CHAPTER 29
Common M&A Taxation Issues
Brief Comments
Unquestionably there is progress. The average American now pays out twice as much in taxes as he formerly got in wages.Henry Louis Mencken
I am proud to be paying taxes in the United States. The only thing is—
I could be just as proud for half the money.
Arthur Godfrey
Prince Georges County, MD—2005
The stepchild, perhaps, of the Washington, DC, area, Prince Georges County (PG, as it is known to locals) is still an economic comer. The predominantly black middle-class population here is the wealthiest, best educated, and most affluent in the United States. Bordered by its richer cousin Montgomery County on the north, large parts of the Potomac River on the west, and its even earlier-stage cousins, Charles and St Mary’s Counties on the south, PG, if not exactly a hotbed of Middle Market business, is certainly a maturing incubator of sorts.
Madeline’s offices were in a mid-rise office building overlooking a strip mall. As I drove up, I thought, It’s not a very pretty site, but at least it’s functional for her particular type of business.
Madeline was a tough and talented business woman. She’s had to be. And she was being tough with me. She said she already had an offer for $15 million for her business from a single buyer, and she wanted to scale my fee for representing her, based on only any incremental value I could achieve. I looked at this offer, and I did not think it really represented $15 million. For one thing, it included a working capital target specified by this buyer of at least $1 million more than it should have been. For another, it included an unorthodox shifting of another $1 million dollars in taxes to her side of the deal. Finally, there was an earnout provision that was at least $750,000 unfair to her side of the deal.
Madeline thought she had $15 million on the table already. I thought, using conventional mergers and acquisitions (M&A) deal structures, that it was a $12.25 million offer. The first thing I would have to do in representing her would be to get back that $2.75 million. She did not understand that yet and I hoped I could explain it to her, as I could work like the dickens to increase her value by almost $3 million without getting paid for it or most of it. I would have to find out how reasonable she was under that hard crust. As for me, I knew I was not going to take this client on under those circumstances, for sure.1
A Brief Tax Overview
This chapter is intended only to be a brief overview of the most common tax issues that arise in Middle Market M&A transactions. It is certainly, as will be obvious, not intended to be a deep treatise on M&A taxation. It is focused mostly on the sales-side point of view and will not directly cover post-transaction concerns of buyers such as tax-based purchase price allocations and acquired asset amortization; the ability to achieve the benefits of net operating loss carry-forwards; or many of the myriad other M&A taxation issues that can arise. It is intended to cover only some very basic things, at a very basic level, for a client who wants an initial overview or an investment banker without tax training who needs familiarity with the concepts. The use of terms here is neither intended to be, nor is, precise, and most of the actual surrounding tax law regarding the areas this chapter speaks to is omitted from discussion.
In short, this is a chapter for laymen. I believe that 90% of the issues that arise over and over again in common Middle Market M&A transactions can be conveniently summarized as coming under one of the following groups:
• Entity type or selection
• Asset versus stock forms of transaction
• Other transaction structural issues
• Reorganization structures
• Presales event tax planning
• Postsales event reinvestment
Entity Selection: S Corporations versus C Corporations and Asset versus Stock Deals
Fundamental to any starting point for considering the tax consequences in an M&A transaction from the seller’s point of view is the selection of corporation type. Under the Internal Revenue Code, a corporation (or its shareholders more accurately) can decide to be taxed as a subchapter C corporation, which is a taxable entity, or by way of a subchapter S election as a corporation that usually pays no taxes (an S corporation).
Virtually all taxes on the income of an S corporation are paid by, and by the consent of, the shareholders when they file their own tax returns. An S corporation is also commonly known as a pass-through entity, as its income and losses generally “pass through” to the shareholders.
The consequences of being a C or S corporation at their most basic level in an M&A transaction are that a C corporation, which sells its assets to a buyer as opposed to its stock, will generally pay a tax; whereas an S corporation generally will not. When the C corporation distributes the remaining proceeds of the sale (after the first round of taxes at the corporate level), the C corporation shareholders will be taxed all over again. In an S corporation, there is generally no corporate-level tax, so even though the gain on an M&A asset transaction is taxed to the shareholders, it is generally only taxed once, which usually provides a distinct advantage to an S corporation over a C corporation in an asset type of sale.
An alternative structure for the sale of a business can be the sale of a corporation’s stock. Here, the playing field is closer to neutral, as both C corporation shareholders and S corporation shareholders will generally pay tax once at capital gain rates.
The effect of all of this is to make an asset sale by a C corporation in most cases totally unpalatable, unless of course the buyer agrees to pay the taxes through a purchase price adjustment (i.e., reimburse the sellers) because of the double taxation situation that arises.
