The public offering vehicle known as a special purpose acquisition corporation (SPAC)—also called a blank check company—has again become a popular way for companies to pursue an initial public offering (IPO).

While SPAC transactions can offer many benefits, there are several tax and operational considerations private companies should analyze before pursuing a transaction, such as:

• What’s a SPAC and how does it work?
• How might a SPAC be structured?
• What happens to SPAC stock after a merger?
• What are tax-loss carryforwards and circular basis rules?
• How are SPACs taxed?
• How does a merger impact SPAC executive and management compensation?
• What are administrative issues to consider during a transition?

Below, learn key tax challenges and opportunities related to SPAC transactions and best practices SPACs and target companies can apply to stay compliant.

What’s a SPAC and How Does One Work?

A SPAC is a type of shell company or other investment vehicle formed to raise money from investors through an IPO. The SPAC is then used to acquire private companies, known as target companies, without having to go through a formal IPO process.

At the time of the IPO, SPACs typically don’t have existing business operations. The SPAC’s purpose is to identify and acquire businesses that meet the SPAC’s investment objectives. The private operating target company effectively becomes a publicly traded company, generally via a merger transaction.

Outcomes of a SPAC Merger

Merging a target company—a private entity—into a SPAC with nominal net assets typically results in two outcomes:

1. The owners of the target gain control over the combined entity after the transaction.
2. The shareholders of the former SPAC continue only as passive investors.

This transaction isn’t usually considered a business combination under Accounting Standards Codification (ASC) Topic 805 because the accounting acquiree, the nonoperating SPAC, doesn’t meet the rule’s definition of a business.

Instead, these types of transactions are generally considered to be capital transactions of the legal acquiree and are equivalent to the issuance of shares by the target company for the net monetary assets of the SPAC accompanied by a recapitalization.

Learn more about SPACs mergers, including disclosure requirements and auditing practices, in our article, SPAC Transactions: Accounting and Reporting Considerations.

How Might a SPAC Be Structured?

For corporate income tax purposes, a SPAC transaction could be structured one of three ways:

1. Taxable transaction in which shares of the target are exchanged for cash
2. Tax-free reorganization under Section 368 as a share-for-share exchange
3. Partially tax-free and partially taxable

To reduce the risk of unintended consequences, prior to signing a binding SPAC transaction agreement, it’s highly recommended that a target company pursue a consultation with a corporate tax specialist who’s familiar with tax-free reorganizations and complex corporate transactions. Depending on the structure of the transaction, there can be a number of additional complicated issues that need to be considered. 

For example, in some instances, companies spin out of an existing consolidated group. It’s  always important to consider historical issues of the target, including consolidated return rules, basis of the target before and after the SPAC transaction, research credit implications going forward, and state and local tax implications.

What Happens to SPAC Stock After a Merger?

In a taxable transaction, it’s common for the target company to compensate its employees by allowing the ability to exercise, or treat as exercised, vested employee stock options at the time of the transaction. This provides employees with some liquidity.

In some transactions, the target’s sellers might negotiate a provision where the seller of a business will receive additional payments based on the future performance of the business sold. This is known as an earnout provision.

If the earnout provision includes employee stock options, with the intent of providing those employees with some liquidity, the employer should be cautious of including stock options in the earnout provision because SPAC and other business acquisitions by public companies could require a lock-up period.

What’s a Lock-Up Period?

A lock-up period is the number of days after an IPO, during which time shares can’t be sold by company insiders. Lock-up periods typically apply to a company’s insiders, such as founders, owners, managers, and employees, but may also include investors.

If earnout provisions haven’t been met yet and employees receive earnout payments in the form of shares in the public company, the employees could have compensation to recognize the tax obligation, but, due to the lock-up, might not have the corresponding cash to pay it. 

Tax-Loss Carryforwards

Corporation tax-loss carryforwards generated by the target company are typically carried forward and available for use against post-transaction SPAC taxable income subject to limitations.

What’s a Section 382 Limitation?

One limitation is provided in Internal Revenue Code (IRC) Section 382, which limits the future use of net operating losses (NOLs).

