DOCSLIB.ORG

A Cliff Effect: the New Landscape for Taxable Asset Transactions

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
A Cliff Effect: the New Landscape for Taxable Asset Transactions A cliff effect: The new landscape for taxable asset transactions New tax act shifts economics of certain transaction structures The Tax Cuts and Jobs Act (the Act)1 signed into law last Taxable sale of stock vs. taxable sale of assets December immediately ushered in a wave of unknowns. It’s In general, an acquisition of a trade or business can take only clear, however, that there is a new landscape for negotiating two possible forms, a purchase of equity or a purchase of and structuring taxable acquisitions. Most significantly, the assets. Although certain provisions in the tax law provide for Act reduced the corporate tax rate to 21% for taxable years gain deferral either in whole or in part, a basic tenet of U.S. beginning after Dec. 31, 2017, down from the highest pre-Act federal income tax law provides that gain or loss is recognized rate of 35%. when property is exchanged in a transaction. In such instances, buyers and sellers engaged in taxable transactions face the Although the Act is arguably a boon to corporations overall, fundamental decision of whether to structure the transaction it presents new, nuanced issues when structuring taxable as the sale of equity or the sale of assets. This age-old tension asset acquisitions. Other modifications to the code,2 when between buyers and sellers is an important negotiating point in coupled with the rate changes, may cause ripple effects that many transactions. Sellers are primarily concerned with reducing fundamentally shift the economics of certain transaction their taxes upon sale, while buyers seek higher deductible, structures. One such modification — and a central topic of depreciable and/or amortizable tax basis to shield the future discussion in this article — is the expanded definition of what is taxable income (referred to herein as the tax shield) of the excluded from capital asset treatment under Section 1221(a)(3) acquired business.3 of the code. This expanded language increases the likelihood As mentioned, the seller’s predominant concern is to pay the that intellectual property held by a business will be taxed at least amount of tax possible upon the sale of the business. If the higher ordinary rates upon a sale or exchange. buyer proposes a taxable asset sale, and that structure results in a greater tax liability to the sellers (which is often the case), The changes imposed by the Act create an environment in which the sellers will demand that the buyer make them whole for buyers and sellers now face a slim margin for error, as their that additional tax liability in the form of additional purchase competing interests are now likely to diverge even further than consideration (referred to herein as the gross-up payment). was previously the case. For buyers, there are new opportunities to enhance economic returns; for sellers, there are heightened risks. This article explores how tax and valuation advice from professionals is essential when navigating this new terrain. 1. P.L. 115-97. 2. All references to the “code” or a “section” are references to the Internal Revenue Code of 1986, as amended, and a section thereof, respectively. 3. This decision can have far-reaching implications to the buyer for years to come because, under Section 1012, the buyer should obtain a cost basis in the assets acquired in the transaction, generally equal to the respective asset’s fair market value. If the buyer acquires the stock of the corporation, the buyer generally will not be able to recover this basis until and unless that stock is disposed of in the future by the buyer (because stock is neither a depreciable nor an amortizable asset). On the other hand, if a buyer acquires the business assets held by the target corporation, and those assets are either depreciable or amortizable under tax law, the basis (to the extent gain has been recognized) may provide incremental depreciation or amortization deductions to the buyer, reducing the buyer’s taxable income in post-close periods. If the target business is held by a C corporation, an asset sale is The value creation and value erosion of a taxable often not desirable due to the inherent double taxation imposed asset sale under the tax regime of Subchapter C. Various provisions of In general, a taxable purchase of business assets will produce Subchapter C ensure that tax is levied first at the C corporation some amount of a tax shield that may be used to offset the future level upon the sale of the business assets, and a second layer taxable income of the buyer. To induce the seller to structure the of tax is levied on the shareholders upon the distribution of the transaction as a taxable asset sale, sometimes the buyer must proceeds (through corporate liquidation or