TAX ISSUES TO CONSIDER IN COMMON ACQUISITION SCENARIOS Panelists: Scott D. Vaughn, Partner – Ernst & Young LLP Annette M. Ahlers, Corporate Tax Partner – Pepper Hamilton LLP Moderator: Herb S. Ezrin, President – Potomac Business Group, Inc. December 13, 2005

Taxable Acquisitions— Stock vs. Asset General Differences

Basic Structure $ Buyer Seller Target Corporation Target Corporation Buyer acquires the stock of Target Corporation for cash.

Taxable Stock Purchase: Results to Buyer Buyer takes a purchase price basis in the stock of Target Corporation (“Target”). However, Target itself does NOT get a stepped-up basis in its assets. (The assets retain their historic tax basis.)

Taxable Stock Purchase: Tax Attributes of Target The tax attributes (e.g., Net Operating Loss carryovers, tax credits, earnings & profits, etc.) of Target are generally retained by Target. Utilization of such attributes following the acquisition may, however, be limited under anti-loss trafficking rules: - See, for example, §§382, 383, 384, 269 (use of NOL carryovers following ownership changes, etc.)

Taxable Stock Purchase: Results to Seller Individual Sellers - Generally, gain or loss determined based upon the difference between the proceeds received and the seller’s basis in the stock of Target sold. - Gain generally taxed at long-term capital gain rate (Federal =15%) • Consolidated Group Seller - Any gain is taxed at corporate rates. - Previously deferred group income or gains could become triggered. - In certain circumstances, losses may be disallowed or deferred.

Taxable Stock Purchase: Sample Transaction Buyer Seller (S/Hs) $100 Seeks to acquire Target Stock: FMV = $100 Basis = $0 Buyer Results: $100 stock basis $0 asset basis Target Corporation Assets: FMV = $100 Basis = $0 • Buyer acquires stock of Target. • What are the net after-tax proceeds to the Seller?

Taxable Stock Purchase: Sample Transaction Results • Seller (Target S/Hs) receives $100 in consideration for its shares of Target stock. • Seller recognizes $100 of capital gain and pays roughly 20%, or $20, in federal and state taxes on the transaction. • Seller is left with $80 at the end of the day. Proceeds $100 Basis – 0 Capital Gain = $100 Capital Gain $100 Rate (x 20%) Tax = $20 Proceeds $100 Tax - 20 Net $80

Taxable Stock Purchase: Issues to Consider Since tax (and other) liabilities remain with Target after the purchase transaction, thorough tax due diligence on Target is recommended.

Taxable Stock Purchase: Issues to Consider Advisable Purchase Agreement considerations. The Buyer typically requires a full indemnity for taxes paid in prior years and that all required returns have been filed. If there are significant issues with respect to certain tax filings or positions, an escrow can be established to hold back amounts until a matter is resolved (i.e., the Target is undergoing a state sales and use tax audit which will be resolved in 12 months.) Recently, Buyers have been requiring representations that no “listed or reportable” transactions have been entered into.

Taxable Asset Purchase Seller $ 2 Distribute Net After-Tax Proceeds $ Buyer Target Sell Assets 1

Taxable Asset Purchase: Results to Buyer Buyer takes a purchase price basis in the assets acquired. - Purchase price usually can be amortized / depreciated for federal income tax purposes, resulting in future tax deductions (over the tax life of assets acquired) for the amount paid. - Goodwill and other intangibles generally have a 15-year straight line life for tax purposes.

Taxable Asset Purchase: Results to Seller/Target Seller recognizes gain/loss based upon the difference between the proceeds it received and the seller’s basis in the assets sold. Character of gain may be part ordinary and part capital. The tax attributes—e.g., NOLs—of Target (seller of assets) remain with Target. After corporate level tax is paid by Target, only net after-tax proceeds are available to be distributed to the shareholders of Target. The shareholders then generally recognize gain/loss based on the difference between the proceeds they receive and the shareholders’ basis in the Target stock that becomes cancelled.

