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M&A Shop Talk: Tax Planning Using One-Day Note Concept Application

One-Day Note
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An S Corporation selling shareholder should always evaluate whether the “one-day note” obligation planning concept will achieve federal and state tax optimization objectives of an asset sale transaction arrangement. There are some exceptions to applying this concept due to business reasons or overriding tax regimes, beyond the scope of this blog.

The current tax provisions of the one-day note tax calculation require that the pre-liquidation calculated tax basis of an S Corporation selling target, following the consummation of an asset sale transaction, should be allocated between the cash and non-cash liquidation components respectively. Accordingly, the selling shareholders will immediately recognize the cash liquidation proceeds less allocated S Corporation tax basis. Any remaining tax basis allocated to the deferred income items will be recognized proportionally as the deferred income items are collected.

The described mandatory allocation mechanism will generally create an acceleration of gain recognition tax effect. This is because a substantial portion of the pre-liquidating stock tax basis calculated, including the gain recognition from the deemed asset sale prior to liquidation, will be allocated to the deferred income item. Such allocated stock basis will not be recognized until the deferred income items are eventually collected. In extreme situations, the non-collection of deferred income items can create an unused capital loss whipsaw tax effect that is beyond the scope of this blog. Therefore, the proper application of the one-day note planning concept will mechanically reduce the pre-liquidation tax basis allocated to the deferred income items and safeguard against the described negative tax implications.

From a state tax minimization perspective, many state taxing jurisdictions currently conform to federal law income tax statutes regarding installment sale reporting rules. This includes the non-taxable treatment and distribution of a deferred note receivable obligation stemming from an asset sale or liquidation scenario. The one-day note planning concept will generally minimize, or in some case totally mitigate, all non-resident income tax burdens incurred by a bona fide residents and selling shareholders living in a  no state tax jurisdiction, such as Florida, Texas, and Washington. This concept would also be applicable to certain selling shareholders who would be subject to double taxation because of non-conformity S Corporation pass-through tax treatment, such as the District of Columbia with respect to Virginia residents. This is because the District of Columbia franchise tax is not considered a creditable income tax under Virginia income tax statute.

Please note that the one-day note tax planning concept will only mechanically work pursuant to an approved and adopted plan of liquidation that is beyond the scope of this blog or pursuant to a Sec 338(h) (10) or Sec 336(e) tax election.

If you are interested in scheduling an initial consultation on how to effectively structure the sale of your business, please contact Jorge Rodriguez, Aronson’s Tax Partner specializing in M&A specialized services for middle market businesses, at 301.222.8220 or email him at jrodriguez@aronsonllc.com.

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M&A Shop Talk IX

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This blog is a continuation of a three part series, the first blog can be found here. As previously discussed, when negotiating the best selling price for your business, tax attributes like NOLs and R&D credits play an important factor during negotiations. Such attributes allow the seller to economically accommodate the buyer with an asset acquisition transaction, which if properly structured would prevent the transaction proceeds from being doubly taxed.

The general rule of thumb in a negotiation process works so that the inherit tax benefits the buyer party receives will at minimum approximate the present value of the 15 years amortization deduction attributable to purchased intangibles. Therefore, it is imperative as the seller that before the letter of intent and/or exclusivity letter is executed, you reach an agreed to percentage of the described minimum tax benefit with the buyer. Moreover, at minimum you want the buyer party to make you whole in case there are not enough tax attributes carried over at the target entity level to offset the anticipated asset sale gain, and thus prevent the double taxation ramifications.

In the context of a typical exiting scenario involving a stand-alone “Target entity”, that is C corporation structured with large NOLs and R&D credits carried over, there are two basic tax structuring approaches to evaluate that could conceivably yield similar tax results that would appear more favorable toward the seller.

The first approach if there are no contract novation constraints, is to consummate a straight asset sale transaction followed by a liquidation of the target entity. Accordingly, an analysis calculation must be conducted beforehand to make a determination of whether the estimated calculated gain from the asset sale structured transaction will be entirely offset with the target entity’s carried over tax attributes. If following this route, make sure to take into consideration transaction bonuses, etc. Now, the net liquidation proceeds from the asset sale would be accordingly taxable to the investor’s selling group and taxed at the preferential federal long-term capital gain rate of 20% and state domiciliary rate, if applicable. From a pure liability assumption protection perspective, this approach would be the most beneficial to the buyer party.

