M&A Tax: Securing Value Before the Deal Goes Down
Welcome to the Cannabis M&A Field Guide from MGO. In this series, our practice leaders and service providers provide guidance for navigating M&A deals in this new phase of the quickly expanding industries of cannabis, hemp, and related products and services. Reporting from the front-lines, our team members are structuring deals, implementing best practices, and magnifying synergies to protect investments and accrete value during post-deal integration. Our guidance on market realities takes into consideration sound accounting principles and financial responsibility to help operators and investors navigate the M&A process, facilitate successful transactions, and maximize value.
Proactive tax planning during the M&A process is one of the key methods to drive value before, during, and after the transaction. In the cannabis and hemp industries, tax planning takes on a special importance due to the various regulatory concerns at the federal, state, and local levels and the overwhelming impact of IRC Section 280E.
In the simplest terms, the crux of tax discussions at the deal structure level are based on the competing interests of the Acquirer and the Target company’s owners – the former seeking to maximize future tax benefits, and the latter seeks to minimize or defer the tax liabilities relating to the gain from the transaction. In the following, we lay out the tax fundamentals guiding optimal value for both sides of an M&A transaction.
Target company tax classification
A key element to the discussion between the Acquirer and the Target’s owners is the tax classification of the Target company, since this affects a number of transaction structuring decisions. The most common tax classification types are the following:
C Corporation – This is the general form of a corporation. A C Corporation is taxed at the entity level. In addition, distributions to shareholders are typically subject to a second level of tax.
S Corporation – This is a corporation with an S Election. An S Corporation is generally treated as a passthrough entity for income tax purposes, although certain items may be subject to entity level taxation.
Partnership – A partnership is treated as a passthrough entity for income tax purposes. Taxation occurs at the partner level.
Disregarded (as separate from its tax owner) – All income is taxed to the tax owner of the disregarded entity. A common legal form for a disregarded entity is a single-member limited liability company (LLC).
Asset vs. stock acquisitions
This topic was addressed in our article focused on transaction structuring but represents such an essential touchstone that a more in-depth examination is warranted.
Broadly speaking there are two fundamental structures to an M&A transaction, each with its own tax implications: asset acquisition and stock acquisition.
The Acquirer purchases some or all of the Target’s assets. The Acquirer can also assume some, all, or none of the Target’s liabilities. (Note that certain successor liabilities can also transfer over.) Target may then either continue operations or liquidate following the transaction.
Tax Impact on Target/Target Owners:
C Corporation: Gain on the asset sale should be subject to tax at the entity level. In addition, any distributions of the proceeds from the transaction should generally be subject to a second level of taxation at the shareholder level.
S Corporation: Gain on the asset sale should typically be subject to tax at the shareholder level. However, certain built-in gains originating from a prior C Corporation conversion could be taxed at the entity level.
Partnership: Gain on the transaction should be subject to tax at the partner level.
Besides the general tax impact by entity type, there are also different classifications of the gain from the transaction:
- Capital Gain – This generally results from the sale of capital assets and assets used in a trade or business.
- Ordinary Gain – This can result from the sale of ordinary income assets (e.g., accounts receivable, inventory) and from depreciation recapture from previously depreciated assets. The amount of ordinary gain can have an effect on a number of tax attributes, as well as how much of a sale can be deferred through installment sale treatment. In addition, for Target Owners that are taxed on the gain as individuals, this gain can result in a higher effective tax rate than capital gain.
Tax Impact on Acquirer:
The Target’s assets that are acquired are typically stepped-up to fair market value, which may potentially generate additional depreciation and amortization deductions, subject to any Section 280E limitations.
An equity transaction involves the sale of equity by the Target company’s owners to the Acquirer. Generally, all assets and liabilities of the Target company are transferred in the process. This often includes the Target’s tax liabilities and uncertain tax positions (although there are certain exceptions for partnerships).
As such, the Acquirer may find itself liable for tax audit adjustments.
This is especially relevant in the cannabis industry, where Section 280E audits can result in significant tax liabilities. As part of the diligence process, Section 280E exposure should be identified and quantified. In addition, indemnifications, representation & warranties, and tax representation responsibilities should consider the impact of Section 280E.
