Tax Considerations in M&A

Tax Complexities

Tax issues in M&A can get very complex very quickly because the best structure for the buyer is not the best for the seller, and vice versa. So they are always at odds with one another when determining the transaction’s structure and what would be best for them. Many of the complexities are informed by the different tax structures of the parties.

• Are they a C corporation? S corporation? LLC?
• Is the deal going to be all cash? Or Equity?
• Is there going to be an earnout?

Also, it's not only US federal income taxes that need to be considered. You also have to think about state and local taxes and if there's any foreign jurisdiction or individuals involved. You also have to think about cross–border taxes. So it can get very complex very quickly.

And the size of the deal doesn’t determine the complexities. My most complex deal is a $750,000 tax-free reorganization, so it's not size-dependent. It's more dependent on these other factors.  

Considering Tax 

Regardless of what side you are on, it's best to have tax involved when you are negotiating the term sheet or the letter of intent. So before you do the definitive documents, you want some tax input.

Often, buyers involve tax after LOI because they often have the upper hand during this stage. They're the bigger company, and they have a playbook. They already know what to do, and they also know the contingent considerations that they want to have. 

Whether it’s revenue or employee retention, a lot of times, the buyer sets these terms that could have negative tax consequences for the seller later on. The seller is the one that usually has an issue with the LOI and is often not as big as the buyers, so they don't have a tax advisor lineup.

As for the seller, the best-case scenario is to bring in a tax expert before they start negotiating a term sheet. Some terms in the term sheet could be disadvantageous for the seller and hard to go back and renegotiate. So at the very least, we would love to have a seller reserve for restructuring in light of taxes in the term sheet if they have no tax advisor.

A lot of times, a seller needs to do some restructuring to get themselves into the best structure for the sale process. And it's great if you could start thinking about what needs to happen ahead. Should they sell their assets or their stock?

For instance, if they sell their assets, there could be a big tax drag. And so, they could start negotiating for a gross-up on the purchase price to compensate them for the tax drag. If you don't start negotiating for something like that at the term sheet stage, it’s very hard to get it later. 

Tax is one of those areas where you can see actual cash savings. So when you're a buyer, you want to consider the future monetization strategy. The best way to own a business is to get a basis step up in the assets. It can provide a tax shield for the buyer in the form of depreciation, amortization, and deductions. 

So when doing the modeling and determining the purchase price to offer, buyers should be thinking about taxes. They should consider what the tax drag is and the tax shields they can get from the basis step-up. 

The buyer also needs to think about post-acquisition structuring. If the buyer has only invested in flow-through businesses, buying a C-corp’s stock might not be advantageous for them. They might not be able to incorporate a business in a C-corp form well into their structure. Otherwise, a corporate buyer buying a C-corp isn’t so bad for their structure. 

Buyers should be mindful of tax issues when structuring a transaction and think about the optimal structure for tax efficiency.

Obviously, buyers should be very mindful of not acquiring any tax liabilities associated with the business prior to their ownership of the company. So they should consider tax indemnity and what that will look like. Buyers should consider special covenants regarding taxes and cleanup matters.

Tax diligence is very important. If major issues are identified in tax diligence, sometimes the buyer wants special indemnity to ensure enough cash to cover the tax liability, certain remediation measures, escrow, or insurance for known tax risks. There are several ways to deal with those issues, but that’s something that the buyer should always be thinking about.

If a buyer sees a C-corp target that has a lot of net operating losses, they might think about how to price the use of those into the deal, especially if they get the benefit of that tax asset post-closing. 

Key employees should also be a consideration. If there is an employee or a seller they want to keep post-closing, there could be a rollover, which would mean some equity compensation in the deal. That also must be tax efficient for both the buyer and the employee. 

Start-up Tax liabilities

For our startup clients, usually SAS businesses, a lot of times, the big tax issue that comes up in diligence is that they have not complied with all their sales tax obligations in the various states. Buyers identify that as a key issue and ask for escrow or purchase price reduction. Sometimes they ask for remediation measures where they will do voluntary disclosures in certain states. 

