Accounting firm transactions often involve complex tax considerations, and it is important to understand their implications. If you have any questions on this article, please do not hesitate to reach out to
This article—part of our ongoing series on tax issues in accounting firm M&A—focuses on two critical topics that arise in private equity ("PE") platform deals: anti-churning rules and debt-financed distributions. These issues are particularly relevant when structuring transactions to preserve tax benefits such as the passthrough entity tax ("PTET"), which was the focus of one of our prior articles.
Anti-Churning
Background.
Before 1993, purchased goodwill was not amortizable for tax purposes.1 The Omnibus Budget Reconciliation Act of 1993 changed this by allowing amortization of purchased goodwill under Section 197 of the Internal Revenue Code of 1986, as amended (the "Code"). However, to prevent taxpayers from converting non-amortizable goodwill into amortizable goodwill through related-party transactions, Congress enacted the anti-churning rules under Code Section 197(f).
The anti-churning rules generally apply when (i) goodwill created before August 10, 1993 is sold to a related party2, and (ii) the seller retains more than 20% of the buyer's entity post-transaction. If the anti-churning rules of Code Section 197(f) apply, then the buyer in a transaction will not be able to get a step-up in the tax basis in the goodwill purchased and will not be able to utilize the associated amortization deductions from such step-up in the purchased goodwill.
This is especially relevant in platform transactions, where sellers often roll over significant equity. In contrast, add-on transactions typically involve smaller rollover percentages and are less likely to trigger anti-churning.
Exception: Code Section 754 Election.
A key exception to the anti-churning rules applies when a buyer acquires partnership interests and makes a Code Section 754 election, allowing a step-up in the basis of the partnership's assets—including goodwill. In this case, the benefit of the step-up accrues solely to the buyer, and therefore the anti-churning rules do not apply—even if the seller retains more than 20% equity. In an asset sale transaction, it is possible for the seller to benefit from the step-up in goodwill as it is not solely allocated to the buyer but to all owners of the buyer entity, including the sellers.
Due to these differences, under an equity sale of partnership interests, the reasonings behind the anti-churning rules are not present, since only the buyer can receive the benefits and the sellers would not get any goodwill tax basis step-up benefits from its continued ownership of the remaining interests in the tax partnership, even if they are over 20%.
Application to Accounting Firm Platform Deals.
We will now discuss how the transaction structure discussed for platform PE transactions in the prior article interacts with these anti-churning rules. Assuming that the accounting firm target ("Target") has both an attest and non-attest business, one aspect that is always present in any structure is to create an alternative practice structure ("APS") to separate the attest business which generally can't be owned by non-CPAs (i.e., can't be owned by the PE buyer directly) and the non-attest business which can be owned directly by the PE buyer.
The formation of the APS in a platform accounting deal is generally accomplished by the current accounting firm forming a new limited liability company subsidiary ("Non-Attest Sub") and contributing all of the non-attest assets to the Non-Attest Sub. The Non-Attest Sub will generally be treated as a disregarded entity at this time and would remain so prior to the transaction if there are no anti-churning issues present in the transaction.
If there are anti-churning issues, then the Non-Attest Sub will need to spring into a tax partnership prior to the transaction with the PE buyer in order to take advantage of the exception to the anti-churning rules. This can be accomplished via the Target distributing out a 1% pro rata interest in the membership interests of Non-Attest Sub to the current partners in the Target, which will result in the Non-Attest Sub becoming a tax partnership, with 99% owned by Target and 1% owned by the partners of Target directly.3
The PE buyer will then buy a portion of the Non-Attest Sub partnership interests with Target retaining the remainder of the interests in Non-Attest Sub for the rollover component of the consideration.4 The Target would then distribute out the remaining membership interests in Non-Attest Sub to Target's partners for the rollover interest in Non-Attest Sub. In connection with the filing of the tax return of Non-Attest Sub for the year of the sale, a Code Section 754 election would be made in order to provide the PE buyer with the step-up in the underlying assets of Non-Attest Sub, including the goodwill.