otherwise). However, make the seller whole for the incremental tax liability that the an asset sale may be feasible if the target C corporation has seller incurs. In effect, the buyer (through its gross-up payment) sufficient tax attributes (e.g., net operating losses) to offset the is paying an incremental tax today to receive an incremental effects of double taxation. benefit in future periods. Any astute financier might immediately question this seemingly counterintuitive strategy; however, value A scenario perhaps more common than the taxable sale of can indeed be created, a “win-win” situation, by entering into assets by a C corporation occurs when the target is an S a taxable asset sale, provided there is substantial forethought corporation and the acquisition is a “qualified” stock purchase given to the purchase price allocations. under Section 338(d)(3). In this scenario, the buyer and seller can make a joint election under Section 338(h)(10) to treat the A key factor to the value creation lies in the arbitrage between taxable purchase of the stock as a deemed taxable purchase the buyer and seller rates. This is no more apparent than when of the assets for federal income tax purposes.4 Due to the flow- dealing with an individual seller and a C corporation buyer. The through nature of the S corporation, and by operation of certain individual capital gains rate is the rate at which the seller (an rules that adjust the basis of the shareholder’s stock, the general individual) will pay tax upon the sale of his capital assets, and effect is that the gain is taxed only once (rather than twice, as the corporate rate is the rate at which the tax shield will offset under Subchapter C).5 the future taxable income of the buyer (a C corporation). Prior to the Act, the highest individual capital gains rate and the When a taxable transaction is structured as either the actual highest corporate rate were 20% and 35%, respectively. The sale of assets or the deemed sale of assets, the magnitude highest individual ordinary rate — generally, the rate at which of the requisite gross-up payment — which can result from the individual seller would pay tax on the sale of his ordinary tax character differences (ordinary versus capital) — could assets — was 39.6%. completely negate the benefit of the tax shield. This article discusses some new (and some old) tax considerations a buyer should take into account when purchasing assets, along with the allocations of value assigned to the various asset classes. The Act generally impacts the allocation between capital and ordinary income due to changes to the definition of what is not a capital asset under Section 1221. Finally, this article addresses certain valuation concepts and subjective valuation methodologies that are used to allocate the purchase price to the various asset classes when a transaction is structured as the taxable sale and purchase of a business’s assets. 4. Treas. Reg. § 1.338(h)(10)-1(d)(5)(i). 5. In general, the gain upon sale of the target S corporation’s assets will be recognized by the target S corporation’s shareholders (i.e., it will flow through to the shareholders) under section 1366, and their bases in the stock of the S corporation will increase under section 1367 by a commensurate amount of the gain recognized. However, under section 1374, property that was transferred from a C corporation to the S corporation, and the S corporation’s basis in the asset is determined (in whole or in part) by reference to the basis in the hands of the C corporation, will be taxed at the corporate level if gain is recognized on the sale or exchange of the property within the recognition period (currently 5 years from the time of the S corporation election). 2 A cliff effect: The new landscape for taxable asset transactions By comparing these three rates, it’s readily apparent that the often annual, income production that results from the sale of value creation of a taxable asset sale with a gross-up payment assets in the ordinary course of a person’s trade or business. can quickly dissipate as more of the gain upon sale of the The one-time, sporadic income from the sale of a capital asset corporation’s assets is taxed at the higher, individual ordinary is typically the result of years of accumulated appreciation in rate. To illustrate, consider a basic example in which the pre- the asset’s value. Prior to 1921, the recognition of this lump sum Act tax rates are applied to an individual seller that is selling a windfall in a single year could have unduly subjected a person cash-free, debt-free business worth $100; the seller’s basis in his to a higher rate bracket, resulting in an increased tax liability, S corporation stock is zero, and all the assets inside the business had the appreciated value been recognized as income over are ordinary in character and have been fully depreciated the capital asset’s holding period.