Taxable Asset Purchase: Sample Transaction Individual Sellers Stock: FMV = $100 Basis = $0 $___ 2 • Buyer Result: $100 Asset Basis Distribute Net After-Tax Proceeds Stock Cancelled 1 $100 Buyer Target Assets Assets: FMV = $100 Basis = $0 • Buyer acquires assets of Target. • What are the net after-tax proceeds to the Individual Sellers?

Taxable Asset Purchase: Sample Transaction Results Target Proceeds $100 Asset Basis – 0 Ordinary and/or Capital Gain = $100 Corporate Tax Rate (x 40%) Tax = $40 Corporate Tax - 40 Net Cash Available to S/Hs $ 60 Sellers (S/Hs) Net Cash to S/Hs $60 Stock Basis - 0 Capital Gain = $60 Individual Tax Rate (x 20%) Tax = $12 Proceeds to S/Hs $60 Individual Tax - 12 Net Cash to Sellers $48 • Target receives $100 in consideration for its assets and recognizes a $100 gain at the corporate level. • Target pays roughly 40%, or $40, in federal and state taxes on the transaction. • Target distributes the remaining $60 to its S/Hs (the Sellers) in a liquidation. • Sellers recognize a $60 capital gain on the liquidation and pay roughly 20%, or $12 in federal and state taxes on the transaction. • Sellers are left with $48 at the end of the day.

Taxable Asset Purchase: Issues to Consider Buyer of assets generally does not inherit any past income tax liabilities associated with the business acquired, such liabilities remaining behind with the Seller/Target. - As such, generally non-income tax due diligence—e.g., sales/use tax, property tax, etc.—is primary focus of tax due diligence efforts. • Buyer and Seller often have adverse interests in allocating the purchase price among the assets sold. Tax rules set forth a method for allocating purchase price among seven classes of assets.

Advisable Contract considerations. Taxable Asset Purchase: Issues to Consider Advisable Contract considerations. Buyer and Seller may want to include a schedule in the purchase agreement which allocates purchase price among assets being acquired or at a minimum have review authority over the other parties’ information statement being filed with the tax return for the year in which the transaction occurs. Buyer will still ask for general tax indemnities that all prior year tax returns have been filed and all taxes have been paid, including sales and use taxes.

What if Target has NOLs to offset? Modeling: Buyers and Sellers Need to Compare and Contrast the Tax and Other Consequences of Each Structure What if Target has NOLs to offset? Buyer may want to buy assets (because Buyer can generally depreciate the purchase cost). Corporate Seller, however, may not want to sell assets (because Seller is often subject to the corporate double tax).

Section 338(h)(10) Elections Elective Asset Acquisitions: Taxable Acquisitions of S Corporations (or of Certain Subsidiaries in Affiliated Groups) Section 338(h)(10) Elections

Elections to Treat Certain Stock Acquisitions as Asset Acquisitions In certain circumstances, if 80% or more of the stock of an S corporation (or an 80%-owned corporate subsidiary of an affiliated group) is acquired in a taxable transaction, then an election can be made to treat a stock sale transaction as an asset sale transaction solely for tax purposes (a Section 338(h)(10) election). BOTH Buyer and Seller must join in making the Section 338(h)(10) election.

§338(h)(10) Deemed Asset Purchase Corporate S/Hs Actual Sale of T Stock Ignored 2 Deemed Liquidation of Old T for Proceeds 1 Deemed Taxable Sale of Assets New T Old T Proceeds Fiction of an asset purchase by “New” Target; asset sale by “Old” Target

§338(h)(10) Election (Deemed Asset Purchase): Benefits Buyer of stock takes purchase price basis in stock. Target obtains purchase price basis in its assets. Generally results in only one level of tax for Seller. Seller reports gain from asset sale but ignores stock sale.

§338(h)(10) Election (Deemed Asset Purchase): Sample Transaction #1 Takes $100 basis in stock Buyer Seller (S/Hs) $100 Stock (ignore for tax purposes) Stock: FMV = $100 Basis = $0 “$100” Deemed Liquidation Takes $100 basis in assets Deemed Taxable Sale of Assets “New” Target S Corporation “$100” Assets: FMV = $100 Basis = $0 • Buyer acquires stock of S Corp. • Assume all assets generate capital gain. • What are the net after-tax proceeds to Seller?