There's a big negotiation around that issue because the seller wants to be able to walk away after the deal if they are not rolling, and they don't want to be worried about tax liabilities trailing them forever. 

• What does the indemnification look like
• How long will it last
• Which states will the company comply with

And the law is always evolving, so there's no right answer. State and local issues have become more widespread in the past couple of years because of covid and all the remote workers. Suddenly, a company that had employees in two states now has employees in 25 states and has tax obligations in each of those states. That has become a big hot ticket item. 

So when we’re preparing a seller, we tell them that these will become issues because buyers want to know about sales tax and income tax compliance. It is best if the seller does their own due diligence to figure out where their weaknesses are. 

And one of the things they should focus on is the employee aspect. Not only will the buyers look at where the workers are located, but they will also look if employees are correctly characterized as employees vs. independent contractors or vice versa. Misclassifications of employees is another hot ticket item in diligence. 

Minimizing Risks

What you'll always see in M&A are tax representations, just like all the other representations you have in a deal. The company is also repping that it paid its taxes and filed its tax returns correctly, and withheld all the payroll taxes it needed to withhold. 

The seller can schedule against those reps. If they know that they can't make any of the reps they were asked to make, they’ll schedule against them. Buyers will also ask for pre-closing tax indemnities. There are many negotiations around what that will look like, which can be extensive. It can cover all tax liabilities, known or unknown, and it doesn’t even expire. 

Sometimes you'll see a deal without tax indemnity and just have a rep and warranty insurance. But a rep and warranty insurance will just cover breaches of the reps and sometimes also a pre-closing tax indemnity if there is one.

The issue is that rep and warranty insurance very rarely will cover any known tax risks. If any taxes were identified on the diligence schedule or in due diligence, the rep and warranty insurance policy usually excludes all of those tax items.

So the buyer will have no indemnification for those items if they don't have it against the seller. Sometimes the seller has negotiated that they're only on the hook for whatever reps and warranty insurance don't cover. In this case, the seller needs to know the tax items have been excluded from the insurance. 

Buyers can also get special tax insurance which is a special product to cover known tax risks. I don’t see that often in M&A, but that is possible. Then sometimes, you see deals structured like public-style deals with no reps and warranty for anything. Both parties just walk away after closing. 

Stock vs. Asset sale

If the target company is a C-corp and has a lot of net operating losses, the buyer might want to buy stock instead of assets. But there are limitations on the ability of a buyer to use net operating losses. 

Another reason is when buyers look at their model, the tax shield depreciation isn’t a major factor in how they look at the deal's success. Another reason is maybe the buyer is a C-corp and the target is a C-corp that will easily consolidate inside the buyer and does not create a tax drag. 

Or maybe the buyer is a C-corp and wants to do an all-stock, tax-free transaction. So there are many times a buyer would be totally fine buying stocks. And sometimes, the seller, if they are a C-corp, will refuse to do an asset sale because it’s so tax-inefficient to structure. 

Net operating Losses

The IRS already shut down the ability to acquire losses Because they did not like the idea of taxpayers being able to traffic in net operating losses or shell companies that had a bunch of losses. 

They enacted a code provision that states the Net operating losses of a corporation will be limited if shareholders increase their ownership by 50% over a three-year period. So if a corporation completely changes hands, the ability of the net operating losses to be used are limited.

Net operating losses carryforwards generally are useful because you can use them to offset 80% of taxable income. But if the ownership changes, the 382 rule provides a limitation for any year and is limited to the amount equal to the value of the company on the date of the change of ownership, multiplied by the long-term tax-exempt rate, which is very low, subject to certain adjustments. 

In short, the ability to use net operating loss carry-forwards is severely limited when there is a change of ownership in a C-corp. 

