Corporate acquisition issues.

In today's economy, many business owners--both large and small--are considering buying other companies or selling the one they own. A recent case addresses some of the issues that may arise when the acquisition is structured to take advantage of opportunities in the financial market.

Jordan Co. negotiated the purchase of the stock of Custom Chrome from its owner, Tyrone Cruze. Jordan structured the acquisition as a leveraged buyout with a covenant not to compete. To obtain the loan, Jordan gave the lenders warrants to purchase stock at $500 per share, the current market price. Jordan paid $650,000 in legal and professional fees related to the acquisition. The Tax Court decided the covenant not to compete was valid and amortizable over its three-year life; however, the expenses associated with the acquisition were nondeductible and the warrants had a zero fair market value, creating no original issue discount (OID). The taxpayer appealed the last two decisions.

Result. In part for the IRS and in part for the taxpayer. The Ninth Circuit Court of Appeals upheld the Tax Court decision denying a deduction for the acquisition-related expenses. Although the transaction was a purchase of stock, it was structured as a leveraged buyout. Specifically, the acquiring corporation formed a subsidiary that, in turn, created a second-tier subsidiary, which borrowed the purchase price. The first-tier subsidiary bought the stock with the borrowed funds and then merged the second-tier subsidiary into the acquired company. At the end of the transaction, the shareholder had cash from a loan that was housed in his former corporation (a second-tier subsidiary of the acquiring corporation).

The Tax Court classified the end result as a stock redemption by the acquired corporation using the step transaction doctrine. The court treated the transaction as if the target company borrowed the funds and used them to purchase (redeem) the shareholder's stock. Since the substance of the transaction was a stock redemption, all related expenses are governed by IRC section 162(k,) which denies a deduction for all redemption expenses except those directly related to any loans. The result was that the $650,000 of legal and professional fees was nondeductible.

When warrants or options are part of a loan package, part of the proceeds is allocated to the warrants, creating OID, which is amortizable over the life of the loan. The amount allocated to the warrants is the value of those warrants at the time of issue, not at exercise, as the taxpayer tried to argue.

The Tax Court assigned a zero value to the warrants primarily because they were "at the money" when issued--the exercise price of the warrants was equal to the current market price of the underlying security. Secondarily, the lender booked the warrants at a nominal value of $1,000 and the taxpayer did not amortize any OID on the tax returns originally filed.

The Ninth Circuit rejected the Tax Court's basic reasoning that at-the-money warrants have no value. The court said that while the warrants have no intrinsic value (the bargain element in a stock purchase) they still can have a time value--a measure of the expected increase in value caused by increases in the stock's value during the time the warrants can be exercised. The appeals court quickly dismissed the Tax Court's consideration of how the lenders booked the warrants and the taxpayer's failure to amortize the amount as immaterial. This part of the case was remanded to the Tax Court to determine the value of the warrants based on valuation techniques that might include the Black-Scholes formula, comparable warrants or the present value of earnings that may be acquired through exercise of the warrant.

Although the value of the warrants is still to be determined, this case addresses several issues that can surround a corporate acquisition that, on paper, seems to be a simple stock purchase.

* Custom Chrome, Inc. vs. Commissioner, 86 AFTR.2d [paragraph] 2000-5039 (CA-9).

--Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.