§338(h)(10) Election (Deemed Asset Purchase): Sample Transaction #1 Results • Seller (S/Hs) receives $100 for its S. Corp. stock but ignores the stock sale for tax purposes. • For tax purposes, S Corp. is deemed to receive the $100 for its assets. S Corp. recognizes $100 in capital gain from the deemed asset sale. • The capital gain is passed-thru to Seller, who reports the gain and pays roughly 20%, or $20, in federal and state taxes on the transaction. • Seller is left with $80 at the end of the day. S Corporation Deemed Proceeds $100 Asset Basis - 0 Capital Gain = $100 Seller (S/Hs) Capital Gain Reported $100 Rate (x20%) Tax = $20 Proceeds $100 Tax - 20 Net = $80

§338(h)(10) Election (Deemed Asset Purchase): Sample Transaction #2 Takes $100 basis in stock Buyer Seller (S/Hs) $100 Stock (ignore for tax purposes) Stock: FMV = $100 Basis = $0 “$100” Deemed Liquidation Takes $100 basis in assets Deemed Taxable Sale of Assets “New” Target S Corporation “$100” Assets: FMV = $100 Basis = $0 • Assume 50% of assets generate capital gain, and 50% generate ordinary income. • What are the net after-tax proceeds to Seller?

• Seller is left with $70 at the end of the day. §338(h)(10) Election (Deemed Asset Purchase): Sample Transaction #2 Results • Seller (S/Hs) receives $100 for its S Corp. stock but ignores the stock sale for tax purposes. • For tax purposes, S Corp. is deemed to receive the $100 for its assets. S Corp. thus recognizes $50 in capital gain and $50 in ordinary income. • The capital gain and ordinary income are both passed-thru to Seller. Seller pays tax of roughly 20%, or $10, on the $50 capital gain, and pays roughly 40%, or $20, on the $50 of ordinary income. • Seller is left with $70 at the end of the day. S Corporation Deemed Proceeds $100 Asset Basis - 0 Gain = $100 Allocation: Capital Gain = $50 Ordinary Income = $50 Seller (S/Hs) Capital Gain Reported $50 Rate (x20%) Capital Gains Tax = $10 Ordinary Income Reported $50 Rate (x40%) Tax on Ordinary Income = $20 Proceeds $100 Tax - 30 Net = $70

§338(h)(10) Election (Deemed Asset Purchase): Issues to Consider For S Corporation targets, tax due diligence is critical to establish the validity of the S Corporation’s status as such. This is critical for two reasons: (1) if S Corporation status was not maintained, then the corporation would have been subject to corporate level tax as if it were a “C” corporation and thus there could be tax exposure in the Target, and (2) the Buyer will not obtain the expected step-up in the basis of the Target’s assets if the Target was not an “S” corporation (and thus ineligible for the Section 338(h)(10) election).

General indemnities on filing returns and paying taxes. §338(h)(10) Election (Deemed Asset Purchase): Issues to Consider Contract Points. Parties specifically state in the agreement that the transaction is intended to be treated as a 338(h)(10) transaction. Buyer may ask for additional representation that target has always been an S Corporation for fiscal income tax purposes. General indemnities on filing returns and paying taxes.

Application of Built-in Gain Tax (§1374) §338(h)(10) Election (Deemed Asset Purchase): Additional Tax Issues for S Corporations Including Those that were Former C Corporations Application of Built-in Gain Tax (§1374) Other potential entity-level taxes -application of LIFO recapture tax -passive investment income tax • State taxes at the entity and shareholder levels • Character of gain on asset sale—ordinary vs. capital • Modeling is crucial to understanding potential for Gross-up

Tax-Free Transactions In certain circumstances the Seller can dispose of the Target Corporation in a tax-deferred manner including by merging the target into an Acquiring corporation for stock of the Acquiring corporation or by exchanging the stock of Target solely for stock of Acquirer. -There are a number of different permutations and tax rules that govern when such transactions are tax-free.