Under Section 382, a change in ownership occurs when one or more 5% shareholders increase their ownership share in the company by more than 50% during a three-year period. If a SPAC enters into a transaction and triggers a Section 382 ownership change, the value of the NOLs and credit carryforwards could be significantly impaired.

To learn more about the potential complexities of Section 382, please read our article.

Is a SPAC Subject to State and Local Taxes?

It’s important to consider whether the SPAC should be registered in the state of its office address or the state where its employees work or reside. If it’s determined the SPAC has created economic nexus as a result of the merger transaction, it should consider registration or related income-tax filing.

The target must also consider whether the SPAC transaction might impact its state tax registrations or filing needs.

For more information on state and local taxes, please visit our state and local tax webpage, tax planning resources, and spotlight on economic nexus.

How Are SPACs Taxed?

The funds a SPAC raises are typically held in a trust or escrow account that will generate interest or dividend income. They’re used to cover the costs of identifying a target and for general administration. The interest and dividend income is taxable income, and typically there are few tax deductions incurred by the SPAC that might offset the taxable income mentioned below.  

Costs incurred to start a business are generally required to be capitalized under Sections 195 and 248. Once the SPAC completes a deal, the capitalized costs are amortized over a 15-year period. Prior to amortization, these costs can’t be used to offset taxable income generated by the SPAC.

How Do SPACs Incur Transactions Costs?

SPACs incur transaction costs in the normal course of doing business. These transaction costs must be analyzed and categorized as facilitative or nonfacilitative costs because the tax treatment differs. This applies to the target as well; if the private operating entity incurs transaction costs, the same process should occur.

Facilitative Costs

Facilitative costs are incurred when a transaction is investigated or pursued. In general, taxpayers must capitalize costs that facilitate a transaction.

Nonfacilitative Costs

Costs are nonfacilitative if they’re incurred in the course of investigating or pursuing an acquisitive transaction and before the bright-line date—typically the date the letter of intent with the target is executed. Most transaction costs incurred by a typical SPAC are facilitative, unless the transaction doesn’t go through.

What’s a Success-Based Fee?

A success-based fee is contingent on the successful closing of a transaction. Success-based fees are generally considered facilitative. However, Revenue Procedure 2011-29 provides a safe harbor and allows 70% of the success-based fee to be treated as nonfacilitative and deductible for tax purposes.

The tax deduction may be immediate or amortized over 15 years depending on whether or not the SPAC is already in the same trade or business as the target.

SPAC Executive and Management Compensation

Management incentive and deferred compensation plans should be analyzed for compliance with applicable tax rules; this includes certain provisions applicable to public companies that may limit tax deductions such as Sections 162(m) and 280G.

Section 162(m) Limitations

Section 162(m) limits the annual compensation deduction of certain executives when it exceeds $1 million annually.

Section 280G Limitations

Section 280G—also known as golden parachute payments—can cause certain highly compensated individuals’ compensation to be nondeductible if there’s a change in control. Section 280G can also create a 20% excise tax liability to the highly compensated individual.

Administrative Issues to Consider During Transition

Information reporting should also be on the radar. For example, Form 1099, Form W-2, and bank account administrative reporting will need special considerations.

The target company may be legally dissolved at the time of the merger transaction. As such, there will be predecessor and successor legal entities holding the employees.

Combined W-2 Reporting

Revenue Procedure 2004-53 provides for combined W-2 reporting in the year of the transaction, if certain requirements are met. This revenue procedure, if relied upon, could help simplify the employment information reporting process.

Combined Predecessor-Successor Reporting

Similarly, Revenue Procedure 99-50 provides combined predecessor-successor information reporting of Form 1099 transactions if certain requirements are met.

Additionally, there are predecessor-successor complications when carrying out postmerger banking transactions due to financial institutions following the form of the legal transaction. Certain procedures within the financial institution will need to be performed and updated by the successor.

Banking information in the name of the SPAC will then need to be updated to allow operational use by the target’s employees.

We’re Here to Help

If you have any questions about potential tax complications and opportunities of SPAC transactions, please contact your Moss Adams professional.