Load more

Recommended publications
  • Fund Accounting Training: Glossary
    GLOSSARY Advance A type of internal borrowing (temporary or long term) between fund groups for which a due to/from must be set up. Agency funds Resources held by the institution as custodian or agent for students, faculty or staff, and organizations. No institutional equity in these funds. AICPA American Institute of Certified Public Accountants Annuity funds Funds established through a deferred giving contract. Payments to beneficiaries include both interest and a portion of principal. Upon the beneficiaries’ death, the funds revert to the agency. Auxiliary enterprise An entity that exists to furnish a service to students, faculty, or staff and charges a fee directly related to although not necessarily equal to the cost of the service; managed as essentially self‐supporting. Balance Sheet Financial statement reflecting self‐balancing classification of each fund group, including assets, liabilities, and fund balances. Board of Regents A group of persons, appointed by the Governor, whose powers are described in the charter or some legislative act that establishes the legal identity of the institution. Also, the governing board. Bond covenant Agreement between bondholders and the issuer, representing the board action that issued the bonds and setting forth related terms and conditions. Book value method Distribution of income among funds in an investment pool by book value of the funds. Capital asset Asset intended for long‐term, continued use or possession, such as land, buildings, and equipment. Synonymous with fixed asset or capital addition. Capital expenditure Expenditure intended to benefit future periods; addition to a capital asset. Capitalization policy Statement of criteria to determine which assets will be expended or recorded as capital assets.
    [Show full text]
  • The Infrastructure Finance Challenge
    A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Walter, Ingo (Ed.) Book — Published Version The Infrastructure Finance Challenge Open Reports Series, No. 3 Provided in Cooperation with: Open Book Publishers Suggested Citation: Walter, Ingo (Ed.) (2016) : The Infrastructure Finance Challenge, Open Reports Series, No. 3, ISBN 978-1-78374-297-4, Open Book Publishers, Cambridge, http://dx.doi.org/10.11647/OBP.0106 This Version is available at: http://hdl.handle.net/10419/182375 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte.
    [Show full text]
  • A Glossary of Fiscal Terms & Acronyms
    AUGUST7,1998VOLUME13,NO .VII A Publication of the House Fiscal Analysis Department on Government Finance Issues A GLOSSARY OF FISCAL TERMS & ACRONYMS 1998 Revised Edition Abstract. This issue of Money Matters is a resource document containing terms and acronyms commonly used by and in legislative fiscal committees and in the discussion of state budget and tax issues. The first section contains terms and abbreviations used in all fiscal committees and divisions. The remaining sections contain terms for particular budget categories and accounts, organized according to fiscal subject areas. This edition has new sections containing economic development, family and early childhood, and housing terms and acronyms. The other sections are revised and updated to reflect changes in terminology, particularly the human services section. For further information, contact the Chief Fiscal Analyst or the fiscal analyst assigned to the respective House fiscal committee or division. A directory of House Fiscal Analysis Department personnel and their committee/division assignments for the 1998 legislative session appears on the next page. Originally issued January 1997 Revised August 1998 House Fiscal Analysis Department Staff Assignments — 1998 Session Committee/Division Fiscal Analyst Telephone Room Chief Fiscal Analyst Bill Marx 296-7176 373 Capital Investment John Walz 296-8236 376 EDIT— Economic Development Finance CJ Eisenbarth Hager 296-5813 428 EDIT— Housing Finance Cynthia Coronado 296-5384 361 Environment & Natural Resources Finance Jim Reinholdz 296-4119 370 Education — Higher Education Finance Doug Berg 296-5346 372 K-12 Education Finance Greg Crowe 296-7165 378 Family & Early Childhood Finance Cynthia Coronado 296-5384 361 Health & Human Services Finance Joe Flores 296-5483 385 Judiciary Finance Gary Karger 296-4181 383 State Government Finance Helen Roberts 296-4117 374 Transportation Finance John Walz 296-8236 376 Taxes — Income, sales, misc.