Tax Impact on Target/Target Owners:
C Corporation: Gain on the equity sale should be subject to tax at the Target owner level, resulting in a single level of taxation. If the stock meets the qualifications for Qualified Small Business Stock and the requisite 5 year holding period is met (i.e., the Section 1202 exclusion), up to $10 million of the gain can be excluded by Target owners that are not corporations.
S Corporation: Gain on the equity sale should be subject to tax at the shareholder level. S Corporation shareholders do not qualify for the Section 1202 exclusion.
Partnership: Gain on the equity sale should be subject to tax at the partner level.
Usually, gain on the sale of an ownership interest is characterized as capital gain. This is especially important for individuals who have held the equity for more than a year, since they may qualify for preferential tax rates. However, note that partnerships with “hot assets” will have a portion of this gain recharacterized as ordinary gain.
Tax Impact on Acquirer:
An Acquirer purchasing a corporate Target’s stock does not obtain a step-up in the basis of Target, resulting in the Acquirer typically not being able to take the additional tax deductions described above for an asset purchase. However, depending on the circumstances, an IRC 338 election ((g) or (h)(10)) or an IRC 336(e) election may be available to treat the stock acquisition as an asset acquisition for US tax purposes. Tax modelling is often recommended to determine whether making such an election is advisable, especially considering that the election may result in adjustments to purchase price to reflect any additional tax costs or to reflect a premium for allowing the election.
An Acquirer purchasing a partnership Target’s equity also generally does not obtain a step-up in the basis in assets, unless a Section 754 election is in place or the Acquirer is acquiring 100% of the Target’s equity. As a result, a Section 754 election is often made in order to step-up the inside basis of the partnership’s assets to match the outside basis of the ownership interests held by the partners.
Tax attributes (e.g., net operating losses, credits) of the Target company transfer over in an equity transaction. However, they may be subject to limitations due to the ownership change (e.g., Section 382). As a result, a review of the availability of tax attributes post-transaction is often factored into the transaction structuring considerations.
Cash vs. stock vs. debt: the perfect storm of tax-free acquisitions
The other major determinant of the tax implications of an M&A equity deal is the form of consideration paid by the Acquirer. Consideration typically comes in some combination of cash, stock, or debt.
In the notably cash-poor cannabis and hemp industries, equity consideration is commonly used to lower the cash flow needs in M&A. However, the proliferation of distressed assets and over-extended operations have made debt assumptions an emerging and increasingly common form of consideration as well. Consequently, an Acquirer willing to pay in cash is relatively unique and brings significant advantage to the M&A negotiation table.
As the percentage of equity consideration in the transaction increases, the opportunity to have at least a portion of the transaction be tax-free also increases:
Corporations – The transaction may be able to be structured as a reorganization (and sometimes a contribution) if the equity consideration is at least 40%. This usually results in no gain recognition for the equity portion of the consideration. The cash/debt portion would still be taxable.
Partnership – The transaction may be able to be structured as a part-sale/part-contribution. This would result in the contribution portion being nontaxable (subject to certain exceptions).
Navigating tax credits
A thorough review of the potential tax benefits and credits available to a Target can influence the structure of an M&A deal and increase the appeal for the Acquirer. Tax credits and incentives in particular can result in significant tax savings. Even cannabis operators subject to Section 280E can qualify for significant credits and incentives at the state & local levels. For instance, cannabis operators have been able to qualify for job creation credits, social equity incentives, and reduced local tax rates.
One final consideration to take into account with M&A is the potential for an international transaction. This can occur in a foreign “go public” transaction or an expansion into international operations. These types of deals add an additional (and possibly unfamiliar) layer of tax considerations to a deal structure. Often, US tax planners familiar with the US tax intricacies of the transaction coordinate with their foreign counterparts to iron out the details of the transaction to ensure that the transaction is tax efficient in all of the respective jurisdictions.
As part of an international transaction, some form of Acquirer structuring usually occurs in order to take advantage of various tax incentives (e.g., treaty benefits) while mitigating exposures such as Subpart F. This can be as simple as forming a new holding company and as complicated as a detailed international structure that considers IP placement, supply chain, and transfer pricing.
Ultimately, any M&A deal will require careful tax planning to minimize tax burdens and maximize the value of the deal. As an important aspect of the M&A process, tax planning is one of the best ways to ensure that both sides of the transaction get the best deal possible.