M&A Tax Considerations for Small and Middle-Market Sellers and Purchasers
By Lawrence A. Litt
What runs through the mind of a small or middle-market business owner contemplating a potential sale of his or her company?The obvious answer to that question is that the business owner wants to know how best to realize the maximum amount of value inherent in his or her company.This amount realized is typically measured by the amount of net cash proceeds (or net consideration) received by the selling business owner. However, what the selling business owner may not be able to fully appreciate is that this obvious answer carries with it a multitude of complexities that must be properly considered or the selling business owner may face the risk of not realizing his or her sale objectives.An example of one such complexity is the potential tax implications of selling a company. Recognizing that what is owed to the government will ultimately reduce the amount of net consideration received, the selling business owner will almost always ask the question, “What will I owe in taxes from selling my company?”The answer to that simple question is unfortunately much more complicated than the mere question itself.
Conversely, what is going through the mind of a small or middle-market company’s C-level executive exploring how to grow his or her company through an acquisition?The answer is typically centered around how best to achieve the greatest return to the shareholders on the company’s investment in the enterprise being acquired.Similar to the selling business owner, the acquiring company’s management will need to fully appreciate the series of tax complexities to be considered or else run the risk of the anticipated return on investment being adversely impacted by certain tax exposures of the acquired enterprise that may unwittingly be assumed by the acquiring company.How does an acquiring company avoid, or, at least, mitigate, such a dilemma?The answer to that question begins with careful planning around properly structuring a transaction, as well as conducting an appropriate level of tax due diligence.
For both the seller and the purchaser, it is essential to recognize and comprehend the tax considerations associated with any merger or acquisition transaction being contemplated.We will begin with the tax considerations of a seller in an M&A transaction.The structure of an M&A transaction is critical in understanding the potential tax implications faced by the seller of a company.Two very important questions must be answered by the seller.First, is the seller looking to sell stock or assets?Second, is the seller seeking a way to defer the gains generated from selling the company or the company’s assets?From the seller’s point of view, the answer to the first question is presumably to sell stock.Aside from the obvious legal and commercial advantages, selling stock is beneficial from a tax perspective as the sale of shares generally results in capital gain treatment for the company’s shareholders with no corporate level tax.On the other hand, the sale of substantially all of a company’s assets generally results in both corporate level tax and tax on the shareholders with respect to the sale proceeds distributed by the company, if the company is a C Corporation. If the company is an S Corporation or Limited Liability Company, then there is only one level of tax as the taxable gains at the corporate level increase the shareholder(s)’ basis in the company’s stock; however, to the extent that the purchase price is allocated to assets sold that had been previously depreciated and/or are utilized in the ordinary course of business (i.e., fixed assets, inventory, receivables, etc.), the gains on the sale may be taxed at ordinary rates in lieu of capital gain rates.There is a significant difference in these rates ranging from approximately 15 to 19%, which should be considered by the seller.
Assuming that the transaction qualifies and that all of the applicable requirements have been satisfied, another option for a seller is to legally structure the transaction as the sale of stock, but jointly agree with the purchaser to treat the transaction for tax purposes as an asset transaction by making an election under Section 338(h)(10) (or unilaterally under Section 336(e)).The seller will typically negotiate with the purchaser to be compensated for any additional tax implications resulting from this type of an election.
What if the seller is seeking to defer gains from the sale of his or her company or company’s assets?There are a series of structuring alternatives potentially available to a seller under certain provisions of the Internal Revenue Code, but such alternatives require that several statutory and non-statutory conditions be satisfied in order to qualify for a deferral.What are the implications of a deferral?It is important for the seller to understand that a deferral does not equate to being “tax-free”.A “tax-free reorganization” is not actually “tax-free”, but represents a mechanism through which a seller may be able to defer recognition of a gain on the sale of a company or company’s assets. These transactions typically involve exchanging stock in the company being sold or substantially all of the assets of such company for stock in an acquiring company.There are generally limits on the amount, if any, of cash, debt, and/or property (also known as “boot”) that may be included as consideration in such a transaction.In addition, there are requirements that the former shareholders of the company being sold continue to have a stock interest in the acquiring company, that the business enterprise of the company being sold continue in the future, and that there is a clear demonstration of a business purpose underlying the M&A transaction.If a transaction fails to qualify as a “tax-free reorganization”, then such transaction will be considered taxable and the seller will then need to focus on the above mentioned considerations for a taxable sale transaction.