    [Show full text]
  • The Capital Asset Pricing Model (CAPM) of William Sharpe (1964)
    Journal of Economic Perspectives—Volume 18, Number 3—Summer 2004—Pages 25–46 The Capital Asset Pricing Model: Theory and Evidence Eugene F. Fama and Kenneth R. French he capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a T Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses.1 The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor—poor enough to invalidate the way it is used in applications. The CAPM’s empirical problems may reflect theoretical failings, the result of many simplifying assumptions. But they may also be caused by difficulties in implementing valid tests of the model. For example, the CAPM says that the risk of a stock should be measured relative to a compre- hensive “market portfolio” that in principle can include not just traded financial assets, but also consumer durables, real estate and human capital. Even if we take a narrow view of the model and limit its purview to traded financial assets, is it 1 Although every asset pricing model is a capital asset pricing model, the finance profession reserves the acronym CAPM for the specific model of Sharpe (1964), Lintner (1965) and Black (1972) discussed here.
    [Show full text]
  • Fund & Revenue Accounting
    UNIVERSITY OF COLORADO BOULDER DEPARTMENTAL FINANCIAL MANAGEMENT GUIDE FUNDANDREVENUE ACCOUNTING TABLE OF CONTENTS - CHAPTER 4 I. CHAPTER 4 – FUND AND REVENUE ACCOUNTING ............................................ 1 II. PERTINENT GUIDELINES AND REGULATIONS .................................................. 1 A. GAAP .............................................................................................................. 1 B. Higher Education Financial Reporting GAAP ........................................................... 3 III. DAY-TO-DAY OPERATIONAL STRUCTURE ......................................................... 4 IV. UNRESTRICTED VS. RESTRICTED ..................................................................... 5 V. FUND AND FUND GROUPS ................................................................................ 7 A. Fund ............................................................................................................... 7 B. Fund Group ...................................................................................................... 8 VI. AGENCY FUNDS (Fund 80) ............................................................................... 9 VII. PLANT FUNDS (Funds 71, 72, 73, 74, 78) ......................................................11 A. Capital Construction Plant Fund (Fund 71) .......................................................... 11 B. Renewal and Replacement Plant Fund (Funds 72, 78) ........................................... 12 C. Retirement of Indebtedness Plant Fund (Fund 73) ..............................................
    [Show full text]
  • Capital/Fixed Asset Policy
    CAPITAL/FIXED ASSET POLICY Capital outlays by a local government for long term use in the provision of goods and services to the citizens are referred to as capital assets or fixed assets. Examples include land, buildings, infrastructure, vehicles, equipment and improvements other than buildings. Once the purchase is completed, it is recorded on the balance sheet as a capital asset and annual depreciation expenditure is recognized over its estimated useful life. This policy establishes uniform and consistent standards for the purchase, control, disposal, and depreciation of capital assets acquired and owned by the City of Belle Isle. Proper reporting, classification and control of capital assets by employees will ensure that such assets are efficiently utilized and protected against damage and loss. The policy outlines the procedures necessary to make certain that capital asset transactions are initiated, authorized and approved by the appropriate level of management to protect against unnecessary purchases, improper disposal or transfers before the life expectancy of the asset is met. An inventory of capital assets, including the location and value of the asset, will be maintained by the Finance Department and the department to which the asset is assigned. The City Manager’s Office is responsible for disposal of all property in accordance with the Belle Isle Municipal Code Section 2-221 to 2-226. Definitions • Capital/Fixed Asset: A capital/fixed asset is a tangible or intangible item with an original monetary unit cost of $5,000 or more and a useful life greater than one year. Such items are recorded on the balance sheet and depreciated based on life expectancy.
