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M&A Shop Talk

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What is the most efficient tax structure to recruit and retain top talent, and set your business model apart from the competition?

The partnership reporting form (i.e., including an LLC owned by at least two members under the default classification rules) is generally the most flexible and accommodating tax operating structure to attract and incentivize top-performing talent.

Keep in mind that the check-the-box classification regulations are intended to be taxpayer friendly. That being said, you can always start your business in a partnership model and subsequently convert (i.e. make the check-the-box election) if it makes business sense to a corporation. This conversion process is usually accomplished on a tax-free basis unless you have negative capital account recapture issues created by recourse debt financing and/or non-qualified recourse financing applicable to certain real estate business activities. As part of the conversion process, any negative capital account balance previously created must be restored to a zero balance upon conversion.

Now, unlike the corporate reporting form that has some flexibility provisions regarding the start-up stage and early business life cycle, under partnership taxation principles pursuant to IRS Section 704(b) provisions, a partnership can typically implement a re-evaluation agreement (i.e., book-up economic agreement) without a ton of constraints. This concept is nothing more than an economic arrangement incorporated into the partnership and/or LLC operating agreement via amendment that clearly defines who is financially entitled to what pre- and post-evaluation. This tax planning technique is typically conducted on a tax-free basis because there is no shifting of pre-existing wealth involved. Additionally, it provides tax ownership structure participation to the recipient key employee to be taxed at the preferential, federal long-term capital gain rate of 20% upon a future exit strategy as long as the one-year ownership holding period is over.

Here is an example demonstrating how to apply the above concept. Let’s say that you own and operate a very profitable business structured as an S corporation and would like to award equity participation and future appreciation to a key employee.

Solution: undergo an F re-organization under Section 368(a)(1)(F)and convert your current S corporation to an LLC operational form for tax reporting purposes pursuant to IRS Revenue Ruling 2008-18 to be owned by a newly formed S corporation holding company that you will still have 100% ownership and control over. Next, issue the desired ownership % in the newly created LLC structure to the key employee in conjunction with a re-evaluation agreement, which would stand for the proposition that all equity appreciation generated through the re-evaluation date will belong to you, and moving forward you are willing to share “X” profits and appreciation based on the agreed allocation percentage.

For more information on the tax benefits of F re-organization, please visit our recent blog posts on the topic here.

Please note that the described partnership re-evaluation planning technique has many variations and application possibilities. To learn how this technique can help grow your current business model and boost employee morale, please feel to call me at (301) 222-8220 or email me at jrodrigiuez@aronsollc.com.


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M&A Tax Shop Talk – “F reorganization” Part II

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Still thinking about selling your business? Do you have the proper techniques and structures in place? I’ll discuss the ins and outs in this week’s M&A Shop Talk.

Generally, one of the most powerful planning techniques to structure a tax efficient sales transaction of your business is the installment sale reporting method under IRC Section 453. However, there are some complexities and inherit limitations that requires an experienced M&A tax planning professional to work around in the context of an S corporation target.

This blog discusses in general broad terms the complexity of installment sale reporting in the context of an F reorganization involving the sale of an S corporation target. For background information on the benefits of an F reorganization involving an S corporation selling target, please visit my previous blog on M&A Shop Talk from Monday, March 28.  

Installment sale reporting doctrine generally supports the proposition that there will not be a tax on the portion of the selling proceeds that you have not constructively received regardless of your overall tax method of accounting. However, keep in mind that the term constructive receipt is very broad and it includes deemed consideration constructively received (i.e., assumed liabilities by the buyer party) and it excludes any portion of the purchase price allocated to hot assets that do not qualify for installment sale treatment.

Under the current rules and regulations, there are tremendous planning opportunities when combining installment sale reporting in the context of an F reorganization. However, if this powerful combination of techniques is not fully understood and properly coordinated, it can yield unintended, devastating tax ramifications to you.