Prior to the Tax Reform Act of 1986, certain tax elections could allow a C corporation to avoid this double taxation, but that Reform Act canceled these elections. Gradually, as a practical matter over the years since 1986, buyers have come to realize that they cannot get a deal done with a C corporation on an asset purchase basis, at least without usually having to compensate the seller for the double taxation effect. I would say that at least 75% or more of the transactions done with C corporations as a consequence are for the sale of their stock and not their assets. So you would think that all is well whether the seller is an S corporation or a C corporation . . . but that is not the case.
The problem is that the buyer, after doing a stock deal, does not really get the full benefit of his purchase price, as he cannot write off the assets he has indirectly acquired (keeping in mind that he merely acquired stock). So this typically gives rise to the buyer’s choice of a Section 338(h) election, where he uses a Section 338(h)(10) election (by the buyers and sellers) to acquire the stock as an S corporation’s stock and is then able to “step-up” the basis in the acquired assets (by hypothetically treating them as if it were an asset deal in the first place) and write them off. In these cases, the S corporation shareholders are taxable on some of the gain, which often results in ordinary income recapture. As a part of the negotiation, the buyer may or may not reimburse the S Corporation shareholders in effect for the taxes that result.
But the buyer will often want the seller to pay the taxes on the hypothetical 338(h) transaction as a purchase price adjustment or, in other instances, directly. So we are somewhat back to square one here, but this still gives the S corporation-asset seller a substantial advantage compared to the C corporation-asset seller when it comes to an M&A deal, as the former can more easily effect an asset sale without onerous tax consequences.
Of course, the sellers can refuse to pay the taxes attributable to the Section 338(h) election, but it is one more thing to negotiate, and if the seller wins this negotiation it may well be at the cost of having to give something else up along the line. All in all, the existence of an S corporation election is usually much better, as is provides more tools to lower the tax costs of an M&A transaction.
The Effect of Timing of S Corporation Elections and the Built-In Gains Tax
It might appear at first glance that the simple solution to this dilemma is to have a C corporation make an S election just before it is sold, but that does not work either. Basically, the rule is that whatever the business was worth at the date of election (built-in gain), that portion of the gain on the sale of the business will still be subject to C corporation double taxation.
Only ten years after the election is made does this rule (the built-in gains, or BIG, tax rule) expire. An election as an S corporation may still make sense if a business is rapidly growing, so that its value at the date of the election is only a small part of its value at the date of the sale, even if the sale is made within the ten-year period. I believe that most Middle Market business owners who still operate as C corporations should consult their tax counsel and a valuation expert/investment banker to decide whether to make an election now.
Other Transaction Structural Issues
It is not uncommon in an M&A deal for advisors to look at ways of characterizing some part of the deal price as compensation to the seller for services (subject to ordinary income taxes to the seller, but deductible by the buyer). This is often looked at as a compromise to enable the deal to get done. Its disadvantages are that if it is carried too far, the deductibility by the buyer will be at risk, and this is aside from the obvious disadvantage to the seller of converting what is usually taxed at a low capital gains rate into a much higher ordinary income rate. However, if it is carefully structured, there are circumstances where the risks and the reward of this approach will make sense to both sides.
Earnouts
For convenience’s sake, I am going to repeat somewhat verbatim here the comments on taxation of earnouts from Chapter 19, which solely devoted to earnouts. The perpetual question in earnouts is whether or not they give rise to capital gains or ordinary income. The courts and rulings are mixed here, so one is left with the need to engage good tax counsel, particularly in
drafting the earnout agreement to protect a client’s position in this regard. In general though, the body of tax law and precedent would seem to support the notion that installment payments of uncertain amounts (earnouts) emanating from the sale of a business would be considered a part of the purchase price and reportable, for the most part, as capital gains income. Without trying to be tax counsel, let me offer some rough guidelines here:
• To the extent the earnout is tied to the continued services of the seller as an absolute condition, this can bode badly for capital gains treatment, as the payment may be treated as ordinary income to the seller as compensation or consulting services.
• If the earnout is consistently referred to as an element of the purchase price in the various agreements, this bodes better for capital gains treatment.
• If the earnout is constructed as a deferred payment note of some sort, reducible by failure to hit the earnout targets, this may help to support capital gains treatment.
• Deferred earnout payments that do not bear interest may be treated partially as interest income (taxed as ordinary income) and partially as sales proceeds (subject to lower capital gains rates).
But as I said, drafting here by tax counsel is everything.
The Effect of Tax Accounting Methods
Many Middle Market companies, especially in the lower end of the Middle Market, report their taxes on a cash basis. This results in timing differences between what is reported for normal financial accounting purposes on an accrual basis and what is reported for tax purposes on a cash basis. Assuming the client has saved money by reporting for tax purposes on the cash basis, someone will eventually have to pay the deferred and latent tax on the difference between accrual-basis income and the cash-basis income reported to the government.