    [Show full text]
  • Capital Assets
    Section 5 – Capital Assets Overview Generally, capital assets are the largest asset of a local government. Capital assets are tangible and intangible assets acquired for use in operations that will benefit the local government for more than a single fiscal period. Typical examples of capital assets include land, land improvements, construction-in-progress, infrastructure/improvements, buildings, furniture, motor vehicles, audio-visual and software. As a general rule, local governments should report only those capital assets that they own. For capital leases, although title to the financed asset does not pass to the lessee until the end of the lease term, the lessee does assume the risk of ownership. Therefore, it is reported as Property under Capital Lease. Statutory Requirements Chapter 274, F.S., governs the administration of tangible personal property owned by certain local governments. Section 274.01, F.S., defines “governmental units” for purposes of the requirements as the governing board, commission or authority of a county or taxing district of the State or the sheriff of the county. Section 274.02, F.S., defines “property” as fixtures and other tangible personal property of a nonconsumable nature and requires the State’s Chief Financial Officer to establish, by rule, the requirements for the recording of property. DFS Rule 69I-73, F.A.C., prescribes requirements for recording and inventorying tangible personal property, marking of property items, and disposing of property items. Capital Asset Valuation Capital assets should be reported at their historical cost, which can include: (1) all charges to place the asset in its intended location (for example, freight); (2) all charges to place the asset in its intended condition for use (for example, installation or site preparation); and, (3) subsequent additions or improvements that enhances a capital asset’s functionality or extends its expected useful life.
    [Show full text]
  • Fixed Asset Guide
    FIXED ASSET GUIDE For Financial Reporting Purposes CAFR Group, State Auditor’s Office—June 24, 2008 FIXED ASSET GUIDE Objective To assist with the accounting for and reporting of the State's assets including new building construction and improvements in conformity with Generally Accepted Accounting Principles and in principal with Governmental Accounting Standards Board Statement 34. Policy Governmental Accounting Standards Board (GASB) Statement 34 requires that all capital assets be reported in the government‐wide balance sheet net of accumulated depreciation if applicable. Each agency is responsible for reporting accurate, complete, and timely capital asset information to the State Auditor’s Office (SAO) annually. The CAFR Group of SAO is responsible for compiling the capital asset information from agencies for inclusion in the State's Comprehensive Annual Financial Report. Capital Asset Definitions and Guidelines Capital assets are tangible and intangible assets acquired for use in operations that will benefit more than a single fiscal period. Typical examples are land, improvements to land, easements, water rights, buildings, building improvements, vehicles, machinery, equipment, works of art and historical treasures, infrastructure, and various intangible assets. (Land associated with infrastructure should be reported as land rather than as part of the cost of the related infrastructure asset). A capitalized asset is a capital asset that has a value equal to or greater than the capitalization threshold established for that asset
    [Show full text]
  • Capital Asset Inventory and Condition Assessment
    APTA STANDARDS DEVELOPMENT PROGRAM APTA SGR-TAM-RP- RECOMMENDED PRACTICE 00x-13 American Public Transportation Association Approved xxxx xx, 2013 1666 K Street, NW, Washington, DC, 20006-1215 Working Group Namexx Capital Asset Inventory and Condition Assessment Abstract: This document outlines the initial steps needed to create and/or improve asset management within a transit agency, regardless of transit agency size. It outlines how to manage capital assets from procurement to disposal (i.e., over the life cycle). Keywords: asset inventory, condition assessment, transit asset management, state of good repair, performance management, MAP-21 Summary: A managed capital asset life cycle can provide critical data for analyzing costs of operating a transit service that, in turn, highlights the benefits and considerable cost savings to be had in standardizing assets. The asset management program forms the basis for long-term financial planning (a projection of future expenditures) that reconciles both the objectives of operations and maintenance and capital budgeting, thus collectively contributing to extension of the useful (economic) life of assets. Investment in capital assets must be systematic and data driven. Collecting regular condition and performance data to better focus scarce resources on coaxing greater reliability from aging assets is central to being good stewards of public funds. Asset management contributes to shaping not only organizational strategies; it becomes a critical input in shaping regional and urban planning, understanding
    [Show full text]
  • Externalities and the Common Owner
    Washington Law Review Volume 95 Number 1 3-2020 Externalities and the Common Owner Madison Condon New York University School of Law, [email protected] Follow this and additional works at: https://digitalcommons.law.uw.edu/wlr Part of the Antitrust and Trade Regulation Commons, and the Business Organizations Law Commons Recommended Citation Madison Condon, Externalities and the Common Owner, 95 Wash. L. Rev. 1 (2020). Available at: https://digitalcommons.law.uw.edu/wlr/vol95/iss1/4 This Article is brought to you for free and open access by the Law Reviews and Journals at UW Law Digital Commons. It has been accepted for inclusion in Washington Law Review by an authorized editor of UW Law Digital Commons. For more information, please contact [email protected]. 04 Condon.docx (Do Not Delete) 4/28/20 6:39 PM EXTERNALITIES AND THE COMMON OWNER Madison Condon* Abstract: Due to the embrace of modern portfolio theory, most of the stock market is controlled by institutional investors holding broadly diversified economy-mirroring portfolios. Recent scholarship has revealed the anti-competitive incentives that arise when a firm’s largest shareholders own similarly sized stakes in the firm’s industry competitors. This Article expands the consideration of the effects of common ownership from the industry level to the market portfolio level and argues that diversified investors should rationally be motivated to internalize intra-portfolio negative externalities. This portfolio perspective can explain the increasing climate change related activism of institutional investors, who have applied coordinated shareholder power to pressure fossil fuel producers into substantially reducing greenhouse gas emissions.
