M&A tax considerations for government contractors

The government contracting (GovCon) industry can expect continued investment in fiscal year 2025. The 2025 National Defense Authorization Act, passed by Congress in October, allocated about $880 billion to the Department of Defense, a boon for small and minority-owned contractors, as well as for those specializing in construction, engineering, transportation, energy, telecommunications and environmental conservation.

From a tax perspective, potential buyers and sellers will need to navigate merger and acquisition considerations in the GovCon landscape through 2025 and beyond. This article focuses on certain tax issues arising with targets that are S corporations, cash basis taxpayers, or taxpayers subject to the capitalization requirements of section 174.

S corporations

With many private equity firms shifting their investment strategy to target businesses that are minority- or women-owned, government contracting opportunities have grown for these businesses. As a result, S corporation is commonly the tax classification of acquired target entities, which conveys additional risks and complexities to buyers.

After the letter of intent (LOI) is signed and the due diligence efforts ramp up, a buyer’s M&A tax advisors should confirm that a target S corporation has properly elected and maintained eligibility for classification as a valid S corporation. If issues are identified with the target S corporation’s tax status, entity-level corporate income tax for historical periods may be subject to IRS examination. Such an event creates a ripple effect on the transaction structure and the purchase agreement, which may require adjustments to maximize and protect the buyer’s future tax benefits (e.g., a tax basis step-up) and minimize any potential liabilities inherited by the buyer.

Most S corporation issues stem from invalid elections and/or failure to maintain a single class of stock, as required for S corporation eligibility. The latter has its nuances, as the IRS can construe various arrangements as a second class of stock. Generally, the stock of an S corporation must confer identical rights to distribution and liquidation proceeds. Although an S corporation’s historical shareholder distributions have always been made pro rata, the M&A tax advisors will be required to dig into a target S corporation’s organizational documents and business arrangements to determine whether a second class of stock could have been created under U.S. Treasury regulations.

For example, suppose a GovCon business taxed as an S corporation has signed an LOI to be acquired by a private equity firm. Over the last few years, the target company has hired several new key employees. Instead of offering traditional equity compensation to the new employees, the company formed a phantom stock plan for employees to participate in the company's growth. The participants are granted limited voting rights and receive annual payments based on the company's profitability.

Under Treasury regulations, such a compensation plan could give rise to a second class of stock and inadvertently terminate the business’s S corporation status. Phantom stock plans and/or stock appreciation rights plans do not always create a second class of stock—but when they do, S corporation status is lost.

When diligence identifies an S corporation risk, additional issues may need to be addressed, particularly with respect to the transaction structure. For example, if the LOI provides for an election under section 338(h)(10), such an election may no longer be available because it requires the target to be a valid S corporation (or a corporate subsidiary of a consolidated group). If the buyer and seller make a section 338(h)(10) election—which treats a legal stock purchase as an asset purchase for tax purposes—and the seller’s S corporation status is deemed invalid, the IRS could “claw back” the step-up in tax basis and assess the successor entity-level income tax for open tax years.

In that situation, the buyer may suggest changing the transaction structure to an asset purchase to protect its step-up in tax basis and avoid successor liability for federal income taxes. However, asset deals in the GovCon industry are rare and often come with legal obstacles (e.g., contract novation) that generally make such a structure unfeasible.

Another solution is for the buyer to acquire the target’s equity following a pre-close F reorganization. The seller forms a new S corporation and contributes the stock of the old S corporation, for which it files Form 8869, Qualified Subchapter S Subsidiary (QSSS) Election, electing to treat the old S corporation as a QSSS. Subsequently, the old S corporation, now a QSSS, converts to a limited liability company (LLC) under state law—and a wholly owned LLC is disregarded as a separate entity for income tax purposes. This pre-transaction restructuring is treated as a nontax event for federal tax purposes to the extent it qualifies as an F reorganization, and the new S corporation succeeds the old S corporation’s historical S election.

Following this restructuring, the buyer acquires the LLC units of the old S corporation from the new S corporation, which is treated as an acquisition of assets for income tax purposes. This transaction structure provides protection for the buyer’s step-up and avoids some of the legal obstacles of contract novation. Since this structure does not give full protection from tax assessments for historical periods, the buyer should still pursue proper indemnities in the purchase agreement with sufficient recourse in the event of an IRS audit of pre-close tax periods. To the extent 100% of the LLC units are acquired, absent an entity classification election, the target will be treated as a disregarded entity going forward.

To navigate the risks of a target’s S corporation status becoming invalid, M&A tax advisors must understand the ripple effects described above and know the right measures to take to maximize the buyer’s future tax benefits and minimize the potential liabilities it inherits.

