For owners of small and medium-sized businesses, the prospect of selling their company is an exciting – and potentially life-changing – opportunity. Although most sellers realize there will be a tax cost at the end of the day, many have little or no experience with the “deal process” and often are surprised – and stressed – by “tax” issues that arise in the course of the transaction. Here are a few high-level, tax-related aspects of a transaction to think about at the front end of the process. (Note that some issues differ depending on whether the business is structured as a C corporation, S corporation or LLC treated as a partnership.)
1. Get the “tax-side” of your business in order before you begin the process.
In almost every transaction, a prospective buyer (or buyers) will undertake a thorough “due diligence” process and look at all aspects of the target business, including potential tax exposure items. Most sellers initially think “what’s to worry about? We have a CPA prepare our tax returns, and we do everything right.”
Well, maybe that will be the case. But, it would also be the exception. Based on my 30+ years of providing tax advice on hundreds of deals, I would estimate that 80-90% of companies have at least some tax issues surface upon thorough due diligence by a buyer’s advisor. Keep in mind that outside advisors who are paid to undertake due diligence may feel compelled to find a least some issues. In many cases, the issues may not be large (or material), but in some cases they are. And, depending on the type of buyer (discussed below), any potential tax issues can be contentious.
Some of the most common tax issues that emerge are:
- S Corporation compliance. A sale of stock of a Subchapter S corporation almost always presents some potential issues. Common problems include (i) documentation of the initial election (including approval by a shareholder’s spouse in community property states), (ii) the eligibility of each shareholder (and shareholders’ spouses in community property states) to be an S corporation shareholder; and (iii) distributions that may be viewed as disproportionate to the shareholders’ respective share ownership (which can arise, g., where one 50% shareholder drives a company vehicle that is a Ford, and another 50% shareholder is provided a much more expensive Land Rover).
- State tax compliance. State and local taxes often present more issues than federal income taxes. In particular, many companies may not be filing returns in all jurisdictions where they do business, or where their employees “work”. Sales and use tax compliance also can be a significant issue.
- Employment tax compliance. It is common for companies to have numerous workers who are classified as “independent contractors”, but arguably should have been treated as “employees” who are subject to withholding and employment taxes. (At least one deal I worked on blew up after the buyer discovered that the target company treated about 70% of its workers as independent contractors, which the company did because “that was how most workers elected to be treated”).
- Restructuring transactions. A business may have reorganized at some point, perhaps in anticipation of a transaction or as a result of a prior transaction. Moving pieces of the business from one entity to another, or changing ownership of the business between shareholders, could have inadvertently triggered tax costs to the company. It is much better to identify any potential issues (and perhaps deal with them) before a prospective buyer is looking at the business and estimating (and probably over-estimating) what the potential tax exposure might be. (Remember, a buyer almost always will focus on the “worst-case” scenario.)
- Prior Acquisitions. If a target company itself had made acquisitions in the past, a buyer will want details about those deals, including the tax history of the acquired companies.
2. Think about and understand the tax consequences of different types of transactions (to both the buyer and seller) before you negotiate the sale price or sign a letter of intent (“LOI”).
Reaching agreement over the amount and type of cash and non-cash consideration to be paid is important, but there are several major tax elements that impact the value of the deal to both parties. These include:
- Whether the transaction will be structured to give the buyer a “stepped-up” tax basis in the assets of the business. In almost all cases, sellers are better off if they can sell the stock of their corporation (whether it is a “C” corporation, or an “S” corporation and no 338(h)(10) election is made to treat the stock sale as an asset purchase) because they generally will face only a single level of tax (e., tax only as the shareholder level, and not at the corporate level). Plus, the shareholders’ gain from the stock sale generally will be taxed at the lower rates applicable to capital gain. Conversely, buyers generally prefer to purchase assets of a business because they will obtain a new “stepped-up” cost-basis in the purchased assets if the deal is an asset purchase, or a “deemed” asset purchase (e.g., from a sale of S corp stock with a 338(h)(10) election).