This structure should still allow for PTET qualification as discussed in more detail in the prior article, as the Target under this structure would be still be selling the interests of Non-Attest Sub. Under the APS, the attest business must remain owned by CPAs.5 Therefore, the Target would generally stay around as the attest business going forward. As discussed in the prior article, this is helpful for the application of the PTET to these types of transactions, as generally the Target has already filed the applicable PTET elections required during the year so that the gain from the sale of the Non-Attest Sub can qualify for PTET.6
Debt Financed Distributions.
Most PE platform transactions include debt financing by the platform entity to fund part of the purchase price for the transaction. This debt financing can be structured to help reduce some of the immediate taxation on the purchase price associated with part of the debt financing and can be structured to help buyer on anti-churning issues.
General Tax Principles.
Under Code Section 752, a partner's share of liabilities of the partnership increases the partner's tax basis in their partnership interest. Under the Treasury Regulations for Code Section 752, nonrecourse liabilities are allocated to the partners based on the partner's share of the partnership profits. Distributions from a tax partnership are generally tax-deferred under Code Section 731 to the extent that the partner has tax basis in their tax partnership interests.
Therefore, to the extent that a tax partnership borrows money and makes distributions pro rata to its partners, such a transaction can generally be accomplished in a tax-deferred manner provided that the liabilities and distributions are both allocated to the partners pro rata based on their profit percentages.
Under Code Section 707(a)(2)(B), in connection with a contribution of assets to a partnership, there can be what is called a "disguised sale" of the assets by the contributor to the partnership, if the contribution has an associated distribution of cash from the partnership to the contributor. However, there is an exception to the disguised sale rules for debt financed distributions7 to the extent that the debt financed distribution does not exceed the amount of such liability that is allocated to the partner under Code Section 752.
Under both of these scenarios, the debt distribution is not currently taxable, but it does result in potential for future gain when the liability is reduced resulting in a deemed distribution under Code Section 752. Therefore, a future dilution of profits in the partnership, including via a sale of partnership interests to a buyer, will result in gain to the partner to the extent of the reduction in liabilities that are allocated to that partner.
The debt distribution also has a tie in with the anti-churning issue that was discussed in the previous section. If the debt distribution occurs prior to a transaction, then the triggering of the gain from the release of the liability is considered part of the purchase price to a buyer, and eligible for a step-up under the Code Section 754 election. If the debt distribution occurs after the buyer has purchased the interests, then the gain on the distribution recognized by the selling partners is a step-up in goodwill that is allocable to the partnership and all of the partners and not just to the buying partner under Code Section 754. If there are anti-churning issues, this can then nullify the portion of the step-up associated with gain from the debt distribution if not structured properly.
Application to Accounting Platform Transactions.
In most PE accounting platform transactions, there is debt financing for at least part of the purchase price. Therefore, the principles of the debt financed rules are important for both the seller to reduce the amount of current tax and for the buyer to get all of its step-up if there are anti-churning issues.
For purposes of this discussion, we will assume that there are anti-churning issues, and therefore, the above structure of having Non-Attest Sub be converted to a tax partnership prior to sale transaction. Under this structure, the debt will be borrowed at the Non-Attest Sub8 level, distributed from Non-Attest Sub 99%9 to Target and 1% to partners for their direct interest in Non-Attest Sub, with the 99% then being distributed out from Target to its partners.
The first issue present in this structure will be whether or not there is a disguised sale as part of the formation of Non-Attest Sub as a tax partnership and the distribution of the debt financing from Non-Attest Sub to Target. As noted above, a debt distribution is not considered to be a disguised sale if the amount of the debt distribution does not exceed the amount of liability associated with such debt distribution allocated to the partner under Code Section 752.
