The Installment Method in M&A

Deferred payment sales are typically subject to the installment method unless the taxpayer affirmatively elects out.  There are three traps that one can fall into with the installment method.

1. With certain types of sellers like S corporations, a tax free distribution can be made to the extent of basis in the pre-transaction planning stage.  This allows cash to come out of the company which increases the profit percentage when the company is sold in the future.  Hence, the lawyer should always think about taking pre-transaction distributions to the extent of basis before entering into this type of transaction.

2.  If the taxpayer holds installment obligations at the end of a tax year of more than five million dollars, he must pay an interest charge on a portion of the tax liability that is deferred for the year. This rule applies for each selling shareholder, so a selling shareholder is sometimes advised to gift shares to a spouse to reduce the amount of installment obligations each would own. Often, a taxpayer might elect out of installment treatment and recognize as income the value of the installment obligation rather than taking the interest charge. This approach however requires recognition of income on amounts that might not be collected, in which case the taxpayer may end up with a (non-deductible) capital loss on the back end.

3. The third trap when dealing with the installment method has to do with basis allocation. As noted above, the first step is to determine the gross profit percentage and the portion of each payment that is taxable and the portion that is basis recovery.  In the case of an earn-out or contingent payment, however, it is uncertain whether the client will collect on those amounts so the determination of a gross profit percentage relies on certain assumptions.  First, the regulations require a taxpayer to assume that the maximum amount possible will be paid (i.e. all of the earn-out targets will be achieved) in determining the gross profit percentage.  If there is no maximum amount, the regulations assume there is a basis recovery over the maximum term of the earn-out.  If there is neither a maximum amount nor maximum term, the regulations assume that the basis will be recovered ratably over 15 years, and the payments in excess of ratable basis recovery are taxed as income.

Intuitively, it would seem that the taxpayer should recover his basis first and then pick up income when and to the extent that the payments exceed basis.  This is referred to as “open transaction treatment” and applies only in rare and extraordinary circumstances. If circumstances justify open transaction treatment, the parties might have a partnership for tax purposes instead of a sale.  If it is a partnership, a different tax regime applies.

The seller should also keep in mind that there is always an interest element when there is a deferred payment.  In other words, part of the payments will be taxed as ordinary income. Fortunately, the applicable federal rate is currently very low.

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A slides at SlideShare.


M&A involving Foreign Corporations

Being on the west coast, much of my work has an international component. Foreign and international tax transactions can be particularly complex. There are many “gotchas” that make these transactions difficult to manage. Non-tax lawyers often deal with foreign tax-sensitive transactions but sometimes the client would be much better served if a tax lawyer is contacted and gets involved in the deal. Here is a snap shot of some of the caveats that make international tax transactions difficult to manage.

Outbound transactions (foreign acquirer and domestic target). In an outbound transaction, a foreign acquirer is engages with a domestic target. This can be done on a tax deferred or tax free basis if there is compliance with numerous requirements. Generally, the acquirer must have been engaged in an active trade or business for at least 36 months and it must be larger than the target so that less than 50% of the acquiror stock is changing hands.

The company’s accountant plays a vital role in these deals and should be heavily involved. Many reporting requirements must be complied with because the failure to comply could result in turning a non-taxable transaction into a taxable one.

Inbound transactions. In a 367(b) inbound transaction, a domestic acquirer acquires a foreign target. Generally, this can be done on a tax-free basis. Nevertheless, it is important to be cautious when the target is a “controlled foreign corporation” (CFC). A transfer of stock of a CFC may trigger an income inclusion (the “1248 Amount”) when the foreign corporation is more than 50% owned by US persons. Section 1248 re-characterizes stock gains as ordinary to the extent of the earnings that are attributable to the US shareholders.