For example, under current law, the S corporation target has the ability to distribute the collection of its outstanding installment sale obligation to its selling shareholders without triggering any taxable gain at the entity level. The selling shareholders will be able to step into the shoes of the S corporation and report the remaining, outstanding installment sale obligation as collected. This planning tax provision is generally referred to as the “H Rule” and is not available unless the installment sale obligation stems from a sales transaction, transacted after the S corporation has adopted a plan of liquidation under the 12 months rule pursuant to Section 331.

Now in the context of an S corporation selling target that is undergoing an F reorganization and converting to an LLC status prior to completing the contemplated sales transaction, the described H Rule provision is not appropriate if it involves an equity rolled-over portion consideration. In this particular circumstance, because the selling S corporation will not be liquidated within 12 months after completing the sales transaction, the H rule is not applicable and the distribution of the installment sale obligation to any selling shareholder would constitute an immediate taxable event.

Stay tuned for the next M&A shop talk when will cover the use of Section 351 to achieve stepped-up basis tax treatment to the buyer party. In the meantime, please feel free to schedule a consultation with Jorge Rodriguez, CPA. Jorge is a Tax Director and part of Aronson’s Financial Advisory Services Group. Jorge can be reached by email at jrodriguez@aronsonllc.com or (301) 222-8220.

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M&A Tax Shop Talk – “F reorganization”

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The “F reorganization” has become the tax planning structuring technique of choice in today’s middle market M&A world. So, what does it mean to you as a seller?

First, F reorganization is only applicable in the context of corporations not LLCs. Second, in the middle market M&A world, which is still controlled by S corporation’s seller target, it means legally converting your existing S corporation to an LLC before selling.

The basic conversion process should be tax-free and it generally consists of the following sequence of steps:

Step 1: Form a new corporation hereafter referred to as “HoldCo”.

Step 2: All the S corporation shareholders (with no exception) will contribute 100% of its ownership to HoldCo. Need to apply for a separate employer identification number (EIN).

Step 3: Pursuant to IRS Revenue Ruling 2008-18, the old S election of the S corporation will automatically revert to HoldCo.

Step 4: Effective the same date as Step 2, convert the S corporation to a Qualified Subchapter S corporation (QSub) by filing IRS Form 8869 within 75 days. Entity will retain old EIN.

Step 5: Convert the QSub still a legal entity for state tax purposes, to an LLC via a formless conversion. Entity will retain old EIN.

In some cases, there may be additional steps required beyond the scope of this blog. For example, if the S corporation is not organized under a state that permits formless conversion process to LLC form. Further, any S corporation that is subject to unrecognized Net Unrealized Built-in Gains (NUBIG) tax under IRC Sec 1374, will not be triggered upon such conversion process but it will become the legal responsibility of the newly formed Hold Co.

The two major tax benefits to the seller are as follows:

  • Permits partial equity rolled-over on a tax deferral basis that cannot be achieved under an asset sale tax election reporting structure transaction under Sec 338(h)(10), and/or Sec 336(e) with no permitted tax deferral rolled-over flexibility. Please note that under certain unique sets of facts and circumstances, there is an alternative planning opportunity to achieve somewhat comparable tax results to both the seller and buyer parties using Sec 351. We will cover this alternate structure in a future blog. 
  • Facilitates the handling of deferred compensation items to be assumed by HoldCo and administer, and satisfied from the collection of future indemnity hold-back and earn-out payout, etc.

The major tax benefit to the buyer is to achieve a stepped-up basis transaction that can be amortized over 15 years with absolute minimum tax exposure. The buyer via the transaction described has legally transferred all income tax-related exposure to the HoldCo shareholders.

Now, the major drawback of the F reorganization with respect to a partial tax deferral transaction as described above, is the elimination of the 12 months favorable liquidation rule provisions in the context of installment sale obligation scenario. Stay tuned for the next M&A shop talk when we will cover this important topic. In the meantime, please feel to schedule a free consultation with Jorge Rodriguez, CPA. Jorge is a Tax Director and part of Aronson’s Financial Advisory Services Group. Jorge can be reached by email at jrodriguez@aronsonllc.com or (301) 222-8220.