The second approach to consider would entail completing a qualified stock sale to make an IRC Section 338 election under IRC Section 338(g) tax regime hereafter referred to as “regular Section 338 election”, to treat such qualified stock sale as a deemed asset sale at the target entity level for tax reporting purposes. Accordingly, from a pure contract novation perspective, it would be the most attractive legal structure to the buyer party. However, from a liability assumption risk management perspective, the buyer party assumes all inherit liabilities of the target entity including unknown contingencies that would require seller party indemnification (i.e., generally 10% to 15% of the base price will be held back in escrow and subject to indemnification terms and conditions). Please note to effect a regular Section 338 election, at least 80% of the underlying stock ownership must be sold within a certain 12-month period and certain legal and administrative requirements must be agreed and complied thereto by the seller and buyer parties.

Now, under a IRC Section 338(g) tax election, tax regime, the selling shareholders irrespective of the asset gain recognition transaction as described above are required to report the stock sale. Lastly, all the tax attributes of the target entity can only be utilized by the selling target entity with the filing of its final return.

Next time on M&A Shop Talk we’ll work through an example illustrating the utilization of tax attributes under IRC Sections 382 through 384 limitation provisions as discussed in the initial blog. We’ll incorporate a summary analysis of both described structuring alternatives, including the pros and cons for selecting each. In the meantime, if you have any questions or need additional information, please feel free to call me at 301-222-8220 or email me at jrodriguez@aronsonllc.com.



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M&A Shop Talk VII

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The most recent M&A Shop Talk highlighted the major tax advantages of completing a leveraged ESOP buyout transaction as an exit strategy for S corporation structured small businesses with no liquidity except its workforce. Now, we’ll cover a parallel discussion in the context of a C corporation target.

Currently, IRC Section 1042 tax provisions allow owners with at least 30% ownership stake in a qualifying C corporation selling target to complete a leveraged ESOP transaction, and invest their entire net cash proceeds received from the transaction into a qualifying replacement property (QRP). Thereby deferring 100% of the underling gain until such QRP is subsequently liquidated. In order to carry out this exit strategy, the following criteria must be met.

  • The qualifying C corporation target must be a domestic corporation organized under state law and actively engaged in a trade or business. For more information on how an LLC can convert and complete an ESOP leverage transaction, and take advantage of the Section 1042 deferral strategy, visit this previous blog post.
  • The sales transaction must be a stock ownership sale transaction with no stepped-up tax election treatment under Section 338 and/or Section 336.
  • The buyer party must be a qualified sponsored ESOP plan. For general background information regarding what constitutes a qualified ESOP plan, including intricacies regarding how to carry out a leverage buyout, please visit the National Center for Employee Ownership (NCEO).
  • The minimum stock ownership sold must represent at least 30% of all voting shares including preferred with voting rights or all stock ownership value except pure preferred non-voting shares of the selling target.
  • The selling shareholder or shareholders if more than one, must all be qualifying individuals with a minimum holding ownership period of three years (i.e., measured at the date of sale).
  • The replacement property rules under Section 1042 must be satisfied within a 15 month prescribed period, commencing 3 months before the date that the sale of the qualified securities occurs, which ends 12 months after the date of such sale.
  • The replacement property generally consists of common and/or preferred stock, bond debenture obligation, etc., as defined by IRC Section 165(g) (2) issued by the qualifying C corporation target.

In addition to the described IRC Section 1042 gain deferral provision, qualifying C corporation businesses can also take advantages of the following favorable tax provisions that are not available under an S corporation transaction format as discussed here.

First tax provision, dividend distributions received by the ESOP constitute an additional pension contribution fully deductible to arrive at the regular corporate taxable income. This is not deductible from the alternative minimum tax calculation by the qualifying C corporation target. Accordingly, this contribution is subject to the normal 25% aggregate employee compensation limitation and overall pension contribution ceiling limitation per eligible ESOP employee participant under IRC Section 415.

Second, the cash contribution portion used by the ESOP to satisfy the interest expense portion with respect to the leverage buyout loan is generally not subject to the aforementioned overall 25% aggregate employee compensation limitation. Further, it is not counted as an employer contribution for purposes of the aforementioned IRC Section 415 tax provisions provided that less than 1/3 of the current year employer contributions are credited to highly-compensated employees.

If you are a small business and your workforce is your most valuable asset, the described leverage buyout sales transaction via an ESOP might be the ideal exit strategy for you. If you have any questions or need additional information, please contact Jorge Rodriguez at 301-222-8220 or  jrodriguez@aronsonllc.com.




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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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Handling Deferred Revenue When Selling Your Business

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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 jrodriguez@aronsonllc.com or (301) 222-8220.

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