Classic inversion. Years ago, there was a lot of press about U.S. companies exporting jobs, inverting, going offshore and forming Bermuda holding companies and not paying taxes ever again. Whole industries seem to have simply got up and left California for tax reasons via the inversion. An example of a classic inversion is as follows: A US semiconductor company forms a foreign company (maybe in the Cayman Islands). Then the foreign company acquires the US company in a stock for stock exchange. When the deal is done, shareholders of the U.S. company own shares of a Cayman company which owns the U.S. target. Under old law, that inversion would have been taxable because, among other things, the Cayman acquiror had no 36-month active trade or business. The company or its shareholders might have paid a tax on that transaction (based on value, which may have been depressed at the close of the transaction) or possibly no tax being paid because the company was able to offset the gains with its net operating losses (NOLs).

Now, there are a whole set of anti-inversion rules to prevent this transaction. Eventually, Congress caught on and passed new laws to govern outbound stock deals. Now, if the shareholders of the U.S. target own more than 80% of the foreign acquirer, the foreign acquirer is treated as if it were a U.S. corporation. Consequently, it does the company no good to do a tax motivated migration.

If ownership continuity is between 60% to 80% meaning that the shareholders of the U.S. target own more than 60% of the foreign company but less than 80%, the foreign company will not be treated as a U.S. company but the company will not be able to use its NOLs to offset the gain on the transaction. Also, if there is a stock based compensation in an inversion, the IRS will impose an excise tax. These rules have pretty much shut down the whole strategy although there are still ways to accomplish those goals.

When a company is sold, section 1248 taxes the sellers as though the earnings were distributed as a dividend. Section 1248 is important to consider when drafting the acquisition agreements because the 1248 inclusion amount is determined at the end of the year and allocated day by day among the year. Thus, post close events can impact the seller’s tax consequences.

Next, foreign joint ventures…

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A slides at SlideShare.


An inbound “flip” transaction (“flip”)morphs a foreign entity (usually a startup) into a US entity, typically to receive US angel or venture capital funding.  Consider the most common scenario:

Forco, a foreign startup, has filled a market need and has accelerating year-over-year growth. Without proper funding, Forco remains highly vulnerable to emerging, funded competitors.  Forco has identified Investor, a US-based angel investor or venture capital firm interested in investing.  However, Investor has expressed discomfort with Forco’s foreign entity structure and foreign governing law.  As a condition to funding, Investor requires Forco to reincorporate in the US.

A willingness to flip opens the world’s top venture capital market to foreign startups.  The Global Venture Capital and Private Equity Country Attractiveness Index ranks the US as #1 in venture capital overall[1] and in five distinct categories:  size of the economy ($15.1 trillion GDP in 2011),[2] size of the stock market ($15.6 trillion stock market cap in 2011),[3] stock market liquidity ($4.7 billion daily trading volume on October 11, 2012),[4] IPO market activity (71 IPOs in the first half of 2012),[5] and mergers and acquisitions (“M&A”) market activity (3,159 M&A deals in the first half of 2012).[6]  Of the $48.7 billion in global venture capital in 2011, the US venture capital market comprised 67%.

Foreign startups should generally not flip before securing US investors:  first, the flip eventually subjects the worldwide operation to US tax because the new US parent is taxed on its worldwide income.  Second, as with Forco and US investors in the scenario above, a US parent would prevent some foreign VCs from investing in the operation.

Once US investment is secured, legal counsel flips the foreign startup.  In a flip, Forco’s shareholders create a new US entity (“Domco”), and exchange their Forco stock for Domco stock.  After the exchange, the shareholders will own Domco, and Domco will own Forco.  Investor invests into Domco.

[Insert Fig. 1 – Flip Transaction, with caption “Fig. 1:  Flip Transaction”]

[Insert Fig. 2 – Post Flip, with caption “Fig. 2:  Post-Flip Transaction”]

In conjunction with a flip, foreign startups should consider a physical relocation to Silicon Valley.  The Silicon Valley venture capital market is the most vibrant in the world, comprising 41% of the US’s venture capital.[7]  Silicon Valley offers exposure to flagship startups and a uniquely experienced and innovative workforce, as well as to Silicon Valley acquirors and customers.