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Does it Make Sense for an LLC Owner to Exit via Sale to an ESOP?

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There are many tax reasons why a small business organized as a limited liability company (LLC) chooses to operate as a flow-through partnership or disregarded entity taxed as a Schedule C filer on Form 1040. What happens, however, if you have successfully operated your business as an LLC, but have reached a point in your personal life that you want to achieve maximum liquidity and are willing to share continued success and the potential upside with your employees? Your exit strategy options may be very limited because you are a small business with a limited pool of viable potential buyers, if any. This is a common scenario among successful, small government contractors that primarily depend on size standards for new contract awards, including re-competes and renewals, making them an unattractive target candidate to larger organizations (i.e., because of contract novation and re-compete constraints).

When you peel back the layers of the onion, so to speak, what generally makes an organization an attractive target? Who knows your business best (i.e., real insider information)? Who is the best candidate to acquire your business? In today’s tight credit market, you will not be able to secure 100% third party financing and will need to partially self-finance the sale transaction and take the junior lien position to third party lenders.

In consideration of all of these important questions, an owner should strongly consider the possibility of selling its business to its employees, including the existing management team. As an inducement to the selling party, the issuance of warrants with an upside (regarding future appreciation rights upon a future sale event) can be attached to the subordinated debt financing.   The terms and conditions, however, must be properly structured in order to avoid second class of stock successful determination upon IRS examination, which would entirely and/or severely eliminate all the favorable tax effects of selling to an Employer Stock Ownership Plan (ESOP).

With the proper tax planning, your existing business (organized as an LLC and currently taxed as a partnership or disregarded entity) can be converted to a corporation to successfully consummate a potential future sale to your ESOP in a tax efficient manner. Under the current tax system, an LLC organized under state law and taxed as a partnership or disregarded entity as discussed above cannot participate in or sponsor an ESOP. Moreover, an S Corporation owned 100% by an ESOP stockholder is generally not subject to federal and state income taxes (other than, potentially, built-in gains tax at the S Corporation entity level) upon its conversion from an LLC to S Corporation. Some tax professional describe an S Corporation that is 100% owned by an ESOP as a tax shield (i.e., the ESOP is a tax-exempt entity not subject to federal including most state and local income taxes with respect to pass-through S Corporation taxable income).

There are two basic ways to convert an LLC to a corporation. One way, if applicable under state law, is for the LLC to undergo a formless conversion process and convert to a corporation. Alternatively, if the LLC qualifies (i.e., the LLC did not change its default tax classification within the last 60 months), it can file a federal election (IRS Form 8832), under the check-the-box provisions, to be classified as a corporation for federal and most state taxing provisions. Please note that there are exceptions to the 60-month limitation classification change rule. This latter option requires an additional step to change the legal form of the LLC to a corporation under state law via F reorganization (the LLC will be merged into a newly-formed a corporation with the corporation being the surviving entity). The check-the-box election option gives you more flexibility since the conversion paperwork election can be filed with the IRS on or before 75 days after the targeted effective date of the conversion.

The next step, after the conversion to a corporation, would be for the corporation to elect Subchapter S tax treatment election, which can be effective the same date as the conversion date. Under the check-the-box election, you can use IRS Form 2553 to convert to an association and elect Subchapter S. Furthermore, similar to IRS Form 8832 discussed above, IRS Form 2553 paperwork can be filed with the IRS on or before 75 days after the effective S election date.

