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 email@example.com.
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.
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 firstname.lastname@example.org.
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.
Have you heard of a horizontal, double dummy technique to achieve a partial asset sale tax treatment with stepped-up basis adjustment? A method that also accommodates a tax-deferred equity rolled-over feature?
Generally, this tax planning technique is more common in the context of a public company business combination scenario; however, it has some limited applicability in private M&A transaction planning considerations. The transaction arrangement uses a combination of tax-free reorganization doctrine provisions under IRC Section 368, along with incorporation tax rules pursuant to IRC Section 351 involving multiple entities to achieve the acquisition of a target entity with stepped up-basis tax treatment to the buyer party.
To keep things simple, if the overall transaction arrangement is properly structured and meets certain statutory provisions including valid business purposes, ownership control absolute minimum rule requirements, and continuity of interest test that are beyond the scope of this blog; the stock equity rolled-over component (i.e. received under the Section 351 incorporation exchange) is generally tax deferred. The cash consideration portion received (i.e. referred to as boot) is fully taxable. The character of the taxable boot is calculated based on the purchase price allocation. Thus the portion of the taxable boot consideration allocated to hot assets (i.e., unrecognized cash basis items including appreciated, non-long-term capital gain assets) are generally taxed as ordinary income. Liabilities assumed as part of the overall deal arrangement are generally not taxable, provided it does not exceed the aggregate tax basis of the underlying assets being transferred. Accrued, unpaid liabilities assumed and not previously deducted for tax purposes are generally not included in the excess tax calculation.
Now, as a general rule of thumb with some intricacies not mentioned in this blog, the major pros and cons from a tax benefit perspective in the context of private M&A deals are as follows:
Pros over asset purchase election tax treatment under Section 338(h)(10) or Section 336(e):
Pros over sale of partial LLC interest including conversion of target to an LLC pursuant to an F reorganization, which involve an S corporation target as described in this previously written blog from April 4, 2016.
Cons compared to an asset sale election tax treatment in general:
Stay tuned for the next M&A shop talk. We’ll discuss the handling of deferred revenue items involving asset sale transaction arrangement. 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 firstname.lastname@example.org or (301) 222-8220.