M+A Tax 101
The Anatomy of a Deal Newsletter August 28, 2020
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
- Your private deal probably isn’t tax free, even if you think it is.
- Deal taxes can be greatly affected by the deal’s structure, allocation schedule, non-competition and consulting arrangements, and installment sale rules.
- Transferring a business within the family sounds like an easy way to minimize taxes, but can be fraught with its own tax complexities.
Welcome to M+A Tax 101. Who’s excited?!?
While few people like talking or even thinking about taxes, they often represent the single biggest drain on the net proceeds a seller receives in a typical deal. Not legal fees. Not investment banker fees. Taxes.
This may come as a surprise, but most sellers would rather keep more of their money than give it to the government. And while a buyer might prefer to stick its head in the sand and let the seller worry about taxes, the truth is that taxes matter to buyers, as well. Consulting with a good tax advisor early in the transaction process—and better yet, before there even is a transaction—will save you taxes and heartburn later.
First, the typical disclaimers: This discussion is a high-level and very generalized summary of some (but certainly not all) U.S. federal tax issues that may impact a typical transaction, with a particular focus on corporate transactions. It does not cover every potential situation, and there are almost always exceptions and peculiarities that may apply in a given case. You cannot rely on this summary or any of the generalizations included below. You are urged to consult with your own accountants and legal counsel who can advise you on the particulars for your deal and situation.
With that out of the way, let’s dive in! Rather than take the normal boring approach, we’re going to take a (slightly) more interesting look at some of the key issues by debunking some of the more common tax myths out there:
1. My deal is probably tax-free.
It’s probably not. A fair amount of public deals are tax-free (more accurately, they’re tax-deferred), but few private deals are. And if you’re receiving any cash for your business, you’re probably getting taxed at least on the cash you receive. If you’re taking all stock in the buyer as your sale proceeds, you might be able to achieve tax-deferred status. Otherwise, you’re probably paying taxes.
2. It doesn’t really matter what I do—the taxes are what they are.
Wrong! There are many variables in a transaction that will directly affect your tax bill. Knowing these variables and their effects on your deal are critical to making the right moves to secure your best tax result. Some of those key variables include:
(a) Deal structure—I’ve said it before, and I’ll say it again: structure matters! There are lots of ways deal structure affects your transaction, but taxes may be among the most significant. While this general rule doesn’t always hold true, buyers generally prefer asset sales, and sellers generally prefer stock sales.
In an asset sale, the buyer isn’t really buying the “business” per se. It’s buying a collection of assets that just so happens to comprise the business. As a result, the buyer gets to allocate its purchase price directly to the assets it’s buying. This means that the buyer gets to take increased tax depreciation and amortization deductions, effectively allowing it to write off the purchase price after the transaction. For the seller, this means that the seller picks up taxable gain for each asset that has an allocated value in the transaction that’s higher than the seller’s tax book value for that asset. When the seller has already depreciated the assets significantly, the seller may pick up “recapture” income which changes what might have otherwise been capital gains into higher-taxed ordinary income.
In a stock sale, the buyer generally doesn’t get to write-up the basis of the assets it’s buying. Instead, it gets additional tax basis in the stock it buys from the seller. But that doesn’t do the buyer any good unless/until the buyer decides to sell off the company’s stock later…hardly the benefit that increased depreciation and amortization deductions offer the buyer. On the flip side, sellers generally prefer stock sales because the seller usually dodges the ordinary income bullet.
While these general rules of thumb hold up frequently, there’s one key variable that might encourage a seller to get comfortable with an asset sale, at least for tax purposes. We’re talking about the…
(b) Allocation—A typical buyer’s draft asset purchase agreement (or the agreement in a stock purchase that’s treated as an asset sale for tax purposes—don’t ask) contains a paragraph along the lines of the following:
Seller and Buyer agree that the Purchase Price and the Assumed Liabilities (plus other relevant items) shall be allocated among the Purchased Assets for all purposes (including tax and financial accounting) as shown on the allocation schedule (the “ Allocation Schedule”). A draft of the Allocation Schedule shall be prepared by Buyer and delivered to Seller within 30 days following the Closing Date.
