The Sysco Merger and the Double Dummy

Recently a financial advisor called me to discuss investments and, more specifically, Sysco’s acquisition of U.S. Foods.  I had to read up on what he was talking about.

The Sysco deal is a reverse triangular merger. It is not hard to understand, although the terms the tax attorneys and CPAs throw around can be intimidating. Let’s use an example with an acquiring company (let’s call it Big) and a target company (let’s call it Small).

·        Big creates a subsidiary (Less Big).

·        Less Big merges into Small.

·        Less Big ceases to exist after the merger.

·        Small survives.

·        Big now owns Small.

Voila!

This merger is addressed in the tax Code under Section 368, and the reverse triangular is technically a Section 368(a)(2)(E) merger. Publicly traded companies use Section 368 mergers extensively to mitigate the tax consequences to the companies and to both shareholder groups.

In an all-stock deal, for example, the shareholders of Small receive stock in Big. Granted, they do not receive cash, but then again they do not have tax to pay. They control the tax consequence by deciding whether or not to receive cash (up to a point).

Sysco used $3 billion of its stock to acquire U.S. Foods. It also used $500 million in cash.

And therein is the problem with the Section 368 mergers.

It has to do with the cash. Accountants and lawyers call it the “basis” issue. Let’s say that Sysco had acquired U.S. Foods solely for stock. Sysco would acquire U.S. Foods' “basis” in its depreciable assets (think equipment), amortizable assets (think patents) and so on. In short, Sysco would take over the tax deductions that U.S. Foods would have had if Sysco had left it alone.

Now add half a billion dollars.

Sysco still has the tax deductions that U.S. Foods would have had.

To phrase it differently, Sysco has no more tax deductions than it would have had had it not spent the $500 million.

Then why spend the money? Well… to close the deal, of course. Someone in the deal wanted to cash-out, and Sysco provided the means for them to do so. Without that means, there may have been no deal.

Still, spending $500 million and getting no tax-bang-for-the-buck bothers many, if not most, tax advisors.

Let’s say you and I were considering a similar deal. We would likely talk about a double dummy transaction.

The double dummy takes place away from Section 368. We instead are travelling to Section 351, normally considered the Code section for incorporations.  

 

Let’s go back to Big and Small. 

·        Big and Small together create a new holding company.

·        The holding company will in turn create two new subsidiaries.

·        Big will merge into one of the subsidiaries.

·        Small will merge into the other subsidiary.

In the end, the holding company will own both Big and Small.

How did Small shareholders get their money? When Big and Small created the new holding company, Small shareholders exchanged their shares for new holding company shares as well as cash. Was the cash taxable to them? You bet, but it would have been taxable under a Section 368 merger anyway. The difference is that – under Section 362 – the holding company increases its basis by any gain recognized by the Small shareholders.

And that is how we solve our basis problem.

The double dummy solves other problems. In a publicly traded environment, for example, a Section 368 merger has to include at least 40% stock in order to meet the continuity-of-interest requirement. That 40% could potentially dilute earnings per share beyond an acceptable level, thereby scuttling the deal. Since a double dummy operates under Section 351 rather than Section 368, the advisor can ignore the 40% requirement.

The double dummy creates a permanent holding company, though. There are tax advisors who simply do not like holding companies.

Sysco included $500 million cash in a Section 368 deal. Assuming a combined federal and state tax rate of 40%, that mix cost Sysco $200 million in taxes. We cannot speak for the financial “synergies” of the deal, but we now know a little more about its tax implications.

Lawsuits, Attorney Fees and What Is A “Relator” Anyway?

I have a friend who was considering employment litigation earlier this year. His job has sufficient visibility that it attracts people – some unpleasant and others unhinged. Couple that with a political-correctness-terrified employer and you have a combustible mix.

The taxation of litigation damages leaves room for improvement. Certain types of litigation – say personal injury or employment – are commonly done on a contingency basis. This means that the attorney does not receive fees unless the case is successful or settled. A common contingency fee is one-third. A rational tax system would recognize that the litigant received 67 cents on the dollar and assess tax accordingly. Our system does not do that.

Our tax Code wants to tax the litigant on the full proceeds, although one-third or more went to the attorney. The Code does allow one to deduct that one-third as a miscellaneous itemized deduction. It sounds great but many – if not most – times it amounts to nothing. Why? 

·        Miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of your adjusted gross income (AGI). Swell that AGI to unrepresentative levels - say by the receipt of damages – and that 2% can amount to a high hurdle.

·        Even that result can be overridden by the alternative minimum tax (AMT). The AMT does not allow miscellaneous deductions at all. Forget about deducting that contingency fee if you are an AMT taxpayer, which you likely will be.

·        Then you have states, such as Ohio, which do not allow itemized deductions. The damages are sitting in your AGI, though. It stinks to be you.

How did we get to this place?

