M&A tax considerations for government contractors

As the seasons change, we still find ourselves in the midst of uncertainties with a pandemic and continued political deadlocks in Congress. Despite the unpredictability, the government contracting (GovCon) industry is expected to see continued investment as the year progresses. The current administration will maintain the increase in contracting opportunities for small and minority-owned businesses. In addition, with the passing of the $1.2T infrastructure bill, there will be new federal investments that will provide opportunities for businesses in construction, engineering, transportation, energy, telecommunications, and environmental conservation. From a tax perspective, there are M&A considerations for potential buyers and sellers to navigate the 2022 GovCon landscape and beyond.

S corporations

Many private equity firms have been shifting their investment strategy to identify targets that are minority and women-owned businesses which have seen a growth of government contracting opportunities. As a result, subchapter S corporations are commonly the tax classification of the acquired target entities that convey additional risks and complexities to buyers in the market.

After the LOI is signed and the due diligence efforts start to ramp up, a key focus of a buyer’s M&A tax advisors will be confirming that a target S corporation has properly elected and maintained eligibility to be classified as a valid S corporation.  To the extent that issues are identified with the target S corporation’s tax status, there may be risk of entity-level corporate income tax for historical periods open to IRS examination. In such an event, there are ripple effects that impact the transaction structure and purchase agreement provisions necessary to maximize and protect the buyer’s future tax benefits (e.g., tax basis step-up) in addition to minimizing 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 of the two has its nuances and will be the focus of this discussion, as there are various arrangements that the IRS can construe 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 in pro-rata fashion, the M&A tax advisors will be required to dig into a target S corporation’s organizational documents and business arrangements to determine whether any second class of stock could have been created under the Treasury Regulations.

For example, a GovCon business taxed as an S corporation has signed an LOI to be acquired by a private equity firm as a new platform. Over the last few years, the company has hired several new key employees. In lieu of offering traditional equity compensation to these new employees, the company formed a phantom stock plan for employees to participate in the growth of the company. Under this phantom stock plan, the participants are granted limited voting rights and receive annual payments based on the profitability of the company. Under the regulations, such compensation plan would likely give rise to a second class of stock and could have inadvertently terminated its S corporation status. It is important to note that the devil is in the details and typical phantom stock plans and/or stock appreciation rights plans do not always create a second class of stock.

When an S corporation risk is identified in diligence, there may be additional issues that will need to be addressed, particularly with respect to the transaction structure. For example, if the LOI proves for an election under IRC Section 338(h)(10) to be made, such election may no longer be available as the election is dependent upon the Target’s status as a valid S corporation (or corporate subsidiary of a consolidated group). In the event that Buyer and Seller make an IRC Section 338(h)(10) election, which serves to treat a legal stock purchase as an asset purchase for tax purposes, and the target’s S corporation status is deemed to be invalid, the IRS could “claw-back” the step-up in tax basis and assess the successor entity-level income tax for open tax years.

As an alternative structure, the buyer may suggest changing the transaction structure to an asset purchase to protect the buyer’s 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 (i.e., contract novation) that generally make such structure unfeasible.

Another solution is acquiring the target’s equity following a pre-close F reorganization. With such restructuring, the Sellers form a New S corporation and contribute the stock of the old S corporation, for which they file Form 8869, Qualified Subchapter S Subsidiary Election, electing to treat old S corporation as a Qualified Subchapter S Subsidiary (QSSS). Subsequently, the Old S corporation, now a QSSS, converts to an LLC under state law, which, as a wholly-owned LLC is disregarded as a separate entity for income tax purposes. This pre-transaction restructuring is treated as a non-tax event to the extent it qualifies as an F reorganization and new S corporation succeeds to Old S corporations historic S-election.

Following this restructuring, the Buyer acquires the LLC units of the old S corporation from 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 provide 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.

In order to navigate the risks of a target’s invalid S corporation status, the M&A tax advisors must understand the aforementioned ripple effects and know the right levers to obtain the often-aimed goals of maximizing the buyer’s future tax benefits and minimizing the potential liabilities inherited by buyer.

Cash basis targets

With the passing of the $1.2T infrastructure bill in Nov. 2021, $550 billion is earmarked for new federal investments over the next five years, which will translate to new opportunities for companies that specialize in construction, engineering, and transportation, energy, telecommunications, and environmental conservation. Such businesses commonly file as cash basis taxpayers, which create challenges to resolving historically and prospectively within the context of a transaction.

Qualified personal service corporations (QPSCs), partnerships with no corporate partners, and S corporations with service-based businesses are generally eligible to report taxable income on the cash basis and do not need to meet the gross receipts tests under IRC Section 448. However, such reporting is typically not available for potential buyers and requires additional consideration in advance of the acquisition. Prior to executing the LOI, buyers and sellers should be negotiating how to handle the cash basis items and who should foot the tax bill. In essence, cash basis reporting is a tax deferral mechanism. And, in many cases, sellers are generally, but not always, more likely to bear the tax cost of the cash to accrual either through a pre-closing conversion or a purchase price adjustment. However, this tends to be a heavily negotiated item between buyer and seller.

There are various avenues for converting from cash to accrual in the context of a pure stock transaction. Ideally for the buyer, 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. Section 481(a) adjustment) in the pre-close period under Revenue Procedure 2015-13. By doing so, no purchase price adjustments are needed; however, such actions need to be agreed to 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 such that the buyer’s final purchase price is decreased as remuneration for the associated tax cost to buyer.

It should also be noted that in a transaction with a tax-deferred rollover (which is common when there is a pre-transaction F reorganization), the contribution of cash basis items (e.g., receivables and prepaids) will result in additional taxable income pick-up 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 seller via partnership allocations, are treated as indebtedness in the purchase agreement so that the buyer is recompensed via an adjustment to the purchase price.

As is the case for most things, getting out in front of these issues can make all the difference. Negotiating the cash basis prior to LOI execution avoids the obstacles later in the due diligence process and keeps the closing date on track.

In closing

Despite any perceived unpredictability, the current GovCon landscape is assured to see significant deal activity involving founder-owned and operated businesses in the middle market. With this comes new obstacles that buyers will need to maneuver. The best course of action for any buyer is to always negotiate the potential tax hurdles prior to providing a seller with an LOI for execution. Furthermore, buyers should be engaging M&A tax professionals as early as possible to identify any tax risks that pose a threat to the deal timeline. Doing so is optimal for combatting any unforeseen hazards.