Tax Considerations in Middle Market Transactions
By Wesley Brooker, Manager, Transaction Tax Advisory Services & Andrew E. Finkle, Partner-In-Charge, Transaction Tax Advisory Services
While the mega-mergers and acquisition (M&A) transactions get all the headlines, the number of deals in the middle market far exceeds those that make the mainstream headlines and are often targets for private equity and strategic acquisitions. An essential component of the deal process is understanding the tax consequences and the risks inherent in the transaction. This article focuses on buyer and seller tax considerations in M&A transactions relating to certain corporate sellers occurring in the lower, mid, and upper ends of the middle market.1
What is the Middle Market?
Firms operate in different market categories. These market categories include Main Street, the lower-middle market, the middle market, the upper-middle market, and Wall Street. While there are many variations as to how to define these categories, it is generally accepted that Main Street companies generate annual revenues of less than $5 million, lower middle companies generate annual revenues ranging from $5 million to $100 million, middle market companies generate revenues ranging from $100 million to $500 million, upper-middle market companies have revenues ranging from $500 million to $1 billion, and Wall Street consists of those companies with revenues over $1 billion and are frequently publicly traded.
From an M&A perspective, middle-market companies generally are privately owned, have fewer risks, and create consistent cash flow by providing essential services like waste management, cleaning services, and heating and air conditioning, to name a few. Further, middle-market companies are better positioned to pivot quickly, leverage innovation, and take advantage of opportunities to grow and capture market share. For the past few years, there has been a significant increase in the number of middle-market transactions.
According to the website Statista, the number of deals in 2022 fell into the following categories (by deal value):2
|Over $1 billion||314|
|$500 to $999 million||261|
|$250 to $500 million||374|
|$100 to $250 million||565|
|$50 to $100 million||442|
|$25 to $50 million||489|
|$10 to $25 million||609|
|Under $10 million||1,243|
|TOTAL # OF DEALS||18,072|
Why Consider the Tax Implications?
M&A are complex transactions that require skillful, and sometimes artful, negotiation. Related tax implications are vital components in the negotiation process between buyers and sellers. Without proper consideration, there can be unintended consequences and unexpected costs.
M&A transactions can be fully taxable, partially taxable, or not taxable at all. Generally, there is flexibility to structure a transaction in a tax-efficient manner while achieving the goals of both the buyer and seller.
Buyer and Seller Tax Perspectives on M&A Transactions
In structuring transactions, a seller generally wants to dispose of their company’s equity, and a buyer generally wants to acquire the targets assets. Sellers want to pass along all potential liabilities to the buyer, and conversely, buyers want to insulate themselves from liability, including tax liabilities.
In the corporate context (C corporations and S corporations), an equity sale takes place between the buyer and the target company’s shareholders. These transactions do not involve the sale of assets, and the target company remains in existence post-transaction. The target company does not generally recognize any gain or loss from the sale of its stock. Instead, the equity holders recognize gain or loss on the difference between the selling price and their tax basis in the equity interests.
Buyers may be deterred from an equity purchase due to potentially undesirable tax outcomes. For example, the tax basis of the target company’s business assets does not get adjusted to fair market value. Rather, the buyer acquires the target company with the historical tax basis of its assets (assuming a valid IRC Section 338(h)(10) or 336(e) election is not made in conjunction with the transaction that treats a stock sale as an asset sale). As such, the buyer does not benefit from an increased basis in the assets (including tax goodwill) and the depreciation and amortization tax deductions that come along with the increased basis. Instead, the target company’s depreciation methods and lives continue post-transaction. Additionally, an equity buyer generally inherits the target company’s undisclosed liabilities and uncertain tax positions. Thus, the buyer could be liable for additional taxes due to an IRS or state agency audit where the target company is a C corporation (most potential liabilities of a valid S corporation generally flow through to the shareholders).
On the other hand, buyers may find a stock sale to be favorable if there are significant tax attributes within the corporation that the buyer can utilize, like net operating losses or high-basis assets, or if the buyer needs to keep the legal entity in existence (for example, customer contractual obligations, union contracts, and the like).
When a buyer acquires the target company’s assets, the transaction occurs between the buyer and the target company. Accordingly, the consideration is paid to the target company for its business assets and liabilities. The target company can remain in existence and distribute some or all of the cash proceeds to the equity owners. Alternatively, it can liquidate, dissolve, or otherwise cease to exist, such that the proceeds are distributed to the equity owners after the transaction is completed. The target company recognizes gain or loss on the difference between the sales price allocated to the assets (generally negotiated by the parties in the asset purchase agreement) and the tax basis of the assets on an asset-by-asset basis. The equity owners are then taxed on any distributions the company receives (in liquidation or otherwise) under separate rules depending on whether the company stays in existence or liquidates.
