In an acquisition, the buyer’s objective — from a tax viewpoint — is to secure a “cost basis” with respect to the target’s assets. To be sure, the cost basis is ordinarily described as the original value of an asset, or in an acquisition, the purchase price. And the cost or “tax” basis is used to determine the capital gain, which is the difference between the asset’s original price and current market value.
In some cases, an acquiring corporation purchases the stock of a target. The basis for the stock is the amount paid, while the target’s assets retain their historical bases. In other instances, the buyer purchases a target’s assets, thereby achieving a cost basis in the target’s assets. Accordingly, the tantalizing question is whether a purchase of stock — by far the most common format for an acquisition — may somehow be transformed into a purchase of assets with a view towards gaining a cost basis in the target’s assets. The answer is yes.
Under Section 338(a) of the tax code, a qualified stock purchase is a purchase completed within a 12 month acquisition period, that involved at least 80 percent of the target’s stock, measured by both voting power and value. In such as stock purchase, the acquirer can elect to treat the target as if, (1) it had sold all of its assets in a single transaction for an amount equal to their fair market value, and (2) the target was a new corporation purchasing those same assets, for a similar amount, as of the beginning of the following day.
The effect of the “deemed sale” is that the target’s assets acquire a new basis equal to their fair market value — a cost basis. However, there are exactions associated with making of Section 338 election. For example, the buyer secures a cost basis in the target’s assets but does so at the unacceptably steep cost of two levels of tax. Thus, the sellers of the target’s stock (to the buyer) will recognize gain on the stock sale and the target itself will recognize gain on the deemed sale of assets that the Section 338 election sets in motion.
When Section 338 was first enacted in 1982, the target recognized neither gain nor loss on the deemed sale because, at that time, the “General Utilities” doctrine still reigned. Under that doctrine, assets were permitted, in certain circumstances — including the deemed sale triggered by an election under Section 338 — to “exit corporate solution” on a tax-free basis.
However, in 1986, the last vestiges of the General Utilities doctrine were conclusively repealed. Therefore, what had formerly been a single level of tax route to a cost basis became a double level of tax route. These changes deprived Section 338 elections of virtually all of their allure.
So today, Section 338 elections are rarely made in cases when the target’s stock is acquired, with the result that the buyer is unable to secure a cost basis with respect to the target’s assets. This means that the buyer’s future taxable income will not be reduced by the depreciation and amortization deductions that a cost basis would produce. What’ more, the inability to secure a cost basis will directly, and measurably, affect the pricing of the deal.
Buying a Partnership
As a result, what is always desirable — but exceedingly difficult to attain — is for the acquirer to obtain a cost basis in the target’s assets at a “manageable” cost. That is, a cost of only a single level of tax. This goal can be achieved if the target is: (1) a subsidiary of another corporation (in which event the buyer and seller might jointly execute an election under Section 338(h)(10)); (2) a real estate investment trust (in these cases no entity level tax is incurred if the REIT distributes to its shareholders the proceeds derived from the sale of its assets); or (3) a non-corporate entity.
Regarding the third variety of target company, witness the recently announced transaction in which National Beef Packing Company LLC will be acquired by JBS S.A. On March 4, 2008, JBS announced that it had entered into a “Membership Interest Purchase Agreement” with National Beef. Under the agreement, JBS will acquire all of the outstanding membership interests of National Beef. In addition, JBS will pay the members of the beef packing company total proceeds of approximately $465 million in cash and $95 million in JBS common stock. In addition, JBS will be assuming all of National Beef’s debt and other liabilities at closing.
Most notably, National Beef is classified as a partnership and not a corporation.* In this case, one person (JBS) purchases all of the ownership interests in a LLC which is classified as a partnership, and the partnership is said to have terminated. The sellers treat the transaction as a sale of their partnership interests on which capital gains are realized. (See Rev. Rul. 67-65, 1967-1 C.B. 168.
However, for purposes of determining the tax treatment of the buyer, the partnership is deemed to have made a liquidating distribution of all of its assets (to its former partners) and, following this distribution, the buyer is treated as acquiring those assets. (See Revenue Ruling 99-6, 1999-1 C.B. 432 and LTR 200807005, November 9, 2007.)
Thus, from the buyer’s perspective, the transaction is treated as an asset purchase and, therefore, the buyer obtains a coveted cost basis in the target’s assets. Moreover, this “basis step-up” is attained at a manageable cost: at the cost of only a single level of tax.
A partnership is not a separate taxable entity. Instead, under Section 701, those persons carrying on business as partners shall be liable for income tax “only in their separate or individual capacities.” In short, the taxable income earned by a partnership is “passed through” to the partners, and taxed to them without first being subjected to any entity level taxation.
Accordingly, JBS will secure a cost basis in National Beef’s assets and the depreciation and amortization benefits which a cost basis provides. The ability to reduce tax liabilities, by virtue of these enhanced deductions, will frequently result in an “effective” cost for the deal that is as much as 20 percent below the “headline” cost. Thus, when one adjusts for the tax benefits that JBS will be securing, the cost of annexing National Be plummets significantly.
Contributor Robert Willens, founder and principle of Robert Willens LLC, writes a weekly tax column for CFO.com.
*On March 5, 2008, JBS announced that it will acquire the stock of Smithfield Beef Group, Inc., a wholly-owned subsidiary of Smithfield Foods, Inc. Here, however, no basis step-up is in the offing because the purchase agreement makes no mention of the execution of a joint Section 338(h)(10). However, it appears that JBS will, nonetheless, secure tax benefits from this acquisition in light of the fact that the parties to the transaction, JBS and Smithfield Foods, Inc., have entered into a covenant not to compete. A covenant not to compete is covered by Section 197, and is therefore amortizable over 15 years, whenever, as here, there is a “related acquisition” of a business through a purchase of either assets or stock. Thus, because there is, in this case, a related acquisition of a business, the amount paid for the covenant, assuming it is shown to exhibit “economic reality”, should be amortizable over a 15 year period beginning with the month in which the deal is closed).