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Avoiding Anti-Churning Traps

By: Michael O’Connor |

True Partners can help you uncover unexpected tax traps and catastrophes that can be lurking within an acquisition. One of the more insidious and elusive issues that we often catch is anti-churning.

What exactly is anti-churning? Prior to August 10, 1993, goodwill and going concern value were treated as non-identifiable, non-amortizable intangible assets, and as such, couldn’t be amortized for tax purposes after an acquisition. The argument between identifiable, amortizable and non-identifiable, and non-amortizable intangibles was a source of significant litigation between the IRS and taxpayers. With the enactment of Section 197 of the Internal Revenue Code, these assets were granted a 15-year amortizable life to avoid this concern.

However, as with any positive change, the availability of this benefit opened the door for potential abuse. Owners could sell to themselves, or a related party—a paper transaction—and create a new tax amortizable asset that would not have been amortizable under previous regulations. This is called “churning.” The anti-churning rules, therefore, were designed to prevent this from happening.

Many transactions today involve an asset purchase where the business was formed prior to August 10, 1993. If this is the case and the seller will retain more than 20% in “rollover equity,” the purchased goodwill may not be amortizable for tax purposes. In other words, if the acquired entity or its owners will own more than 20% of the equity in the acquiring entity immediately after the transaction, anti-churning rules may come into play.

In most cases, the expected tax benefit from amortization of goodwill is figured into the value of the transaction. If anti-churning is triggered, however, and the deal is not correctly structured, it could mean millions of dollars lost.

Here are a couple of examples of anti-churning in action:

  • While performing due diligence on a Healthcare Clinic acquisition, a look at the formation documents revealed that the entity was founded in 1988 which piqued our interest. As the deal intended to include more than 20% in rollover equity for the seller, anti-churning became an active structuring focal point. Our solution included the restructuring of the target entity to an LLC in conjunction with the application of specific Internal Revenue Code sections, avoiding anti-churning issues.
  • While reviewing a platform investment, the documents indicated that it was incorporated in 1996, so even as a 20%+ rollover equity deal, anti-churning didn’t appear to be an issue. Our due diligence, however, uncovered the fact that the company was originally founded in 1992 and reincorporated in 1996, creating an anti-churning issue. We structured the transaction so that asset values could be marked to market without a sale, and anti-churning traps could be avoided.

Though these rules have been around for nearly 30 years, anti-churning can still cause major problems for the unwary. Thankfully, with True Partners you’ll have the tax expertise you need on your side to uncover these issues, avoid the traps and perhaps save millions of dollars.