I received a call last week from an out-of-state Private Equity Fund (PEF) that focuses on targeting companies operating in urban areas reminding me how little time is spent by companies during the acquisition phase to identify some pretty low-hanging fruit. This particular PEF focuses on businesses in select industries - just like other PEFs - but also puts an added emphasis on companies that operate in regions that generate various financial incentives such as grants, hiring and equipment credits, etc., which can improve their profit margins and provide their investors with a significantly higher overall investment return as compared to investments in which these incentives are not a factor.
Unrecorded Assets and Overstated Expenses
During the buyer’s acquisition due-diligence phase, much effort is generally spent evaluating understated or unreported balance-sheet liabilities, overstated revenues and/or understated expenses. Less time is generally spent focusing on overstated expenses and under-reported assets.
The main reason for the lack of focus on unrecorded assets and overstated expenses is the fact that the vast majority purchase-price formulas are tied to EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) and the balance sheet at the date of closing (“Closing Balance Sheet”). Therefore, if the purchaser identifies unrecorded or under-reported asset balances or decreases expenses, it may actually drive the cost of the target business up. Conversely, if a purchaser decreases asset balances or increases liabilities on the Closing Balance Sheet or if EBITDA is decreased, the purchase price of the transaction will also generally decrease.
Previously unreported tax items will not generally impact EBITDA (since they will impact the “T word” —TAX), but can be factored into the purchase-price negotiations to the advantage of either the buyer or the seller, depending on the nature of the item and which party first identifies the unrecorded assets.
Typical tax items that can generate Closing Balance Sheet assets and also improve annual after-tax profits include:
- Federal and State Research & Development Credits (IRC Section 41) AICPA R&D article
- State and Local Sales Tax Exemptions and Credits
- Local Property Tax Exemptions and Credits
- Federal and State Energy Tax Credits (IRC Section 48)
- Federal Empowerment Zone Hiring Tax Credits (IRC Section 1396)
- Federal Renewal Community Zone Hiring Tax Credits (IRC Section 1400H)
- Federal GO Zone Hiring and Other Credits (IRC Sections 1400N and 1400R)
- Federal Indian Tribal Land Hiring Credits (IRC Section 45A)
- Federal HIRE Act Payroll Tax Exemption (IRC Section 3111(d)) AICPA HIRE Act article
- State Enterprise Zone Credits and Incentives AICPA Federal/State Hiring Credit article
Since most of the benefits can be claimed for three or more prior years via amended returns and the credits can generally be carried over to future years (subject to IRC Section 383 and other provisions), the magnitude of these benefits and the impact on the purchase price can be very significant. Therefore, the purchaser should have a list of similar items to evaluate as part of their due-diligence process.
Once either the buyer or the seller has quantified these benefits this information can be used as follows:
Seller’s Negotiating Advantage
To the extent the buyer identifies these overlooked or under-reported benefits, they can factor the benefits into the sale structure, for example stock sale, asset sale, 338(g), 338(h)(10), etc. If the target business is an S Corp, LLC, Partnership or Disregarded Entity, the aforementioned credits will generally have flowed out to the individual equity holders and there will be no pre-acquisition refund potential at the target company level. However, the seller can point out the future benefits to the buyer at a strategic time in the negotiations in order to enhance the value of the business and purchase price. The sooner these benefits are quantified, the better chance the seller can maximize an upward adjustment in the company value. The increase in the target’s company valuation can be associated with prior year refunds as well as enhanced future profitability (above historically reported profits) associated with the newly quantified benefits.
If the target company is a C Corp, the seller will often want to sell stock in order to minimize double taxation and maximize the allocation to capital gain income. These additional pre-acquisition refunds may make a stock purchase more appealing to the buyer because a stock purchase will generally be required in order to allow the buyer to obtain the prior year refunds.
If an asset sale structure is required to achieve overall tax efficiencies, to deal with regulatory issues or just general preferences of the buyer and the seller, the seller can simply file for the pre-acquisition refunds after the sale has been completed and retain the refunds, provided there are no provisions in the purchase agreement that would allocate such refunds/assets to the buyer.
Buyer’s Negotiating Advantage
Buyers, who identify these unclaimed tax benefits during the due-diligence phase or even better, during the crafting of the Letter of Intent, are well positioned to structure the transaction to take advantage of monetizing these past and future benefits, but they will generally not be required to increase contract purchase price for the additional benefits they identify.
Again, the quantification of these unrecorded assets by the buyer can provide the buyer with added flexibility in structuring either an asset purchase or a stock/equity interest purchase of the target. However, special attention to the legal form of the target’s business and evaluation of where the refunds and any carryovers reside is critically important in drafting the specific purchase agreement language.
The under-reported assets will need to be factored into the purchase price allocation on Form 8594 (PDF) in the case of an asset sale or IRC Section 338 election pursuant to IRC Section 1060.
The moral of this story is that the due-diligence teams for both the buyer and the seller must fully evaluate these potential tax benefits prior to completing the sale/purchase in order to ensure that their respective client understands the full scope of assets being transferred and that the offering price is a fair price (from their client’s perspective) for the stock and/or underlying assets (both reported and off balance-sheet).
By fully quantifying the balance sheet, including these under-reported past and future benefits, the parties can also be in a much better position to determine the optimal legal structure to purchase or sell the business entity or the underlying assets.
CPAs, PEFs and other investors and consultants involved in merger and acquisition (M&A) activities can actually become the “smartest guy or gal in the room” by thoroughly evaluating these additional benefits embedded in many target companies.