    [Show full text]
  • Health Capital
    CHAPTER 5 Health capital Kenneth Arrow, Partha Dasgupta, and Kevin Mumford KEY MESSAGES Health is an essential characteristic of Most health capital services influence human well-being. human well-being directly rather than through the production of goods and services that are Health capital is an important part of inclu- counted in GDP. sive wealth. In the absence of better estimates of the The economic model of health capital pre- direct and productivity effects, gains in life sented in this chapter allows health to affect expectancy should be used as the primary mea- human well-being through three distinct sure of health capital. channels: direct well-being, productivity, and longevity. Annual gains in health capital in the U.S. are worth approximately US$10,000 per person. CHAPTER 5: Health capital 123 1. Introduction 2. Health as a capital asset Attempting to measure human well-being with- Health is a multidimensional concept. There is out considering health would be a great over- no single standard way to measure the health sight. Health is central to our happiness. Health of an individual or a population group. A physi- affects our enjoyment of life, our productivity in cian may examine a patient and measure health employment, and our risk of death. Our desire along several dimensions including mental for good health influences our decisions regard- health, severity of illnesses, nutrition, body ing eating, sleeping, exercising, and our demand mass index (BMI), risk of disease, and level of for medical services. As shown in Table 1, total pain or discomfort. An individual may track spending on medical care from both public exercise and eating behavior or rate his or her and private source makes up an important and own subjective health along a scale of overall fit- generally increasing share of national income ness.
    [Show full text]
  • Link to Capital Assets Administrative Rule
    CAPITAL ASSETS Administrative Rule Adopted by Council ARC FIN 6.11 Purpose These administrative rules establish minimum standards for capital assets applicable to all City bureaus for recording assets in the City’s Enterprise Resource Planning system, and reporting in the Comprehensive Annual Financial Report (CAFR). “Minimum standards” includes documentation supporting the acquisition or donation value for an item used longer than a one-year reporting period by the City bureau with a value outlined by the established thresholds. Authority Authority for this administrative rule is established in the City Charter and the City Code. This administrative rule has been approved by the City Council. Compliance The Accounting Division of the Bureau of Revenue and Financial Services of the Office of Management and Finance (Accounting Division) will monitor bureau capital asset inventory schedules to assess compliance with the minimum standards of this rule. Identified instances of non-compliance require the development and implementation of a bureau corrective action plan. The Accounting Division will provide assistance to bureaus, if requested, to develop this plan. The Controller will report all significant instances of non-compliance to the Chief Financial Officer (CFO) and City Council. Capitalization - Acquisition 1. Capitalize direct cost(s) and ancillary cost(s) for the purchase or acquisition of an asset meeting the value threshold that has a useful life greater than one reporting period. The purchase or acquisition includes the following: a. direct and indirect cost b. incidental cost in acquiring ownership or title c. other cost for preparation for the intended use d. shipping cost or other cost required for: i.
    [Show full text]