Tax Challenges Impacting the SPACs Boom

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters. Today is June 22, 2021, and the topic is the tax implications of SPACs, special purpose acquisition companies.

HOST: Before we delve in, let's introduce our colleagues.


SARAH MCGREGOR: This is Sarah McGregor, calling in from Greenville, South Carolina.


CHRIS TRUITT: This is Chris Truitt, transaction tax partner from Charlotte, North Carolina.


BARRY WEINS: This is Barry Weins, director in Tampa, Florida, in our professional practice group.


HOST: I'm Brooks Nelson, sitting in downtown Richmond, Virginia.

HOST: Sarah, how's life treating you?


SARAH MCGREGOR: Life is good. We're aiming toward the Fourth of July holiday, which means the first part of busy season is over. We've completed our compliance work, and it's time for South Carolina peaches.


HOST: I thought peaches were only in Georgia.


SARAH MCGREGOR: They have them in South Carolina, too.


HOST: Let's talk about SPACs. These are shell companies with limited investors and no business operations initially. They're also called blank check companies. They raise funds by going public, then acquire or merge with an operating business, which becomes public through the process.

HOST: SPACs can cut out much of the traditional IPO process, including some legal, registration, accounting, and disclosure burdens, but there are significant pros and cons. For context, in 2020 approximately 200 SPACs went public and raised about $64 billion, roughly comparable to the traditional IPO market. In 2021 so far, about 300 SPACs have gone public, a substantial increase in activity.

HOST: Some names you may have heard that went public through SPACs include Virgin Galactic, DraftKings, and Open Door. The mechanics look simple on the surface, but the tax consequences are complex.

HOST: Chris, what's happening in your world with respect to SPACs?


CHRIS TRUITT: SPACs are another vehicle, alongside private equity, that we see buying companies. We deal with them regularly. Some are formed by private equity groups to fund acquisitions. They provide a relatively easy way to raise capital, and acquisition volume has increased. We expect activity to continue unless the SEC imposes additional hurdles.

CHRIS TRUITT: There have been some roadblocks regarding warrants and valuation of warrants, but overall volume has picked up. SPACs act as another significant buyer in addition to traditional private equity.


HOST: At a high level, how do the tax issues compare for someone going into private equity versus SPACs?


CHRIS TRUITT: They raise very similar issues. A primary difference is how to obtain tax-deferred rollover equity. It's more complicated in the SPAC context. Typically, you use an up-C structure, which involves a partnership that can exchange partnership units for public company shares at a predetermined exchange rate. You generally must keep the partnership intact for rollover equity.

CHRIS TRUITT: In a traditional private equity rollover, you can usually exchange stock or partnership units for stock of the acquiring entity. The mechanics in the SPAC world often require more sophisticated structuring.


HOST: You mentioned up-C, akin to an up-REIT structure.


CHRIS TRUITT: That's exactly right. Partnership units often have an agreement allowing exchange for an equivalent number of publicly traded shares. When you exchange, you typically create a taxable event for the partner who exchanges units for shares. People use up-C structures when they want liquidity for rollover equity, and tax generally arises when units are exchanged or when cash is actually received from selling the shares.


HOST: Founders or sponsors create many of these SPACs. How are those individuals taxed?


CHRIS TRUITT: Founders typically issue themselves shares, and sometimes warrants, at very low cost when forming the SPAC. That initial issuance is a non-taxable transaction. The taxable value generally arises after the SPAC raises capital and completes an acquisition, which is when founder shares appreciate. It's somewhat akin to carried interest in private equity: little initial capital for a share of the upside. Taxation mainly occurs at a liquidity event.


HOST: Is there downside if founders can't find a suitable acquisition?


CHRIS TRUITT: Not really. Founders usually lose only a small amount of capital they invested because the SPAC must return investor funds before founders realize any liquidity from their shares.


HOST: Barry, what about investor tax consequences when they invest or when a target is acquired?


BARRY WEINS: Buying a SPAC share is generally like buying stock in any public company, so there's no immediate tax on purchase. The complication is that many SPAC shares include warrants or partial warrants. Part of the purchase price is allocated to the stock and part to the warrant. Investors should understand that allocation because warrants can start trading within 30 to 60 days, and selling warrants separately affects computation of gain or loss.

BARRY WEINS: Fees are usually paid by the company for seeking targets and other costs. If the SPAC fails to complete a transaction, investors generally get their money back in theory, but not all funds are returned because some amount will have been spent, leading to a loss.


HOST: The SPAC will file tax returns as a C corporation, correct?


BARRY WEINS: Yes. Most SPACs are C corporations because they're publicly traded corporations. Between formation and acquisition, SPACs often place raised funds in escrow accounts generating interest income, and certain acquisition costs may be capitalized. Prior to the acquisition, interest income may exist but typically is not significant. The acquisition of the target generally is not taxable to the SPAC, and after the deal you begin filing as a normal operating company.