Cash basis targets

Since 2021, many new federal, state and local contracting opportunities have emerged for companies specializing in construction, engineering, transportation, energy, telecommunications and environmental conservation. Such businesses commonly file as cash basis taxpayers, which creates challenges in a transaction.

Qualified personal service corporation partnerships with no corporate partners and S corporations with service-based businesses are generally eligible to report taxable income on a cash basis and do not need to meet the gross receipts tests under section 448. However, such reporting is typically unavailable for potential buyers and requires additional consideration before the acquisition. Prior to executing the LOI, buyers and sellers should negotiate how to handle the cash basis items and who should foot the tax bill.

In essence, cash basis reporting is a tax deferral mechanism. Sellers are generally, but not always, more likely to bear the tax cost of the change from cash to accrual, through either a pre-closing conversion or a purchase price adjustment. Additionally, when a transaction providing for a tax basis step-up is agreed to, a buyer may agree to make a seller whole for any incremental cost, but often does not regard the tax cost on the sale of the cash basis assets as an incremental cost that the buyer should bear. However, this issue tends to be heavily negotiated between buyer and seller.

Various avenues are available to convert from cash to accrual in the context of a pure stock transaction (i.e., with no tax basis step-up). For the buyer, ideally the target can file Form 3115, Application for Change in Accounting Method, to adopt the accrual method in the pre-close period. In conjunction, the target may be able to elect to accelerate the adjustment into taxable income (i.e., with a section 481(a) adjustment) in the pre-close period under Rev. Proc. 2015-13. If so, no purchase price adjustments are needed. However, such actions need to be specified in the purchase agreement.

In many cases, the cost of converting from cash to accrual is treated as indebtedness in the purchase agreement. In this scenario, the buyer is responsible for filing Form 3115 and absorbing the adjustments to taxable income in post-close periods. However, the cost of the accounting method change results in a negative purchase price adjustment, with the buyer’s final purchase price decreasing as remuneration for the associated tax cost it must bear.

In a transaction with a tax-deferred rollover (which is common with a pre-transaction F reorganization), the contribution of cash basis items (e.g., receivables and prepaids) will result in additional taxable income pickup post-close, even if the transaction is structured as an asset purchase. Thus, it is important that the post-close tax on any contributed cash basis items, to the extent not specifically allocated to the seller via partnership allocations, is treated as indebtedness in the purchase agreement so that the buyer is recompensed via an adjustment to the purchase price.

As is often the case, getting out in front of these issues can make all the difference. Negotiating the cash basis impact before LOI execution prevents obstacles from arising later in the due diligence process and keeps the closing date on track.

Section 174 considerations

Section 174 requires the capitalization of certain research and experimental (R&E) costs due to changes introduced by the Tax Cuts and Jobs Act. Section 174 capitalized costs are now amortized over five years (or 15 years for costs attributed to foreign research). With GovCon’s focus on aerospace and defense, the change has significantly affected many taxpayers within the industry. In M&A transactions, taxpayers must determine the appropriate treatment of the unamortized section 174 costs, for which IRS guidance has been unclear.

The IRS has provided interim guidance under Notice 2023-63 to address the tax treatment in the context of specific M&A transactions. Unfortunately, the interim guidance does not address the treatment of section 174 costs in all common M&A transactions.

For example, the guidance is limited for a taxable asset transaction in which the seller remains in existence, which may be the case for S corporation acquisitions structured with a pre-close F reorganization. The notice states that the seller will continue to amortize its unamortized costs and will not use the basis of capitalized costs in the gain calculation. In other words, unamortized section 174 costs cannot be conveyed in a taxable asset acquisition, and the seller must continue to amortize until a taxable liquidation event. However, the guidance does not consider whether the seller is entitled to deduct the unamortized costs if no longer operating any business and the costs have no current or future potential value, such as an S corporation that simply holds rollover equity post-sale.

From the buy-side due diligence perspective, small-business targets often have not appropriately adopted the tax treatment for section 174 costs (i.e., deducting costs when incurred). In stock transactions, the buyer may inherit the historical risk if the target company has not been properly capitalizing applicable R&E costs. In such an event, it is important for the purchase agreement to provide the buyer with appropriate protection and for the buyer to take action to avoid further risk going forward.

The takeaway

In the year ahead, the GovCon landscape will see significant deal activity involving middle market businesses owned and operated by founders—and with it come new obstacles for buyers to navigate. The best action for any buyer is to understand and negotiate the potential tax hurdles before providing a seller with an LOI for execution. Buyers should also engage M&A tax professionals as early as possible to identify any tax risks that threaten the deal timeline and to avoid unforeseen hazards.