In addition to the tax planning required to minimize and mitigate the triggering of built-in gains upon conversion to an S Corporation as mentioned above, there are many other hidden tax traps that should be considered and addressed in advance when incorporating an LLC. This includes any pre-binding buy-sell agreements or other step transaction doctrines that, under certain circumstances beyond the scope of this blog, could entirely negate the tax-free status generally associated with an incorporation of a partnership and make the entire transaction a taxable sale. In addition, because of the conversion mechanics, the converting entity faces complex accounting method matters that require special handling, including the potential filing of a non-automatic accounting method change application and the review and approval of the IRS national office within certain statutory due dates.

Please note that the tax planning option described above might only be ideal for an owner looking for maximum liquidity versus deferral and diversification. Also, stay tuned for future blogs regarding other ESOP sale transactions, including transactions involving a C Corporation and Sec 1042 deferral exchange election treatment, or a combination of sale transactions involving first stage (Sec 1042 deferral) and second stage (electing Subchapter S tax treatment and selling the rest of the ownership). For more information on ESOPs, please visit the website for The National Center for Employee Ownership (NCEO).

If you have any questions or would like more information regarding this matter, please consult your Aronson LLC tax advisor or contact tax director Jorge L. Rodriguez, CPA at 301.231.6200.

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Important Tax Considerations When Selling Your Business

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Ready to negotiate the sale of your business? First you should sit down with your tax advisor to gain a general understanding of the major tax considerations and constraints that should be evaluated. Partnerships, LLCs, C Corps, and S Corps all have various entity-specific tax consequences that should be evaluated before making any decisions.

The decision analysis process, however, is now more complicated because the top long-term capital gain rate was raised to 20% versus 15%, and there is an additional 3.8% Medicare tax applicable to certain passive investors. In the case of LLC sale transactions, your choices are limited and the transaction will generally be accounted for tax reporting purposes as an asset sale. In the case of a corporation, depending on whether the entity is an S Corporation or you are selling one of the subsidiaries within a consolidated group, it can qualify as a deemed asset sale under Sec 338(h)(10). If the entity is a C Corporation owned 80% by an affiliated group, it can also qualify for deemed asset sale provisions under Sec 338(g) election provisions.

Note: Please be aware that the tax return mechanics and reporting provisions under Sec 338(h) (10) versus Sec 338(g) are very different and need to be fully reviewed and analyzed before reaching any conclusion. Also, this blog does not discuss an election available under Sec 336(e) that might be more advantageous, for example, where an 80% or greater owned target subsidiary (i.e., must be a domestic entity) being acquired has high basis assets or has large unused net operating losses. (An article regarding the tax benefits of a Sec 336(e) election, including a general discussion on the recently passed final regulations which have relaxed certain provisions, will be forthcoming.)

Some of the factors that should be considered when weighing pros and cons of various taxing regimes are as follows:

Issues Unique to an LLC Taxed as a Partnership

  • The potential importance of EIN retention. For example, the wrong sequence of formation steps to convert an entity from LLC to C Corporation status under state law can eliminate the taxpayer’s ability to retain its old EIN.
  • Hot asset reporting provisions which are subject to ordinary income tax regime generally applicable under the following circumstances:
    • Cash basis taxpayer (i.e., the cumulative cash basis deferral is taxed at ordinary tax rates)
    • Gain realized from the sale of substantially appreciated inventory items (i.e., FMV exceed tax basis by 120%)
    • Depreciation and amortization recapture to the extent of taxable gain applicable to depreciable tangible personal property and amortizable intangible assets (i.e., previously acquired intangibles being amortized under IRC Sec 197)
  • Understanding how the assumption of liabilities by the purchaser will affect the taxability of the overall consideration and who is entitled to taking a deduction for the payment of contingent liabilities.
  • If applicable, the taxability of negative tax basis due to previously deducted losses and cash distributions to bring the capital account balance back to zero
  • All long term capital gains (LTCG) realized from the sales transaction by passive members will be subject to the newly enacted 3.8% Medicare tax under Sec 1411, which is generally applicable to any taxpayer with modified adjusted gross income in excess of $250,000.

