M&A Tax Concepts: What is a “gross-up payment,” and why does it matter?

Buying or selling a business is an exciting experience, and potentially lucrative opportunity for all parties. Most often, during the letter of intent / early negotiations phase, a “deal” is struck based primarily on economic and business terms. However, a proposed transaction’s tax consequences can vary significantly based on how the deal is structured and transaction effectuated. The parties should be familiar with these considerations, and, in order to navigate properly, well-advised by counsel with M&A tax expertise.

Let’s examine a fairly typical scenario wherein a buyer (“Buyer”) is interested in making a strategic acquisition of a competitor’s business (the “Target”), with the expectation that, post-acquisition, the combined enterprise is significantly more profitable and valuable for the Buyer (due to the consolidation of businesses).

In this case, let’s assume that Target is organized as a C corporation for tax purposes. Let’s further assume, as is often the case, that in order to consummate the proposed transaction, Buyer prefers to purchase Target’s assets from the company (i.e., an asset acquisition), rather than Target’s stock from the company’s shareholders (i.e., a stock sale). Buyer’s preference is likely driven by various tax, and non-tax reasons. From a tax standpoint, an asset acquisition generally is preferable because it allows Buyer to (i) insulate itself against Target’s historic income tax liabilities; and (ii) obtain a valuable “step-up” in the purchased assets’ tax bases (which provides future tax depreciation and amortization deductions that reduce taxable income).^[1] In a stock sale, Buyer typically does not receive either of these benefits.

Unfortunately from a negotiations standpoint, Buyer’s preference for an asset acquisition generally will conflict with a seller’s (i.e., the beneficial owner of the Target, “Seller”) preference for a stock sale. From Seller’s standpoint, a stock sale is cleaner (i.e., the assets do not need to be re-titled, contracts and licenses do not need to be assigned, etc.). Perhaps more importantly, a stock sale almost always comes at a lower tax cost to Seller (i.e., resulting in more money in Seller’s pocket when the dust settles), and the delta can be significant. The higher tax cost of an asset acquisition as compared to a stock sale generally results from (i) the “double layer of tax” attributable to C corporations; and (ii) disparate characterization of income in respect of the assets sold.

With respect to (i), when a C corporation sells an asset, the company realizes and recognizes gain on that sale, and pays entity-level corporate tax (i.e., the first layer of tax).^[2] The net proceeds may then be distributed to the company’s shareholders, who then must take the distributed cash into income, and pay tax as appropriate (i.e., the second layer of tax). The distribution most often is in the form of a taxable dividend. In a stock sale, however, only the selling shareholders recognize gain, and so that gain is taxed only once.

With respect to (ii), a sale of stock generally results in favorable capital gain treatment for selling shareholders. But depending on the nature of the underlying assets sold in an asset acquisition, a target company may instead realize a portion of the sales price as less favorable ordinary income.

And so, often, in order for both parties to emerge content from the transaction, they will agree to an asset acquisition (Buyer-preferred) with an accompanying “gross-up payment” in order to make Seller whole (taxwise). Essentially, a gross-up payment is an increase to the purchase price that, on a post-tax basis, leaves Seller with the same amount of cash it would have walked away with had the parties agreed to a (less tax expensive) stock sale.

Use and benefit of a gross-up payment generally comes down to a modeling (math) exercise. The calculation can be quite detailed, and must take into consideration many factors (including, for example, Seller’s federal and state tax rates, the target company’s asset composition and tax profile, etc.).^[3] But in the end, the calculation typically compares (A) the dollar amount of the gross-up payment paid by Buyer to (B) the present value of the tax-benefits associated with the step-up that Buyer receives from the asset acquisition (i.e., on a present-value basis).

Simply stated, if (B) exceeds (A), then, from Buyer’s standpoint, the gross up payment is worth paying. At that point, so long as Seller walks away with its base-line amount of post-tax cash (and notwithstanding any other determinative factors), it generally should not care whether the deal is structured as a stock sale or asset acquisition.

Adam Margulies provides domestic and international transactional tax advice to clients within the private wealth, insurance, banking, and asset management sectors, with a focus on tax research, planning, structuring and modeling at Farrell Fritz. He regularly advises on the tax-related contents of various legal documents, and drafts opinions and memoranda interpreting and applying tax law to diverse and complex transactions.

———————————————————————————————————————–

[1] Typically, the largest and most valuable of these results from newly-created “goodwill” that is amortizable for tax purposes over fifteen years.

[2] For tax purposes, a distribution from a C corporation generally is treated first as a dividend to the extent of the company’s current and accumulated earnings and profits, then as a return of the shareholder’s basis (but not below zero), and capital gain thereafter.

[3] Gross-up payment modeling is also useful when comparing other transaction structures, for example, when the parties intend to treat a stock sale as an asset acquisition (solely for tax purposes), via a special tax election under Internal Revenue Code Section 338(h)(10). Discussion of these (and other) circumstances and transaction structures is beyond the scope of this article.