HOST: Chris, for a private company that a SPAC founder approaches as a potential target, what should management and owners consider?


CHRIS TRUITT: Beyond tax, evaluate the credibility of sponsors and founders and their ability to grow the business and realize value. Sellers often seek liquidity and someone to help grow the business for future upside. From a tax perspective, have your tax matters in order and understand your structure.

CHRIS TRUITT: If you're a partnership or LLC taxed as a partnership and you want rollover equity, think about keeping the partnership intact and negotiating the exchange agreement with the SPAC. In up-C structures, exchange agreements can trade based on trading value, or they can include tax reimbursement arrangements. If a partner exchanges units for shares, the SPAC often gets a step-up in tax basis equal to the gain the partner recognizes, resulting in future tax deductions for the SPAC. Agreements can allocate some of those tax savings back to the seller.

CHRIS TRUITT: If you are not a partnership, consider how much cash you want versus rollover equity. These transactions can allow founders to liquidate some ownership while others, including management, retain equity and participate in future upside.


HOST: From a tax diligence standpoint, what should sellers prepare before SPAC due diligence?


BARRY WEINS: Conduct sell-side preparatory diligence for both financial and tax matters. Unresolved state and local tax issues, incorrect accounting methods, or missing filings can become significant deal problems. Many transactions use reps and warranties insurance, but insurers exclude known issues, so uncovered significant tax liabilities can kill a deal.

BARRY WEINS: Ensure you have performed a detailed nexus study, filed required returns, and entered into voluntary disclosure agreements where appropriate. Sales and use taxes and state and local income taxes should be addressed together; you can't generally do one without the other in a voluntary disclosure context. Clean up these issues before diligence because they often stall or derail deals.

BARRY WEINS: Also evaluate whether your current advisors can guide you through a complex SPAC merger or whether you need advisors experienced with such transactions.


HOST: Barry, on entity selection up front, if a founder is starting a private company with an ultimate strategy to be acquired by a SPAC, what entity should they choose?


BARRY WEINS: The optimal entity selection doesn't hinge solely on the exit strategy. Timing matters. For example, if you're a C corporation and qualify for Section 1202 and you hold stock for five years before a sale, you may get favorable exclusion. If you are a pass-through, an up-C structure may offer benefits. Consider how long before exit, whether you'll extract cash or reinvest, and other business factors; those drive entity selection more than the exit mechanism itself.


HOST: Chris, what role does location play for the SPAC itself?


CHRIS TRUITT: Location generally isn't significant for most U.S.-based SPACs. Most are U.S. public companies, often formed in Delaware, and they typically have no state filing requirements until they operate a trade or business. Foreign jurisdictions introduce more complexity, like PFIC or other international tax issues. As long as the SPAC is a U.S. company, many cross-border complications are avoided.


BARRY WEINS: We're seeing SPACs in Canada that aim to acquire cannabis-related businesses in the U.S. Cannabis companies face unique challenges because they are generally ineligible for listing on U.S. exchanges, so cross-border SPACs complicate investor tax reporting and taxation. If a SPAC is formed outside the U.S., U.S. investors may face different reporting obligations and tax outcomes than a typical domestic stock purchase.


HOST: What do you see on the horizon for SPACs and tax issues?


CHRIS TRUITT: SPACs are likely to remain active for a while. The SEC's regulatory actions, such as recent guidance on warrant valuation, could affect pace and structure. Tax issues are not fundamentally different from other acquisitions, but private companies entering the public reporting arena must rapidly scale their accounting and reporting capabilities to meet public company requirements.


BARRY WEINS: For investors, tax treatment is relatively straightforward, like buying stock. For founders, the key is getting founder shares at a low price. For targets, the de-SPAC transaction offers many structuring options, and there are correct and incorrect ways to execute them. Sellers should prepare for a much higher level of accounting and reporting frequency post-transaction, and ensure they can meet quarterly reporting and other public company obligations. SPAC founders should provide a team to assist, but sellers must understand the operational demands.


SARAH MCGREGOR: SPACs are an additional vehicle to move private companies into the public markets faster and more efficiently, with similarities to private equity transactions. Planning and professional assistance are essential to avoid major missteps.


HOST: This concludes our discussion on special purpose acquisition companies. A quick disclaimer: we are not providing tax advice in this podcast. Please consult your tax advisor, preferably at Cherry Bekaert, about your specific tax issues or information from today's podcast.

HOST: Visit cbh.com for the latest guidance and materials on this and other tax and business topics. We have a three-part series of articles on SPAC transactions written by today's guests, Barry and Chris, which provide greater depth than today's discussion.

HOST: Thank you, Chris, Barry, and Sarah, and thank you to our listeners for spending time with us. Let's call it a day.