The world as we know it, both socially and economically, has been turned on its head these last few months and likely into the future. The same holds true for the M&A marketplace. For most of the past decade, the merger and acquisition market has been bullish for much of the country, and sellers often had the upper hand when negotiating deals. This may no longer be the case moving forward. With a distressed and depressed marketplace, consolidation of certain industries may take place and buyers with cash capacity may move into a stronger negotiating position. This article focuses on three key considerations in the current M&A marketplace and the tax implications associated with them.
With most mergers and acquisitions, the structuring of debt is important. During times of market distress, debt modifications can become more important from a cash flow and headroom capacity perspective. The tax impacts of debt modification should be considered as well. Debt modification may generate unintended taxable income that could partially negate the sought-after cash flow capacity discussed above. In addition, net operating losses can now be carried back five years. This unintended taxable income from debt modification could reduce the potential benefit of the net operating loss carryback.
Contingent Consideration/Earnout Provisions
With the distressed marketplace and buyers perhaps in a stronger negotiating position, contingent consideration and earnout provisions could become more prevalent. These provisions could be buyer- friendly during a down market and put more economic pressure on sellers. Larger portions of deals could be paid out over time and less paid upfront.
There are tax implications to both the buyer and seller when contingent consideration and earnout provisions exist. Even though the seller will not receive cash as quickly, they can potentially defer recognition of gain until cash is received. Buyers generally don’t receive a tax basis and a corresponding tax deduction in what they acquired until consideration is exchanged, thus deferring the tax deduction.
CARES Act Interplay
With the passage of the CARES Act, companies can now carryback net operating losses to the previous five years, and restrictions on the interest expense limitations under IRC Section 163j have loosened. Both create opportunities for companies to recognize cash tax benefits in the near term. Parties involved in a transaction that may have net operating losses should consider ways to maximize these losses. Often times, equity incentive compensation plays an important role in a transaction. Terms within these equity incentive agreements often have change of control provisions upon which immediate vesting or exercise of the equity awards takes place. This event can result in significant tax deductions to the company paying the equity incentive compensation and can increase the amount of net operating loss available.
For deals that have already been signed and are moving towards closing, these tax benefits should be quantified, and a determination should be made as to whether the buyer or seller is entitled to them. For deals that have not been signed, these tax benefits should also be quantified, and negotiations should take place between buyer and seller to determine who is entitled to them.
Bonadio is Here to Help.
Like most aspects of our lives, the merger and acquisition marketplace has changed dramatically, both in the present and likely into the future. There is still the opportunity for transactions to take place and the negotiated terms and associated tax implications of these transactions need to be considered closely. Bonadio will continue to provide guidance and be here to assist in these uncertain and rapidly changing times.
Feel free to contact Nathan Pensgen with any questions.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.