Royse Law Firm, a tax, business and corporate law firm headquartered in Palo Alto, California, regularly connects startups with compatible investors in the stages prior to the flip.  Royse Law Firm has been performing flip transactions since 2006, and the transaction is typically executed tax-free within about 3–4 weeks.  See our Recent Transactions for prior representations.

[1] Alexander Groh, Heinrich Liechtenstein and Karsten Lieser, The Global Venture Capital and Private Equity Country Attractiveness Index 2012, (last visited Oct. 11, 2012).

[2] International Monetary Fund, World Economic Outlook Database, (last visited Oct. 11, 2012).

[3] The World Bank, Market Capitalization of Listed Companies, (last visited Oct. 11, 2012).

[4] WSJ, Market Data Center, (last visited Oct. 11, 2012).

[5] PriceWaterhouseCoopers, After Strong Start to 2012, IPO Market Sees Pullback, PwC Says, (last visited Oct. 11, 2012).

[6] MarketWatch, Ernst & Young:  U.S. M&A Activity Falling, (last visited Oct. 11, 2012).

[7] Ernst & Young, Globalizing Venture Capital:  Global Venture and Insights and Trends Report, (last visited Oct. 11, 2012).

Tax Aspects of Mergers and Acquistions: Types of Acquisitions

In our last post, I described some general issues relating to tax free reorganizations. This posts decsribes the types of tax free mergers and reorganizations and the requirements for each, especially as I see them in my law practice in Silicon Valley, San Francisco, Los Angeles and Palo Alto Califoirnia.

Type A-Statutory Merger.  Mergers require compliance with a state merger statute.  For this reason, they are often referred to as “statutory mergers.”  The typical merger occurs when two companies combine but only one survives.  Domestic companies can now merge under Code Section 368 with foreign companies, subject to certain requirements described below.

There is no “substantially all” requirement in a merger.   A “substantially all” requirement would have prevented the target from making distributions prior to the merger.  There is also no “voting stock” requirement in a merger, which means that an acquirer can exchange non-voting stock for target company stock in a tax-free merger, in addition to cash and other property subject to continuity requirements.

There must be a business purpose for the reorganization; a tax motivation alone will not suffice. As a practical matter, the business purpose requirement has not been much of a hurdle.  However, the “economic substance” doctrine (which has been codified into law) may subsume this requirement entirely. See below.

Plan of Reorganization. The acquirer must have a written plan of reorganization which should describe the transaction. This is the one requirement that should always be met.

COBE. The acquirer should intend to continue the acquired business after the transaction. Under the regulations, this means that the transferee must either continue the target’s historic business or use a substantial portion of the target’s assets in a business.

No Net Value. The relatively recent recession has spawned a newer requirement in the areas of tax-free reorganizations. The “no net value” rule requires an exchange of net value.  Specifically, the deal must have equity, in other words, no net value would be exchanged at the owner level if debt exceeds the value of assets.  Such a transaction would simply be a sale in exchange for debt, and would no longer be tax free (but see below).

Type B-Stock for Stock.  Despite appearing to be the easiest type of reorganization, a Type B reorganization is rarely the right approach.  The problem with a Type B is that no boot is allowed.  Theoretically, if there is even one dollar of non-stock consideration, the transaction is treated as a taxable sale.  Although Type B reorganizations are not done very often, it is sometimes a way of converting a non-taxable sale to a taxable one, which could be desirable depending on the parties’ preferences.

Type C-Stock For Assets. In a Type C reorganization, the acquirer transfers stock and cash to the target in exchange for substantially all of its assets and then the target liquidates.  A Type C reorganization may be preferred to a Type A reorganization for two reasons.  First, an acquirer might not want all of the assets of the target.  A Type C reorganization allows the acquirer to be selective when purchasing the target’s assets while allowing the seller to obtain tax-free treatment.