Other considerations for a seller include how best to approach the tax due diligence process, such as whether to conduct a sell side tax diligence to preemptively identify potential tax exposures prior to commencing any diligence process with the purchaser. In addition, a seller will need to consider the potential tax implications of whether the purchaser is proposing to include certain terms in the acquisition agreement that include seller’s notes (i.e., installment payments), contingent consideration (i.e., earnouts), and/or a post-transaction employment agreement (i.e., compensation for services that may be taxed as ordinary income), as well as the appropriate tax treatment of certain costs incurred to facilitate an M&A transaction.
The purchaser of a company or company’s assets has a multitude of tax considerations, as well. Specifically, the purchaser is seeking to structure an M&A transaction in as tax efficient a manner as possible while preserving any available tax attributes (i.e., net operating losses, tax credits, etc.) and minimizing the amount of potential tax exposures assumed.These considerations can be addressed through both transaction structuring and tax due diligence.Similar to a seller, a purchaser needs to carefully consider how to optimally structure an M&A transaction from a tax perspective.When stock of a company is acquired, the purchaser receives carryover tax basis in the underlying assets of the company. Therefore, a purchaser may be seeking to structure the transaction to achieve a “step-up” in the tax basis of the underlying assets to the fair market value paid for the company.This “step-up” would generate future tax deductions for the company, including a tax deduction for the amortization of goodwill not otherwise available in an ordinary stock acquisition. How is this “step-up” achieved? The options available to the purchaser include, for example, acquiring assets in lieu of stock, jointly making the above mentioned Section 338(h)(10) election, if applicable, with the seller, or acquiring 100 percent of the partnership interests in an LLC under Revenue Ruling 99-6.In any one of these transaction structures, the price paid by the purchaser (including certain liabilities assumed) will be allocated to the underlying assets of the company utilizing the respective fair market values of such assets with the residual generating tax basis in goodwill. In addition, a purchaser will have to consider whether the company being acquired has any tax attributes and the potential limitation under Section 382 upon the future utilization of such attributes.A purchaser may have to consider the opportunity cost between achieving a “step-up” and preserving certain tax attributes, and, therefore, analyze the implications of structuring an M&A transaction to accomplish one objective potentially at the expense of the other. Similar to a seller, a purchaser will likewise need to consider the appropriate tax treatment of certain costs incurred to facilitate an M&A transaction.
The intended benefits of an M&A transaction can be adversely impacted by potential tax exposures assumed by the purchaser.The purchaser should consult with the appropriate advisors to perform tax due diligence on the company being acquired as a means of mitigating the impact of assuming any potential tax exposures. When a purchaser acquires the stock of a company, all of the company’s historical federal, international, state and local income and non-income tax liabilities are assumed by the purchaser. If the purchaser acquires assets in lieu of stock, the purchaser may continue to be subject to successor liability for certain historical tax liabilities of the company. Tax due diligence provides a purchaser with the opportunity to identify a company’s potential tax exposures for purposes of negotiating certain favorable terms in the acquisition agreement either to protect against such exposures through a series of representations, warranties, and indemnities or to trade-off protection against such exposures in exchange for certain other deal-related concessions in the agreement. In addition, tax due diligence provides a means of validating certain assertions about a company being acquired that may prove to be critical for accomplishing the structuring objectives of an M&A transaction.For example, a Section 338(h)(10) election to achieve a “step-up” for an S Corporation being acquired can only be made if such company is truly a valid S Corporation and has not historically undertaken any transactions that may have created a second class of stock, and, thus, invalidated its S Corporation status.
Purchasers and sellers of companies have a number of tax considerations to keep in mind when undertaking an M&A transaction. It is highly recommended that both purchasers and sellers consult with the appropriate advisors, including a public accounting firm which specializes in transaction structuring and tax due diligence. Ignorance is not bliss when it comes to tax considerations in an M&A transaction, and, therefore, a purchaser and a seller will be better equipped to achieve the intended benefits of their transaction only to the extent that tax matters have been properly considered prior to the closing of any prospective deal.
Lawrence A. Litt is a Partner in the Tax and Business Services Department of Marcum LLP, a top national accounting and advisory services Firm. Mr. Litt specializes in advising on tax matters associated with mergers and acquisitions, as well as in providing tax accounting, tax compliance, tax controversy, and domestic and international tax consulting services.