Issues Unique to S Corporations

  • Consider whether all shareholders have a long-term holding period position that qualifies for LTCG tax rate.
  • All long term capital gains (LTCG) realized from the sales transaction by passive members will be subject to the newly enacted 3.8% Medicare tax under Sec 1411, which is generally applicable to any taxpayer with modified adjusted gross income in excess of $250,000.
  • Was the company always an S Corporation or do you have net unrealized built-in gains double tax exposure under IRC Sec 1374 that you need to realize upon sale?
  • Do you have significant tax basis deferral subject to ordinary taxing regime stemming from accounting methods (i.e., cash basis, long-term contract method, installment sale reporting, etc.) and excess tax depreciation and amortization over book basis?
  • Understanding how the assumption of contingent liability will affect the overall taxability of your consideration
  • Is the application of a one-day note planning concept to isolate tax to your resident home state appropriate in your particular situation and respected by the state taxing authorities?
  • How much is the additional tax that you would be required to pay if you agree to a Sec 338(h)(10) election? Depending on your company’s tax basis composition and tax attributes, including accounting methodology, you can generally negotiate an additional 1-3% plus tax gross-up on top of the already agreed upon total consideration for making the joint election requiring your legal consent.

Issues Unique to C Corporations

  • Does your stock investment qualify for partial gain exclusion provisions under IRC Sec 1202 (qualified small business stock) or Sec 1397C (Enterprise zone business)?
  • The gain realized on the sale of stock is subject to the newly enacted 3.8% Medicare tax under Sec 1411 that is generally applicable to any taxpayer with modified adjusted gross income in excess of $250,000.
  • Have you inventoried all the company’s tax attributes (e.g., NOLs and general business carried forward) and confirmed whether or not there is a limitation under Sec 382 provisions because of previous ownership changes?
  • If contract novation and EIN retention for contract performance history is not an important business issue on the table, it might be advantageous to explore an asset sale transaction. This strategy may be particularly appropriate for an equity-backed company with substantial NOLs and/or general business tax credits carried over that are not limited under Sec 382 limitation, or a company with high tax basis assets from previous acquisitions. Under these described scenarios you can negotiate a premium because of the tax benefit associated with an asset sale.
  • Negotiate the tax refund from NOL carried back years as part of the overall consideration. Quite often, because of the acceleration provisions with respect to unexercised stock options and deferred compensation arrangements, NOLs are generally created in the year of sale and can be carried back two years.
  • Be aware of unforgiving Sec 280G provisions that affect the deductibility of accelerated unvested stock options, deferred compensation and other employee benefits. These provisions impose a 20% excised penalty under Sec 4999 to the recipient employee. Also, discuss with your tax advisors the safe harbor exception provisions available to you.
  • Be aware that only certain transactional expenses are generally deductible, such as: pre-LOI due diligence and a portion of the investment banking fees. As a rule of thumb for negotiation analysis purposes, use 70% of the investment banking fees as a deduction, which is the safe harbor deductible amount under recently passed IRS administrative rulings. Note: to take advantage of the aforementioned 70% deduction, the corporation will need to make certain elections in its corporate tax filings for the year of the transaction. Please consult your tax advisor.

Other Tax Considerations Applicable to All

  • Familiarity with the installment sale reporting mechanic provisions, including maximum price consideration requirements imposed by IRS regulations
  • Being aware of unfavorable tax provisions under Sec 453A that impose interest payment due to the IRS with respect to installment sales obligations with unpaid principal balance at any given year-end in excess of $5M per shareholder
  • Related party sale provisions that could prevent LTCG tax treatment, depreciation and amortization eligibility, and installment sale basis reporting

Understanding the major tax provisions and hidden tax traps applicable to your particular situation is a critical first step in an effective negotiation process. If you are interested in a pre-sale analysis and review of your specific tax situation, please contact your Aronson LLC tax advisor or Tax Director, Jorge L. Rodriguez, CPA at 301.222.8220.

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