Another question I get a lot is about buying assets and getting the losses, similar to a tax asset of a c-corp. The answer is no, you can’t buy net operating losses. What can happen is if there’s a C-corp that has a lot of losses, the shareholders might be more amenable to doing an asset sale because the corporate-level gain would be shielded by the net operating losses. 

So there is some benefit in having losses in a c corporation in a sale transaction. 

Buyer’s Benefits

It depends on what the buyer’s doing. Post-transaction integration is very much a function of who the buyer is and what the buyer’s looking to do with this investment. So if you have a fund that's purchasing the company as a portfolio and not have it be part of a roll-up, they might think of it more as a standalone investment and ask the management team to stay on and run the business. 

On the other side is big strategic investors. A big company that wants to buy a target company and operate it as part of the overall business. They see it as adding something they don’t currently have. And sometimes they just want the assets, and not the people. 

But when they want the people too, there’s often negotiations around who will run the company and the level of autonomy. In this case, it will come back to taxes when thinking about earnouts, and contingent deal considerations. How that will be measured and paid out. 

For the sellers, they’re thinking about how to get paid as much as possible as long-term capital gain, versus as ordinary income.

Creating a Holding Company  

 For buyers, that depends on the pre-transaction structuring considerations.  

• Where will the target company sit in its overall structure? 
• Do they need to reorganize
• If they are a foreign company with a US subsidiary, which one should buy the target company?
• If it’s an asset purchase, should one of their existing businesses buy the asset? Or form a new holding company?

It's all very dependent on buyer structure and the ultimate monetization goals with respect to the acquisition.

The international component makes it very complex. Most people know that US seeks to tax worldwide income where it can. So you do want to make sure, especially if you have a foreign buyer, that you are not going to subject them to unnecessary US taxes.

It's wise for a foreign buyer, in particular, to get US tax advice before buying a US-based business, which most do. 

Equity Compensation

One issue that we see commonly is you'll have key employees who are also equity holders of the target company. And oftentimes, the buyer seeks to subject some of their deal’s  consideration to contingencies.

For instance, investors can get their deal considerations up front, but the key employees only get their piece if they are still employed or been employed for a certain period of time. But you have to be very careful because generally, deal consideration can receive long-term capital gains. You don't want to turn any of it into compensation income by subjecting it to contingencies like retained employment.

So if any of those contingencies or complexities come into play, you need to talk to a tax advisor on the sales side to ensure that you’re not disadvantaged by agreeing to those conditions. 

Experienced buyers understand all of these tax issues, and are often willing to work with seller’s council to help structure a tax-efficient structure for the seller. 

Efficient Tax Structuring for Sellers

If a seller is supposed to be receiving equity from the buyer to stay in the company, it's very important for the seller to talk to a tax advisor and make sure that it is structured tax efficiently. 

So the seller has tax deferral on the equity portion of the consideration. You don't want to be a seller who receives equity consideration for your equity in the target but has to pay tax cause you won't have the cash to pay the taxes on that portion.

And there are also a whole host of other tax efficiency goals in mind that the seller is thinking about when doing M&A.  Usually, the seller's main goal is 

• You pay as little aggregate taxes possible on their sale proceeds. 

• They want to structure the transaction so there’s only one level of tax on the cash.
• They want deal consideration to be long-term capital gains, not ordinary income.
• They don't want to pay taxes if they are getting inequity for their equity.

And it all depends on the seller’s structure. If the seller is a C-corp, it's generally the most tax efficient for the seller to sell their C-Corp stocks. There's one level of tax on that sale. It's usually long-term capital gain.

If a buyer requested a C-Corp seller to sell its assets, it could be very tax inefficient for the seller's shareholder because there’s tax at the corporate level, and there’s tax again when the cash comes out. 

S-corps are a flow-through entity. If you sell their stock, it only has one level of tax on that gain. Usually it's long-term capital gain, because it depends on the holding period of their stock. Except for certain states that don’t follow the federal income tax rules for S-corp and they impose an entity-level tax on that gain. 

