Read about a notable M&A case where a buyer’s argument for substance over form led to a $3 million amortization income tax deduction. Learn how the court’s decision highlighted the importance of aligning transaction structure with economic substance.
M&A Stories
February 18, 2021
Introduction
In a notable case, the buyer’s argument favoring substance over mere transactional form resulted in a significant $3 million amortization income tax deduction.
The deal
The revised deal called for a combination of buyer stock and $3 million in cash to purchase the assets, with the cash intended to buy out the problematic seller partner. However, the transaction’s complexity arose from the requirement that the buyer first purchase the seller’s business assets using stock and then repurchase a portion of that stock for around $3 million in cash.
The lawsuit
The buyer asserted its right to claim a $3 million amortization deduction. The IRS disputed this claim, contending that the buyer was bound by the formal aspect of the transaction, which was initially designed as a tax-free acquisition solely utilizing stock, hence invalidating the $3 million amortization deduction.
The matter was brought before the Tax Court when the buyer filed a petition. The crux of the buyer’s argument rested on the transaction’s substance rather than its formal structure. The buyer asserted that the core essence of the deal was the acquisition of the seller’s assets for about $3 million in cash in addition to buyer stock. The Tax Court sided with the buyer’s interpretation, ruling that the later step of repurchasing buyer stock from the seller for cash was effectively a payment for the seller’s assets. The court held that the buyer’s issuance and immediate buyback of 1,875,000 common shares lacked real economic significance and was thus disregarded under the “step transaction doctrine.” Consequently, the $3 million in cash was recognized as supplementary consideration for the assets. This favorable decision allowed the buyer to claim the $3 million amortization deduction, resulting in a reduced after-tax purchase price for the business.
This case is referred to as Complex Media, Inc. v. Commissioner Of Internal Revenue, Docket Nos. 13368-15, 19898-17.[1], United States Tax Court, (Filed February 10, 2021)
Comment
In hindsight, it’s apparent that the restructuring of the deal may not have sufficiently considered tax implications. The original arrangement, based solely on stock for assets, was tax-free and did not offer the $3 million amortization deduction.
The alteration of the deal to incorporate a cash buyout of the seller’s partner introduced the $3 million amortization tax advantage. However, this benefit was only certain if the transaction shifted from an exclusively stock-for-assets structure to a blend of stock and cash. Regrettably, without the guidance of tax experts, the buyer and seller adhered to the stock-for-assets framework, followed by the $3 million cash redemption. On a surface level, this approach seemed problematic. Nevertheless, the buyer succeeded in convincing the court to prioritize substance over mere form.
Typically, arguments favoring substance over form tend to favor the IRS. This case emphasizes the importance of aligning the formal structure of a deal with the actual nature of the transaction. The most effective way to achieve this is by involving tax advisors from the inception of the deal to its conclusion.
By John McCauley: I help people manage M&A legal risks.
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
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Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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