Seems fine…and boring, right? But the unwary seller who agrees to this paragraph has literally told the buyer “I really don’t care how much of the purchase price I actually end up getting.”
In these transactions, the allocation could be the most important issue, aside from setting the purchase price. If the seller lets the buyer control the process, the buyer will look to establish an allocation that allows the buyer to write off the purchase price as quickly as possible after the closing. However, doing so often means that the seller will end up paying taxes on a larger share of the purchase price at the higher ordinary income tax rates.
In contrast, if the seller actively negotiates the allocation (or at least the allocation methodology) prior to finalizing the agreement, the seller could suggest an allocation like this:
- all fixed assets allocated at their tax book values—so there’s no gain or loss (including dreaded recapture income) on these assets; and
- the balance of the purchase price allocated to goodwill, which is generally taxed at capital gains rates.
In this case, the seller probably does about as well—or possibly even better—than in a stock sale, assuming the seller is a “pass-through” for income tax purposes (i.e., not a C corp.). While the buyer won’t get to write off the purchase price as quickly as it otherwise might (depending on the nature of the assets and the tax law in existence at that point in time), the overall tax benefit to the buyer from quicker depreciation is usually less than the overall tax cost to the seller. Rational buyers and sellers generally prefer to minimize the overall tax costs of the deal—it doesn’t do either side any good to have more money going to the government. As a result, the parties can usually work out a deal that minimizes the overall tax costs. In some cases where the buyer sees meaningful value in the additional “step-up” for the assets it’s acquiring, the buyer may even decide to pay the seller a little extra for these increased tax benefits.
Note that sellers who have C corps for tax purposes have the dreaded “double-tax” problem when they sell assets, but not when they sell stock. And C corps don’t get preferential capital gains tax rates. So an asset sale is almost always going to be a problem for C corps. There are some potential workarounds for the C corp stuck with an asset sale, but that’s far beyond the scope of this primer.
Also, as noted in prior installments of this series, an asset sale poses other downsides to the seller beyond taxes (e.g., liabilities, consents, etc.). So even if you can make the taxes work, sellers will still want to make sure they know what they’re getting into by accepting an asset sale.
(c) Non-Competition and Consulting Arrangements —Sometimes buyers come up with unique structures that play around with the character of consideration a seller receives. As a seller, which deal is better?
- $5 million paid for the business’ stock; or
- $4 million paid for the business’ stock and $1 million paid to the seller for a non-competition agreement.
As a seller—assuming you weren’t planning on competing after the closing (another topic for another day)—it doesn’t really matter, right? You get $5 million either way.
But that non-competition agreement will be taxed at the higher ordinary income rates. By agreeing to the second transaction structure, the seller voluntarily agreed to pay a lot more in taxes. Your government thanks you.
Sometimes buyers will insist on allocating purchase price to a non-competition agreement. Many times, buyers will say that they need to do so in order to make the non-competition agreement enforceable. While that may be true in some states, it’s not true in many states. Don’t let the buyer fool you.
Consulting agreements present a similar issue, but there may be at least some planning flexibility. Like non-competition agreements, payments under consulting agreements will be taxed at ordinary income rates. However, these payments can be made—and therefore, taxed—over time. This at least provides some benefit to the seller because it allows the seller to defer the purchase price over a period of time post-closing, thereby spreading out the tax cost—albeit at a pretty high tax cost. Speaking of deferral…
(d) Installment sales—As a seller, you usually want to get 100% cash at closing, but sometimes sellers end up taking some portion of the purchase price over time. Even in the proverbial “all cash” deal, there are often escrows or holdbacks that are paid at a later date. In some cases, the seller ends up financing part of the deal with a “seller note” that is paid over time.