Generally, when making this distribution, a pro rata distribution will be made to the 99% owner of Non-Attest Sub, Target, and 1% to the direct partners. Target should be allocated 99% of the liability under Code Section 752 with 1% of the liability allocated to the direct partners, such that there should not be a disguised sale on the initial debt distribution.
The liabilities should be further allocated under Code Section 752 from Target to the partners of Target based on their profit percentage in Target. Assuming that the distributions from Target to the partners are made pro rata to such partners, then the partners should not recognize taxable income on the actual distribution of the debt proceeds.
However, when the PE buyer purchases their share of the Non-Attest Sub from Target, this will cause an additional gain equal to the portion of the debt distribution equal to the percentage of Non-Attest Sub interests sold. If the Target and ultimately partners receive a distribution of $10 million from debt proceeds and end up selling 60% of Non-Attest Sub, $4 million of the debt distribution should be tax deferred until a later time and $6 million of the debt distribution will be recognized at close.
Ordering the debt distributions in this manner also has a beneficial effect for the PE buyer. Under the above structure, the PE buyer is treated as having purchased the portion of the debt distributions that are recognized by the Target and partners, with such amounts being eligible for a step-up in tax basis under a Code Section 754 election.
This is contrasted to if the debt proceeds were distributed after the PE buyer already had purchased its 60%.In that scenario, the Target and partners would only be allocated $4 million from the debt distribution, with the remaining $6 million being taxable as either a disguised sale of assets or a redemption payment.
In either case, that $6 million would not be eligible for a Code Section 754 election allocation directly to the PE buyer and should result in a step-up in basis in the assets of Non-Attest Sub generally. Assuming that there is an anti-churning issue present in the transaction, this step-up would then not be eligible under the anti-churning rules as it did not meet the Code Section 754 exception on a purchase of partnership interests.
The above are a couple of important items that should be considered in any PE accounting platform transaction. The corporate and tax attorneys at Levenfeld Pearlstein have vast experience advising professional service firms on exit strategies and PE buyers on platform formation. For more information, please contact Matthew Hinderman at
[1] Self-created goodwill is still not amortizable. Although beyond the scope of this article, the remaining need for anti-churning rules discussed below seems somewhat arbitrary at this point, as sellers could "churn" self-created goodwill that was not subject to amortization currently as long as the goodwill was created after August 10, 1993. Hopefully, as some point, Congress will see fit to repeal anti-churning as its effects can generally be circumnavigated, but doing so adds additional complexity and costs to transactions.
[2] The anti-churning rules contain complex constructive ownership rules that need to be analyzed to determine whether the sale is to a related party.
[3] Alternatively, the 1% of Non-Attest Sub could be contributed to a new LLC and the new LLC membership interests distributed out to the partners of Target. This may facilitate an easier transaction from a corporate perspective as none of the partners would be individual owners at the time of the transaction, thus needing to be parties to the purchase agreement. The new LLC could be liquidated and such interests in Non-Attest Sub distributed to the partners after the transaction.
[4] If transactions that are partially financed by debt, prior to this step there would be a debt distribution, as will be discussed in more detail in the following section of this article.
[5] Although beyond the scope of this article, generally the Non-Attest Sub would enter into a management services agreement with the remaining attest entity pursuant to which much of the value would be allocated to the Non-Attest Sub and away from the attest entity.
[6] For certain states, such as New York, the election must be filed by March 15 of the year in which the sale occurs in order to apply for PTET for the year. If a new tax partnership were required to be formed due to a different structure being utilized, and such tax partnership was formed after such election period has lapsed, it could be more difficult to qualify for PTET on the sale.
[7] Treasury Regulation Section 1.707-5(b).
[8] The debt may be incurred at a lower tier entity that is wholly owned by Non-Attest Sub, but for tax purposes, this would still be treated as Non-Attest Sub being the borrower on the debt obligation.
[9] This refers to the net debt, after the gross amount from the debt has first been used to pay off existing debt and other liabilities of Non-Attest Sub and/or Target, with remainder being used as additional cash proceeds at close to the partners.