- Which party will bear the incremental tax cost of a transaction structured to give the buyer a step-up in asset tax basis. It is essential that the buyer and sellers address this sooner rather than later in the negotiations, preferably in the LOI. The sellers likely will incur additional tax from a deemed asset sale compared to a sale of stock, because some gain is likely to be treated as ordinary income (rather than capital gain), and state taxes may be higher on the gain from the deemed sale of the business’ assets. Additionally, the sellers will have additional tax on their receipt of any additional gross-up payments. The buyer should calculate whether it makes economic sense to “gross-up” the sellers for the tax benefits the buyer expects to receive from a step-up in the tax basis of the assets (including goodwill) of the acquired business. Because those tax benefits will accrue over several years, whereas the tax cost to the sellers will be immediate, there is a time value of the tax-basis step-up that must be taken into account. These can be complex calculations that should be undertaken by accountants who are knowledgeable about the tax rules in all of the jurisdictions where the business operates, and the selling shareholders are taxable, and also can model out the impacts (as to both income tax on the selling shareholders, and tax benefits to the purchasing corporation). With so many variables in the calculations, neither the sellers nor the buyer should expect that the initial calculation will be 100% accurate of the ultimate result and avoid haggling over relatively small dollar differences.
- The tax impact of the sellers retaining an interest in the target business or receiving a “roll-over” interest in the buyer as part of the consideration. Unless any roll-over consideration from the transaction is structured to be tax-free (or tax-deferred) to the sellers, the sellers could face an immediate tax cost and need to consider if they will have adequate cash liquidity to deal with that tax cost, or perhaps forego the roll-over and take additional cash instead.
If these issues are not addressed in the initial LOI, it often is difficult for a seller to later negotiate to be indemnified (i.e., in negotiations over the purchase agreement language) for any incremental tax cost to the seller as a result from the deal following the terms outlined in the LOI. The tax cost to the seller just becomes another issue to be negotiated, and probably “traded” for something the buyer wants (that will disadvantage the seller).
3. Understand the differences between a private-equity buyer and a strategic buyer.
Experienced transaction lawyers know there is a world of difference between a strategic buyer (e., a public or private company already in the target’s business, or a related or complimentary business) and a private equity investor.
- A strategic buyer generally has decided that the target business is one that it would like to acquire, albeit at the right price and terms. It is looking to ensure that the target business will be a “good fit” with its existing business, culture, and practices. The due diligence process often focuses on “integration” considerations (e.g., getting the target business onto its “systems” for accounting employee benefits, etc.), customer fit, and other business combination issues.
- In contrast, the private equity buyer generally will be laser-focused on the financial bottom line. How much cost can be cut? Can we combine certain functions with existing operations? Can we reduce head-count? How can we reduce the purchase price paid to the Sellers?
- A strategic buyer generally will be thinking about the long-term and assumes that the Target business will be part of its operations for an extended period. In contrast, most private equity buyers have a relatively short time horizon, hoping to increase the profitability of the target business fairly quickly to increase its value, and hold it for only a few years until it can sell it at a gain (possibly with complimentary acquisitions).
- In negotiating the deal and associated documents, most private equity buyers are tough negotiators, who often beat down (or at least “wear down”) the sellers during negotiations over the dozens of deal points to obtain some economic or financial advantage. Remember, they generally are looking to quickly turn the company and sell it at a profit. Strategic buyers often are more focused on “closing the deal”, which their senior management wants to get done.
- Private equity buyers tend to have more layers of investors and financial backers, which eventually must become involved in the deal, often going through their own due diligence (sometimes on the eve of a scheduled closing). In general, this is a much more contentious and stressful process for sellers, and they need to be prepared for it – both mentally and with experienced counsel.
Whatever deal you may be involved in as the seller of a business, you need to work with experienced legal advisors and accountants who can represent your interests, guide you through the process, and work to obtain the best result – while reducing the stress to you.
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