Now let’s say that this seller—already upset that he or she didn’t get paid for the entire purchase price at the time of closing—finds out that he or she has to pay tax on 100% of the purchase price immediately at closing, even though a portion is deferred until a later year. Ouch…
Fortunately, the seller gets some help through the “installment sale rules,” which generally provide that the seller ends up getting taxed on these subsequent installments only as and when they’re received. However, the installment sale rules can be tricky in some cases, so you want to make sure that you’re getting good advice so that you avoid any traps.
3. I’m the buyer. I don’t care about all that tax stuff—that’s the seller’s problem.
Nice try. The buyer certainly cares about the taxes. As noted above, the allocation in an asset transaction (as well as non-competition and consulting agreements) will directly impact the buyer’s ability to obtain tax benefits after the closing—tax benefits that may be important in financing the deal or making the economic model work. If the buyer is wrong about what tax benefits it will receive after the closing, that would be a major strain.
In addition, buyers certainly care that the seller’s attitudes toward tax compliance don’t get the buyer into trouble itself. The buyer wants to ensure that the seller takes care of its tax obligations so that the buyer doesn’t get dragged into a messy fight with the government.
4. This makes my head hurt. It’s better to let the accountants figure all of this out later.
Great idea, so long as you don’t care about the tax costs (for sellers) or tax benefits (for buyers). If that’s the case, the accountants will be happy to prepare tax returns for you after the deal closes. Just remember to drop off a blank check payable to the government.
5. If I keep the business in my family, I don’t have to worry about taxes.
Unfortunately, that’s not the case. But the tax issues will be quite different. Welcome to the world of estate and gift taxes!
Transferring a business within the family should be much easier than it is. If dad wants his daughter to own the business, he just needs to sign over the stock, right? Well, sadly, that would be a “taxable gift” from dad to daughter. And whether that “taxable gift” actually results in a tax bill depends on a number of factors, including:
- The value of the company;
- How much of the company dad is transferring;
- Who controls the company;
- What the lifetime estate and gift tax exemption amount is at that point in time;
- The total “taxable gifts” dad has made during his lifetime up until this gift;
- How the gift will be structured; and
- So on…
While the exemption amount is historically high right now (about $11.5 million per person—meaning that an individual can, over the course of his/her lifetime, gift up to an aggregate amount of $11.5 million in value without triggering a gift tax bill), that benefit could well be going away anytime between 2021 and 2025.
While this sort of family transfer is unnecessarily complex, the good news is that estate and gift taxes are one form of voluntary taxes—you don’t have to pay them if you’re willing to do some planning far enough in advance.
6. This is all fine and good, but it’s too late for me to do anything.
This one actually may be true, depending on where you’re at in your deal.
There are many different strategies that can be used to limit or defer taxes. Some of these are income tax strategies and some are estate and gift tax strategies. Some are federal tax strategies and some are state tax strategies. Welcome to the alphabet soup that only tax geeks can appreciate: ESOP, QOZ, GRAT, IDIT, CRT, WTF, etc. (OK, so I added WTF, but it seemed appropriate here).
We can’t go through all of them here and you don’t even want me to. The key point is that most of these strategies only work when there’s sufficient time in advance of the transaction to allow for tax planning. For many of these (and other) potential tax planning strategies, you need to start the tax planning months—or years—in advance of a transaction. So the sooner you start thinking and planning with an expert tax advisor, the better.
Taxes aren’t fun. They’re not interesting (except for tax nerds like me). But taxes matter. In. Every. Single. Deal.
Taxes can eat up a huge share of the purchase price a seller receives in a transaction, threatening a seller’s future plans. Tax issues can spell the difference between a successful acquisition for a buyer and a failed acquisition. Taxes can stand in the way of a parent achieving his or her lifelong dream of passing the family business on to the next generation.
Yes, taxes definitely matter. Some tax issues can be resolved pretty easily; others are much harder. But there are often—though not always—solutions to many tax issues, if you’re willing to start early and invest resources. Tax planning must be a high priority regardless of where you are and where you’re headed. Now is the time to get started!
Next Month: Due Diligence 101
Read last month’s piece: M+A Motivations