Stock Deals and Cash-Basis Sellers
So, in an M&A transaction, who is liable for these latent but real taxes? If a buyer buys a corporation (a stock deal), this latent or deferred tax is an assumed liability of the acquired corporation and will go along with it from a tax law point of view. But in an M&A negotiation following the conventions, the liability is not an ordinary balance-sheet operating liability in the sense that I have used that term before (Chapter 27) on balance sheet conventions. So it is not one of those liabilities that by convention the buyer is automatically assumed to inherit—except, of course, by negotiation.
Assets Deals and Cash-Basis Sellers
The sale of the assets of a cash basis S corporation constitutes the sale or exchange of, among other things, its heretofore unrecognized accounts receivable, which would give rise to a tax to the selling corporation (or, more precisely, its shareholders) on those receivables, thus generating the taxes on the timing difference just discussed. So another form of built-in gains tax for cash-basis S corporation shareholders would be a day of reckoning in paying the taxes that were avoided previously by opting for cash-basis reporting.
Installment Notes and Cash Basis Tax Payers
Installment notes are less common in M&A transactions in the Middle Market (except for usually smaller deals under $5 to $7 million in transaction value) then one might expect, the principal forms of consideration being usually cash, earnouts, and then stock, in that order.
When they do occur, they have the interesting tax advantage that if these notes are qualified for installment reporting, no taxes are paid by the cash-basis seller until the payments are received. This is particularly attractive when the seller receives a market interest rate on the face amount of the note that is the equivalent of other investments he could make if he had the cash, because he is, in effect, investing the government’s taxes on his own behalf until the time comes to report the payments. If the maker of the note is very credit worthy and the note is well secured, this can be a real boon to a seller.
Reorganization Deal Structures (Taking Stock)
Oddly enough, the reorganization sections of the Internal Revenue Code that deal with merger transactions (mainly Sec 368) do not appear all that commonly in Middle Market M&A deals, but an awareness of them at a very basic level is important. They do come up in at least some deals, and many clients are curious about them, being at least dimly aware that taking stock as part of their sales price might be tax free.
Let’s start by clearing up that “tax free” remark. Even where taking stock actually results in the payment of no immediate taxes, this is simply a tax-deferred transaction, not a tax-free one. When the seller eventually sells the stock, he or she will be taxed, and his/her basis in the stock for determining gain will be the same as his/her proportionate basis in the business sold earlier, so the tax has merely been deferred. The only things certain in life are death and taxes.
Furthermore, any tax deferral in a reorganization type of transaction is solely on the stock, not on cash or other consideration taken in addition to stock.
Tax-free reorganizations are built around the concept of continuity of ownership interests in the surviving entity. Hence, these types of deals are more like mergers than outright sales of businesses, as the owners of the selling corporation will become in-part owners of the buying corporation. They may be accomplished by exchanging buyer stock for either the assets or the stock of the seller. As a rule, where there is cash or other nonstock consideration involved (boot), the upper limits of cash, if allowed at all (see B-type reorganizations below), will be around 50% of the overall deal price. However, there have been rulings that allowed a greater amount, and each transaction needs to be guided by expert tax counsel.
The Alphabet Code
There are seven types of reorganizations, A through G, and variations known as “triangular” (this is why code section 368(a)(1) is often called the Alphabet Section). However, only three of these are really germane to this light overview, as they are the ones that appear the most frequently in deals where an reorganization (stock exchange) is involved. They are A, B, and C reorganizations:
A REORGANIZATIONS In an A reorganization, the structure must comply with the relevant state law for a statutory merger. These A reorganizations usually result in the acquiring corporation (in M&A terms, the buyer) acquiring the assets of the seller corporation in part for stock and in part for cash. The seller corporation ceases to exist, and the shareholders of the seller corporation end up with the stock of the buyer corporation, plus any other consideration received.
B REORGANIZATIONS In a B reorganization, only stock and absolutely no cash can be used, and the acquired corporation usually continues its existence as a subsidiary of the acquiring corporation. Here again, in M&A terms, the buyer corporation exchanges stock for all of the stock of the seller corporation.
C REORGANIZATIONS In a C reorganization, one corporation (the buyer) acquires the assets of another (the seller), which then distributes to its own shareholders the stock and other consideration received again, with the proviso that only the stock gets tax-deferred treatment.
While, as promised, I have barely touched on the topic of tax-free reorganizations, it is important to point out that these are very complicated, often suggest the need for advanced letter rulings from the IRS to see if they will work, and always require the assistance of expert tax counsel.
Disposing of Business Interests by Gifting Prior to a Sale and Charitable Remainder Trusts
Two popular devices for tax planning prior to the sale of a Middle Market business are the use of charitable remainder trusts (CRTs) and gifts (often of family limited partnership interests, or FLPs). Both, in effect, involve giving up some or all of an owner’s interest in a Middle Market business before it is sold. In short, the recipient of the given-up share, whether it is a family member or a charitable trust created by the owner, become the sellers when the business is eventually sold.
