The department of revenue tried to reclassify that income and charge them an additional half a million dollars in the eighties. And the court found in favor of Texaco-Cities, that the income was non-business income, that it was because of the sale of 90%. And, and the eventual wind down of this particular subsidiary of Texaco, they found that this was not the normal course of business. This was an unusual sale and it was basically not a sale that was part of its normal business operations, but it was a sale of its business. So in that case, that is an unusual occurrence. It’s not an operating, it’s not gain related to operations. So in other words, in Texaco-Cities favor this, this allocation between non-business and business income, was very important as far as the tax rates.
[00:20:00] Ellen: And this has to be thought of, you know, prior to drafting agreements, that kind of thing. So it needs to be analyzed. Beforehand, not after the transaction’s finished or after the initial tax returns are filed. So it’s an important area. It’s, it’s, uh, a little bit technical, but it is very important as to saving money, which in this case was substantial.
[00:20:25] Ellen: So that’s why I brought up this case. It it’s one more part of the planning behind mergers and acquisitions. Because so many companies react rather than plan.
[00:20:36] Ashley: Well, I think this was a really great overview and thank you for your time today to explain primary considerations when determining taxability of a merger and acquisition transaction. If any of our listeners have any questions or would like to learn more, would you please share how they might be able to reach you?
[00:20:51] Ellen: Sure they can reach me via email at firstname.lastname@example.org. They can also reach me at (312) 975-1646. I’m happy to help. And, we have a great department that handles due diligence and, and we can do a great job for this if we can help.
[00:21:13] Ashley: And thank you to our listeners. Don’t forget to visit us at pkfmueller.com to learn more about our Firm’s services. You can also follow us on social media for updates, insights, and upcoming events.