Leveraged Buyouts and Tax Incentives

Article excerpt

* Leveraged buyout activity increased from 99 transactions worth $3 billion in 1981 [18] to peak 338 transactions worth over $61 billion in 1989 [19]. Suggested motivating forces for corporate acquisitions include non-value-maximizing behavior on the part of managers, the free cash flow problem, tax incentives, deregulation, synergies, economies of scale and scope, and increasing globalization of U.S. markets ([2], [9], [10], [13], and [22]). However, of this list, tax incentives are the most frequently discussed motivation for corporate acquisitions, especially in leveraged buyouts ([4], [8], [9], [10], [13], [14], and [20]). Kaplan [14] estimates the median value of tax benefits in management buyouts of public companies to be anywhere from 21% to 143% of the premium paid to pre-buyout shareholders. Hayne [8] shows the use of tax shields, that would not be fully utilized in the absence of an acquisition, is significant in explaining the gains to target firms' shareholders as well as to the acquiring firms. The step-up in the basis of asset, in particular, is significant in explaining these gains in taxable acquisitions (Hayne [18]).

The purpose of this study is to investigate the tax incentives to managers of leveraged buyouts by estimating the change in taxes paid by a firm due to a leveraged buyout. Kaplan [14] estimated the tax change for management buyouts according to tax rules existing before the 1986 Tax Reform Act (TRA '86) and on the basis of static rules, such as the repayment of debt in eight equal principal payments. Our study estimates that change in taxes paid by 23 of the largest leveraged buyouts in the years 1988, 1989 and 1990. The estimates are made under four different tax structures. First, the change is estimated according to two possible acquisition structures allowed under TRA '86 rules. Then, it is estimated again assuming the buyout can be structured to preserve the "General Utilities" treatment repealed by TRA '86. Finally, as a reference point, the change in taxes is estimated under a structure that would mimic pre-TRA '86 rules. Under each structure, the reduction in taxes to the leveraged buyout is expressed as a percentage of the acquisition premium and also as a present value at the time of the buyout. The first section of the paper briefly explains tax treatment of leveraged buyouts and describes the significant changes brought about by the TRA '86. The second section explains the method used to estimate the reduction in taxes paid by a firm due to a leveraged buyout. The third section presents the results of the estimation, and the fourth section offers a summary and conclusions.

I. Tax Background

Before TRA '86, the General Utilities [7] doctrine allowed no gain to be recognized by a corporation when it distributed assets in a liquidation under Section 336 of the Internal Revenue Code. Further, by suitable restructuring of the acquisition under Section 338, and despite nonrecognition of a gain, the acquiring corporation could step up the basis of the acquired assets, thus securing increased depreciation and reducing future taxes.

With congressional belief that the taxpayer was subsidizing leveraged buyouts, TRA ;86 repealed the General Utilities doctrine. Section 336 now requires that a gain be recognized by a liquidating corporation and in order to obtain a step-up in basis, achieved by a Section 338 election, there is a payment of capital gains taxes levied at the target level. Because TRA '86 also repealed the corporate capital gains tax, the applicable tax rate rose from 28% on an actual sale to 34% on a deemed or actual sale. After TRA '86,(1) in the simplest example with a stock sale and a Section 338 election, the tax payable would be 62% on the increment in value (34% on corporate gain plus 28% on stockholders as they are cashed out by the leveraged buyout). With other straightforward structures, such as a stock sale with no Section 338 election, the tax would be 28% (payable by the stockholders -- but the corporation could get no step-up in basis), and with an asset acquisition followed by complete liquidation (under Section 337), the tax would be 52. …