We know that the tax Code allows one to deduct business expenses against related business income. There may be restrictions – entertainment expenses, for example, or limitations on depreciation – but overall the concept holds. The result of this accounting exercise enters one’s tax return as net profit or loss.

But not always.

For example, I am in the trade or business of being an employee of my accounting firm. My salary enters my individual tax return as gross income. What if I have business expenses relating to the practice?  The IRS allows me to deduct those, but not directly against my salary. The IRS instead wants me first to itemize and then claim my accounting-practice expenses therein as a miscellaneous deduction. Miscellaneous deductions are the redheaded stepchild of itemized deductions. They are never deductible in full, and depending on one’s situation, they may not be deductible at all.

Extrapolate this discussion to the recipient of a legal settlement and you have the issue I have with accounting-practice expenses – but greatly magnified, as the dollars are likely more substantive.

So I was pleased to review the case of Bagley v United States.

Richard Bagley had an MBA and a M.S. in accounting. He worked for TRW Inc, and from 1987 to 1992, he was the Chief Financial Manager for their space and technology group. TRW did a lot of work for the government, meaning they had to follow certain accounting procedures when requesting payment from the government. Remember that Bagley was in charge of the accounting, and you have a good idea of where the story is going.

Bagley became aware of bad accounting. He nonetheless signed certifications to the government, mostly because he needed the job. He did the good soldier thing and reported his concerns to his superiors. TRW in turn notified him that he was going to be laid off because of a corporate reorganization, rising tides, Punxsutawney Phil not seeing his shadow and the Chicago Cubs missing the World Series.

He was laid off in 1993.

In 1994 he brought a wrongful termination lawsuit against TRW.  He lost that lawsuit.

In that same year, he filed a False Claims Act (FCA) on behalf of the United States against TRW.

There is a peculiarity about a FCA lawsuit that we should discuss. Although Bagley brought the FCA lawsuit, the action was technically brought by the United States against TRW for fraud. Bagley stood-in as an agent for the United States, and his status was that of “relator.”

Bagley took this matter seriously.

During the 1994 to 2003 time period, Bagley exclusively worked on his FSA prosecution activity, and was not otherwise employed.”

He maintained a contemporaneous log of hours he worked on the litigation. He attended meetings with his attorney and government counsel. He spent a lot of time looking through TRW documents. He stayed involved because the attorneys

… weren’t accountants and hadn’t spent 25 years working with TRW and didn’t have an in-depth understanding of TRW’s accounting system or the people or the products or anything about the company which was  necessary to understand how the frauds occurred and where the evidence was.”

He logged approximately 5,963 hours working on the FCA. He put in those hours 

… in order to successfully prosecute the claims so that [he] would receive an award.”

In 2003 TRW paid the government, which in turn paid Bagley $27,244,000. He in turn paid his attorney $8,990,520. TRW also paid Bagley’s attorneys $9,407,295 and issued the Form 1099 to Bagley.

NOTE: This is standard treatment. The payment to the attorney is imputed to the litigant.

He filed his 2003 Form 1040. There was some complexity on how to handle the attorney fees paid directly by TRW, so he amended the return. He went the usual route of deducting the attorney fees as a miscellaneous deduction. He amended a second time, this time showing the relator litigation as Schedule C self-employment income. He was now deducting the attorney fees directly – and fully - against the litigation proceeds.

The IRS bounced the seconded amended return.

There really was only one issue: did Bagley’s litigation activity rise to the level of Bagley being self-employed?

The Court went through the analysis:

·        Pursuing the activity in a business-like manner

·        Expertise

·        Time and effort expended

·        Success in carrying on similar activities

·        History of income and losses with respect to the activity

·        Financial status while pursuing the activity

·        Elements of personal pleasure or recreation

·        Regularity and continuity

The IRS argued along different lines. They reminded the Court of the origin and character of the activity giving rise to the FCA claim. Bagley’s claim was that of an informant, according to the IRS, not that of a relator prosecuting the case. According to them, it was Bagley’s status as an informant, not his activities as a relator – that drive the tax consequence.

The Court decided that an action under the FCA was different from a tort action, as the “gravamen” of a FCA action was fraud against the government. The relator stands in the shoes of the government in order to prosecute the claim. This consequently was not a personal claim that Bagley had undertaken. He had no personal stake in the damages sought – all of which, by definition, were suffered by the government.

The Court decided that Bagley did have a trade or business, and that the second amended return was correct. The government was to refund him approximately $3,874,000 plus interest for his 2003 tax year.

Note the tax year involved: 2003. This case was decided just this summer. Sometimes these matters take a while to resolve, but this was an especially slow boat on a lazy river.

OBSERVATION: The facts are too unique for this case to provide much precedence, but I am pleased that Bagley won. Frankly, a minor change to the tax law would make this case obsolete and remove the tax nightmare from future litigation settlements. Simply allowing the litigant to recognize the net damages as income would solve this matter. It would also reflect the equity of the transaction. Do not hold your breath, though.

Merry Christmas