One of the most complicated tax accounting items to handle in the context of an M&A transaction is deferred revenue. In the below scenario, we assume the affected taxpayer reports on the accrual basis and uses the deferral method permitted under IRS Revenue Procedure 2004-34. This method permits the deferral of cash payments received in advance over a two-year period.
In a taxable sales transaction involving asset sale or equivalent asset sale tax election, and/or stepped-up transaction form, the described deferred revenue item is generally beyond the scope of this blog and is recognized in full by the selling party. This anomaly triggering event creates unexpected tax results that could adversely affect the overall economics of an equitable deal for you. Therefore, in the context of a pass-through entity seller party where the federal income tax rate differential plays between long-term capital tax rates and ordinary tax rates, the difference could be as much as 19.6%. Without an understanding of the described tax ramifications beforehand can be a deal killer.
Generally, most sophisticated buyers (i.e. private equity, public company, etc.) won’t agree in principle to compensate you for incremental tax with respect to the described acceleration event. The buyer party will always assert that the negotiated price already factors-in all such costs. Accordingly, to hedge this additional tax costs when you start your negotiation process, you need to factor-in the estimated incremental tax. Now, with respect to negotiating your current working capital adjustment that will ultimately affect your overall net selling price, the deferred income item assumed by the buyer party should be capped at what you believe is the estimated fulfillment costs to earn such deferred revenue in the future.
If you are planning to sell your business and would like more information regarding the handling of this tax item, or other transaction-related tax techniques available, please contact Jorge Rodriquez at email@example.com or (301) 222-8220.