Tax Refunds May be Available to Sellers in Transactions Closed in 2018 & 2019

BOSTON – The recently enacted Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) may present a unique opportunity for M&A sellers who closed transactions in 2018 and 2019 to monetize unexpected tax refunds arising from transaction expenses.

In M&A transactions, profitable target companies often generate a net operating loss (NOL) in the year of sale due to deductible, transaction-related expenses (e.g., deal bonuses, option cash-outs, and investment banking fees). Prior to the 2017 “Tax Cuts and Jobs Act” (“TCJA”), corporations could carryback these transaction-year NOLs to prior, tax-paying years, generating tax refunds. Purchase agreements typically (but not always) reserved such refunds for the benefit of the sellers.

The TCJA, however, eliminated loss carrybacks for tax years beginning after December 31, 2017. Thenceforth, transaction-related expenses could reduce the corporation’s taxable income for the year of the sale but could not be carried back to prior years. Unused deductions were typically carried forward (subject to the notorious Section 382 limitation) to reduce the corporation’s post-transaction income.

If few could foresee the COVID-19 pandemic, even fewer expected the CARES Act to reinstate the “old” NOL carryback rules for 2018, 2019, and 2020 (technically, for tax years ending before January 1, 2021). Sellers in M&A transactions closed in 2018 and 2019 may be retroactively eligible for a tax refund if (1) the transaction generated sufficient deductible expenses, and (2) the purchase agreement permits the sellers to claim a refund generated by a carry back of those expenses to prior years. Don’t forget that a carryback to 2017 or earlier saves a 35% corporate tax (instead of the current 21%), making a carryback valuable indeed.

It’s relatively straightforward to identify if a transaction closed in 2018 or 2019 and determine whether deductible transaction expenses exceeded that necessary to offset taxable income for the year of the transaction. It could be messy when one examines the purchase agreement to ensure it gives sellers access to a carryback-generated refund. Pre-TCJA, a well written purchase agreement would not only give sellers the right to such a refund, but also (1) prohibit the buyer from waiving the carryback right or a cash refund (which a corporation could otherwise to convert a carryback refund into a refund or credit for post-transaction years), and (2) require the buyer to exercise reasonable diligence in seeking the refund (necessary because it’s the corporation itself, and not the sellers, who must apply for the refund). Post-TCJA, when purchase agreements were negotiated under the assumption that carrybacks were no longer allowed, there may be general pro-seller tax refunds language, but the other fine detail may be absent or ambiguous. In all events, the purchase agreement needs to be dusted off and given a good, hard look.

After establishing the sellers’ legal rights under the purchase agreement, they must still get the buyer to cooperate, even if reluctantly. The buyer may have to recompute taxable income for a consolidated or multi-national group and amend 2018 and 2019 tax returns. The silver lining is that a carryback loss worth 35% (instead of 21% if carried forward by the buyer) may be the tax-efficient outcome for all parties, which could get the buyers to the table.

All that said, re-examining transactions closed in 2018 or 2019 for valuable NOL carrybacks may be a very smart investment. But do not procrastinate – statutes of limitations clocks are ticking, and buyers who already filed corporate tax returns for 2019 may be less inclined to cooperate. Plus, found-money like an unanticipated tax refund may come in handy during this time of societal, and economic, uncertainty.

As always, this summary is for informational purposes only and is not tax or legal advice. Always consult a professional tax advisor for advice in light of a taxpayer’s particular circumstances.

For further information regarding stock options, deferred compensation plans, or other types of executive compensation and incentives, please contact:

Benjamin Damsky
(617) 918-7084
BDamsky@BlaisTaxLaw.com

Travis Blais
(617) 918-7081
TBlais@BlaisTaxLaw.com

Michael Lieberman
(617) 918-7083
MLieberman@BlaisTaxLaw.com