The other instance when a Type C reorganization might be preferable to a Type A is when there are regulatory issues that would prohibit a statutory merger.  This situation is rare but can occur in regulated industries such as banking.

A Type C reorganization implicates other issues that lawyers should be aware of.  A type C reorganization is relatively restrictive since there has to be a transfer of at least 90% of the fair market value of the target’s net assets, and 70% of the target’s gross assets. An odd “hair trigger” boot relaxation rule provides that liabilities are not included in this net asset determination unless there is cash or other property passing from acquirer to the target, in which case it is all considered.

Type D Divisive Reorganizations. A divisive Type D Reorganization typically involves the transfer of assets to a corporation, the stock of which is then distributed to shareholders of the distributing company. A “spin off” is like a non-taxable dividend in that the stock of the transferee is distributed to shareholders pro rata. A “split off” is like a non-taxable redemption in that the transferee is distributed in exchange for some of the shareholders’ stock in the distributing company. Finally, a “split up” is similar to a non-taxable liquidation in that the distributing company’s businesses are dropped into companies that are distributed in complete liquidation of the distributing company.

Type D Non-Divisive Reorganizations. An acquisitive Type D Reorganization occurs when the shareholders of the transferor own 50% or more of the acquirer.  Typically, an acquisitive D occurs when a corporation transfers assets to a controlled or related corporation in exchange for stock. The transaction might otherwise be a Type C reorganization except for the 90%/70% rule.  However, 50% common ownership of the transferor and acquirer would allow this reorganization to be a Type D Reorganization.

Liquidation/Reincorporation Doctrine. Closely related to the concept of a forced Type D Acquisitive Reorganization is the judicially created concept of ignoring a liquidation that is followed by an incorporation. A company’s shareholders might want to engage in such a scheme in order to trigger losses built into their stock while maintaining the benefit of the corporate form. Under step transaction principles however, if the liquidation followed by a reincorporation were collapsed into one transaction, the transaction would be recharacterized either as a non-event (i.e. the result is the same as the starting point) or a Type D Reorganization. The success of the plan basically depends on there being no plan, and it is thus a risky strategy.

Triangular Mergers. Triangular or subsidiary mergers allow an acquirer to acquire a company in a tax-free reorganization without leaving liabilities at the subsidiary level, similar to a stock purchase in the taxable context. In a triangular merger, the acquirer will acquire the target in exchange for acquirer stock by merging it with or into a subsidiary, usually formed just for that purpose. When the smoke clears, the acquirer will own the stock of the subsidiary, which in turn will own the business of the target.

Forward and Reverse Triangular Mergers. In a forward subsidiary merger, the target merges with and into the merger subsidiary. The subsidiary survives and the separate existence of the target ceases. A good forward triangular merger requires the same five factors that are normally required for a merger – continuity of proprietary interest, continuity of business enterprise, business purpose, net value, etc.

In a reverse merger, the target survives and the separate existence of the merger subsidiary ceases. In both cases, the merger consideration is stock of the parent/acquirer (if it were stock of the merger subsidiary, it would simply be a merger, not a triangular merger).

In a reverse merger, the assets and business of the target stay with the target, and only ownership changes. In a forward merger, the business of the target is inherited by the subsidiary by operation of law. Sometimes that transfer by operation of law triggers anti-assignment clauses in contracts that would not be triggered by a reverse merger. In addition, the merger subsidiary will obtain a separate taxpayer identification number, requiring a new payroll. For those and other non-tax reasons, targets and sellers of targets typically prefer a reverse merger to a forward merger.

Often times in a reverse triangular merger, companies will have shareholder debt.  This occurs when shareholders loan money to the company but do not document the loans, do not charge interest, etc. This debt sometimes does not get repaid and sometimes is instead converted into stock of the borrower.  The tax risk is that debt would be treated by the IRS as a class of non-redeemable preferred stock.  If that’s true, and that “deemed stock” is not exchanged for stock or securities of the acquirer, the transaction will fail to qualify as a reverse triangular merger because 80% of ALL classes of stock will not have been acquired for stock or securities.