Charitable Remainder Trusts
In this approach, the seller donates his interest to the charitable remainder trust, which is, in general, a tax-exempt entity that is then not taxable on the later sale of its interest in the donated business. In turn, the CRT (or one of its various forms) agrees to pay the donor (the original business owner) amounts of principal and income over a period of time. The business sales proceeds, of course, end up with a charitable organization. This type of presales event tax planning may be particularly good for:
• Owners who have sufficient other personal liquidity over and above the interest they that have just given to the charitable remainder trust
• Owners who are philanthropically inclined
The tax benefits should be obvious, as the entire value, if the business interest donated is later sold (since there was no tax on its sale), earns income for the donor and the charitable beneficiary on a larger portion of the sales price of the business (before taxes, since the entity is a tax-exempt entity) then would have been otherwise possible.
Gifts and Family Limited Partnerships (A Generation-Skipping Tool)
By shifting business ownership interests to other family members, either through family limited partnerships or a direct gift to the next family generation, the business ownership interest can be placed in the hands of heirs to appreciate prior to their sales, thus avoiding estate and capital gains taxes by shifting post-gift appreciation to the new owners. In addition, by receiving less than a controlling interest in the business, the value of such interest will usually be valued at less than a proportional percentage of the business. Minority interests are usually valued after taking discounts of as much as 20% to 40% because they would be difficult to resell to a third party, as they have by themselves no control over the operations of the business.
Divisive Reorganizations
Section 355 of the Internal Revenue Code (known as the Morris Trusts) allows the historical owners of a company to divide up the company’s assets with no gain recognition, provided the owners transfer the assets to a separate business (controlled by the shareholders of the transferring company). This is in concept—and must be in practice—a mere shifting of the assets to a separate entity, but with the retention of at least 80% control by the shareholders of the distributing company. Tax-deferred distribution is basically the same intended outcome as contemplated by the Section 368 reorganizations section, referred to above.
Small Business Corporations
A shareholder in a qualified small business under IRC Section 1045 can exclude up to 50% of the gain on the sale of the stock, up to the greater of $10 million or 10 times his cost basis in the stock. A small business is any C corporation
2 with an active business not depending on the professional services, licensing, or reputation of its owners (among other exceptions), with aggregate gross assets of less than $50 million. Alternative minimum tax preferences apply to the exclusion, so the actual benefit is often less than what the tax savings would be otherwise. If the owner uses the proceeds from the sale of a small business corporation to acquire another small business corporation within six months after the sale of the first (a rollover) there will be no tax until a later sale of the newly acquired stock.
How Much Do Taxes Matter During the Negotiation?
Keeping in mind that businesses do not pay income taxes, one would think that very little of the negotiation for the purchase and sale of a business would involve tax considerations, and in fact, that is literally true.
However, businesses are owned by entities, and that is where taxes come in. Depending on the form of the deal (assets versus stock); the nature of the selling entity (S versus C corporation); and the elements of consideration (cash, stock earnouts, balance sheet targets, etc.), the tax consequences can be significant. But I find it easier and more accurate to view the negotiation for the sale of a Middle Market business to consist of two separate negotiations, in effect.
The first is the sale of the business itself (e.g., negotiating a value based on multiples, auctions, and so forth that the parties can live with. The second and quite separate negotiation is about the tax aspects of the transaction. Thinking about the negotiation this way (just as thinking about earnouts as either incentive or comfort earnouts, as discussed in Chapter 19) can focus the mind on these two separate topics appropriately but as a rule, in practice, they are often just as jumbled together as the two different types of earnouts.
Chapter Highlights
The main tax elements or areas that appear over and over again in Middle Market deals are:
• Stock versus asset forms of deal structure
• C versus S corporations
• Section 338(h)(10) elections
• Timing of S corporation elections and the built-in gains (BIG) tax
• Purchase price versus compensation
• Tax treatment of earnouts
• Tax accounting methods and their effect
• Installment elections available to cash-basis tax payers
• Gifting of business interests prior to the sale of the whole business:
• Charitable reminder trusts
• Direct gifts and family limited partnerships
• Reinvestment of sales proceeds or their tax deferral (partial) in the sale of qualifying small business corporations
• Separating the tax from the business aspects of deal making
Notes
1 It is interesting to surmise that a C Corporation asset sale of $15 million may leave the owner who has a zero basis with only $8 million of after-tax proceeds, whereas a stock sale for $14 million may let her bank $10 million after taxes. Which deal is better? The $15 million sounds better at the cocktail party, but the $14 million deal puts an extra $2 million in the bank.
2 Organized after August 1993.