Tax planning tool available for structuring the private equity deal
For decades, private equity firms have been handcuffed by the Internal Revenue Service through double taxation and complex legal maneuvering if they wanted to undertake certain acquisitions and achieve a stepped-up tax basis in the assets. Historically, Section 338(h)(10) of the IRS code only allowed purchasers to be a specific legal entity — namely a corporation. However, a 2013 regulatory provision now generally accepted by the IRS and the Treasury Department provides an efficient way for private equity firms to purchase certain companies, including S Corporations, in a more tax efficient manner. Code. Sec. 336(e) creates a more favorable return to investors by decreasing tax liabilities, making purchases less cumbersome, and gives the purchaser the ability to obtain a stepped-up basis in the seller’s assets.
Pass-through benefits. One of the biggest challenges faced by private equity firms to date has been their inability to easily structure a pass-through entity as an acquirer and obtain the preferred stepped-up tax basis in the target’s assets. Given that corporations, and not tried-and-true partnerships/pass-through entities, were the only types of entities that could make a stock purchase and treat as an asset purchase, the purchasing entity that wanted pass-through taxation would be subject to a much higher rate of taxation, without additional legal structure maneuvering. Section 336(e) allows corporate stock purchasers to be partnerships, LLCs or any other form of legal entity thus passing the taxation liability onto the partners/investors of a fund or entity, and escaping corporate “double taxation”. This game-changing development automatically provides a better return for investors by completely eliminating corporate level taxes.
Less complicated acquisition timeframe. Given that certain pass-through entities are now allowed to make acquisitions in corporations and achieve stepped-up tax basis, the legal maneuvering of creating pre-acquisition holding companies or other corporate entities are no longer needed. Not only will this change decrease legal fees which will result in cost savings, it also speeds up the acquisition timeline. Of course, this is not guaranteed but the legal requirements are far less complicated translating into lower costs at some level. Unlike Section 338(h)(10), the 336(e) election is agreed to by the buyer and seller and then is made on the seller’s tax return. It is important to note here that this does put the private equity firm acquirer at somewhat of a disadvantage as they have to rely on the seller to make this elect this on their timely filed tax return. Generally, the acquirer would want reps and indemnifications from the seller to affirm the election is properly made.
Stepped-up basis in stock acquisition. Arguably, one of the most significant benefits that private equity firms and investors will see from Section 336(e) is the opportunity to obtain a stepped-up basis in a corporate acquisition. It can be extraordinarily complicated to outright purchase tangible or intangible assets of a seller. Third-party consent or other legal impediments can be very time consuming and/or require a lot of capital. These hurdles are overcome with Section 336(e) because the legal structure is that the purchaser is acquiring the stock of the entity. However, for federal income tax purposes, the transaction is treated as an asset purchase, thus providing the additional tax benefits. Of course, the buyer also takes on the liabilities of the seller that they would not historically have been subject to in an asset acquisition. The taxation benefits from this type of arrangement are generally significant s and often create a much more attractive deal for investors.
Section 336(e) is a tremendous opportunity in the private equity world. GPs and LPs alike will now have a variety of tax tools at their disposal which make investment opportunities more attractive and easily obtainable. and the tax benefits can make the financial returns much more profitable.
Gary G. Wallace, CPA is a partner at Richmond-based Keiter. He has more than 25 years of accounting experience in the private and public sectors.