The tax consequences and risks set the stage for an odd dynamic when considering whether to do a deal as a reverse or a forward merger. The continuity requirements of a reverse merger are more stringent, as discussed below, requiring that 80% of all classes of stock of the target be acquired for stock or securities of the acquirer. A forward triangular merger, however, is only subject to the general continuity requirement, so that an acquisition of 50% of the target stock for stock or securities of the acquirer would suffice, and it is not necessary that 50% of every class of stock of the target be acquired for acquirer stock or securities. Thus, it would seem that a forward merger is the safer bet, since it is easier to comply with the requirements.

The consequences of failing to qualify as a merger reverse the tax incentives. A “busted” forward merger is treated as an asset sale followed by a liquidation, which results in two levels of tax – one on the deemed sale of the target’s assets and again on the deemed sale of the target’s stock in liquidation. A busted reverse merger, however, is treated as a stock sale with only one level of tax at the shareholder level.

Thus, the seller has a Sophie’s choice – either take a heightened risk that the transaction will fail the tax-free reorganization provisions but with a potential of one level of tax (as a reverse merger), or take a lower risk of failure with a higher potential penalty (two levels of tax) as a forward merger.

This is a tough choice, since valuation issues can make the tax-free conclusion less than doubt-free. In addition, there may be concerns over what will be considered a class of stock for this purpose, so a reverse merger is rarely risk free.

Next post – a solution to this problem.

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A slides at SlideShare.

Tax Free Mergers and Reorganizations in California: Continuity of Interest

Tax Free Mergers and Reorganizations in California: Continuity of Interest.

Tax Free Mergers and Reorganizations in California: Continuity of Interest

As noted in an earlier post, some types of acquisitions can be tax free or tax deferred to the sellers. In order to determine whether the tax-free reorganization provisions are available, the type of currency being given to the sellers in exchange for their stock or assets must meet certain requirements. The “currency” could be in the form of buyer stock, cash, compensation, debt or contingent and deferred payments.  Of that currency, some portion must be in the form of buyer equity. The amount of equity in the deal will drive the rest of the analysis.

A seller must retain a sufficient equity stake in the acquirer in order for a transaction to be treated as a tax-free reorganization. That “stake” is commonly referred to as the “continuity of interest” requirement and according to the IRS, there should be at least 50% continuity to meet the IRS safe harbor.  By “at least 50% continuity,” we mean that at least 50 % of the value of the consideration to be received by the seller will be equity of the buyer.  Fifty percent is considered safe. Case law goes as low as 25% but most tax lawyers will not accept such a low amount as sufficient continuity for the transaction to be tax-free. 

Traditionally, the IRS will rule on a transaction if there is at least 50% continuity (e.g. 50% of the consideration is Buyer stock). Escrowed shares tend to count for continuity purposes and relatively recent developments in the law are more tax friendly towards transactions with less than 50% equity.  Under current law, buyer stock is valued the day immediately before the signing of the definitive acquisition agreement.  Fluctuations in value between the day of signing and the day of closing are less of a concern.   Additionally, if there is other property that has a specified value (e.g. $100,000 worth of stock), that specified value will be used. 

The percentage of equity in a tax-free merger is important because the shareholders in a tax-free merger realize gain only to the extent of boot.  “Boot” includes non-stock property and securities.  Selling shareholders will not recognize taxable gain or pay tax on the value of stock received in a transaction.  They will take a low “exchange” basis in the buyer stock received in the merger and recognize a gain when they eventually sell the buyer stock, but they will not recognize that gain at the time of the merger. 

In our next post, I will discuss the different types of tax free reorganizations.

For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A slides at SlideShare.