From a seller’s perspective, an equity transaction is often highly desirable because it results in one layer of taxation (by the shareholders) and avoids the double taxation that occurs with asset sales by C corporations. Furthermore, the character of the gain recognized by the shareholders is generally long-term capital gain, which is taxed at favorable rates under the current system (20% plus 3.8% net investment income tax in certain circumstances).
Considerations During Tax Due Diligence
As previously mentioned, a buyer, even in an asset acquisition, inherits some or all of the tax history of the target company. Accordingly, buyers engage us to perform transaction advisory services related to taxes in the following areas:
Tax liabilities/exposures assumed
The structure of the transaction generally dictates what liabilities carry over, although certain tax liabilities/exposures carryover no matter the structure of the transaction (i.e., sales and use tax). As such, buyers generally engage us to perform buy-side tax due diligence regardless of the deal structure. A sampling of some of the more frequent issues uncovered during tax due diligence are as follows:
- S corporation validity – if a company’s S corporation election is invalid or was inadvertently terminated, the S corporation converts to a C corporation. As such, the buyer assumes the company’s tax history, including any prior entity-level income tax liabilities that were never paid. Furthermore, an inadvertent conversion to a C corporation may affect the intended structure of the transaction.
- Sales tax – the U.S. Supreme Court issued a decision in South Dakota v. Wayfair in 2018 that overturned the 1992 physical presence rules it established under Quill v. North Dakota. As a result, taxpayers can now be required to collect and remit sales tax as a result of making sales in excess of state-specific statutory thresholds, notwithstanding the fact that the taxpayer does not have a physical presence in that state.
- Related party transactions – companies often transact with the owners or related parties. These transactions can apply terms different than those with unrelated third parties. This can happen when the owners rent the building to the company at above- or below-market rates, related party loans at favorable or no interest rates, or operating transactions between related companies at favorable terms, all of which distort the company’s taxable income.
- Worker classification – worker classification is often a key area of focus by the IRS when conducting an audit. The employee vs. independent contractor determination is facts and circumstances based. If an independent contractor is classified as an employee, upon audit, any services performed on behalf of the Company are subject to federal and state withholding tax on any compensation paid.
Potential for a tax basis step-up in the assets
As noted above, a step-up in the corporate context can only occur with a purchase of assets or a stock sale with an election (i.e., IRC Section 338(h)(10) or 336(e) election). The buyer must then carefully consider the transaction structure and whether they will benefit more financially from a stock or asset deal. As such, buyers engage us to perform structuring work, including modeling the tax consequences for the sellers and the buyer.
Tax due diligence and other transaction tax advisory services are not solely for buyers. The following lists a few considerations of sellers during the transaction process:
Sell-side tax due diligence
Sellers will perform sell-side due diligence for several reasons. First, it gives the opportunity to identify and quantify any tax exposure areas and either remedy issues or prepare the owners and/or management to discuss them with potential buyers. This can be helpful when a buyer proposes a “worst-case” scenario, and the seller is already armed with a more accurate calculation of any exposure. Second, sell-side due diligence often shortens the buy-side due diligence process when buyers can rely on a sell-side tax due diligence report. Third, it can identify efficiencies that can be implemented immediately.
Maximize after-tax proceeds
Like the buyer, a seller can benefit from tax structuring and modeling the transaction’s tax consequences to determine the type of gain (ordinary vs. long-term capital) generated from the transaction, thus maximizing the cash proceeds to be received by the seller. This includes assistance in negotiating any purchase price allocation related to assets acquired. It is also helpful for sellers to know the potential “tax shield” the buyer may receive on an asset deal. Additionally, there can be instances where the seller of a C corporation can qualify for gain exclusions (i.e., qualified small business stock) on an equity sale. These rules are complex and depend on the transaction’s specific facts and circumstances, so careful analysis is necessary to determine the most tax-efficient structure.
Regardless of the transaction’s structure, a seller may want to hold equity in the buyer for numerous reasons. Generally, if structured correctly, rollover equity defers any gain recognition on the buyer’s equity received to future tax periods.
As noted throughout this article, M&A transactions are quite complex. We are here to provide any assistance (buyer-side or seller-side) to ensure the appropriate tax considerations are implemented while achieving the goals of the buyer or seller.
- Partnership M&A transactions will be the topic of a future follow-up article.
- It is likely that the undisclosed deals are in the lower deal value ranges.