Also, if an S-corp sell its assets, some of the gain might be ordinary income rather than long-term capital gain. It was almost always the case that it was more efficient for them to sell the stock rather than assets. 

However, recently, there are a whole new host of new rules called PTET tax regime. (pass through entity tax). Certain states have enacted rules that allows S-corp and tax partnerships to pay  state taxes on behalf of their individual owners at the entity level, and then the share the equity holders get a deduction against their federal taxes. 

So whenever we have a seller  that is S-corp or tax partnerships, you need to do modeling based on tall of the state implicated in the transaction,  to determine whether the offset from the PTET regimes is greater than the savings by doing an equity sale. So now we are actually seeing as it says be more tax efficient which is a very big change than what we were used to. 

For LLC, generally the sale of equity or assets from an LLC is subject to one level of tax. And when a partner of a partnership or a member of an LLC sells its equity, certain of the long-term capital gains is recharacterized as ordinary income. It's something called the hot asset rules.

So generally, inventory items and depreciation recapture are recharacterized as ordinary income. If an LLC or partnership sells its assets, they're also some ordinary income. But now because of the PTET regime, if an LLC sells its assets, there could be the ability to deduct state taxes against federal taxes on the gain, which could be a big tax saving.

So there's a need now to model out what is better when you're a seller, and you hold equity in LLC whether you should be selling the assets or equity would be more tax efficient, and the buyer can receive basis step-up. So there's a lot more flexibility in structuring. 

Negotiations

The party that has more leverage depends on the deal and who needs to get the deal done. There are certain fundamentals where if a seller is a C-corp, they cannot do the deal if it’s an asset purchase because it’s so tax efficient. 

But if the target is an S corporation or an LLC, there is often some negotiation regarding optimal structure. It's usually fairly easy to find a structure that works for both parties.

One of the bigger issues is with S-corp targets, which are finicky. S-corp can only have certain types of shareholders, specifically US individuals. 

So if the buyer was a corporation or a partnership like a fund, if it purchased the equity of an s s-corp, the S-corp turns into a C-corp automatically. And so typically, buyers don’t want to buy the equity of an S-corp. And if you have any rollover sellers, they’re not going to want it either. 

But there couldn't be a real tax efficiency for a seller of an s corp to sell the equity because they can get all long-term capital gains versus a portion of ordinary income. And so sometimes there are negotiations around gross-up.

It is where the seller lets the buyer get the tax structure they want but will increase the price of the transaction to cover for the taxes that they will owe because of the structure. And it’s tricky because it’s an additional deal consideration. So what you really need to do is gross-up on the gross-up. So it’s an iterative consideration.

What you think could be a $1 million dollar difference in taxes could be $2 million in gross-up. This could be a big negotiation point. 

Tax Considerations in LOI

This is why I like to get involved very early in the LOI, but it depends on a lot of things.

• Who’s negotiating
• What the positions of the parties are
• What the big deal points are

For example, there will be some contingent considerations in the form of equity. Sometimes we’ll just put a one-liner that says the transaction will be structured in a manner that's tax efficient for the sellers. Or tax so that the equity is received on a tax-deferred basis.

Sometimes we'll figure out the whole deal structure because it's that important and it's that tricky. 

If we represent an S corporation target, we’ll put in the contract that if the buyer wants a full basis step up on the assets on an asset purchase, we have to receive a gross-up for the additional taxes we’ll have to pay because we didn't do a stock sale. 

Those are the material issues that you want to get into at the term sheet stage. It’s very hard to renegotiate this stuff if the seller has already agreed to it in the LOI, even though it’s not binding. You have to talk about these issues early. 

We’ve seen many times where buyers have the upper hand in the term sheet stage because they’ve dictated the structure and the seller hasn’t engaged a council to help negotiate. It will all depend on who has the upper hand. 

But in the end, you just need to give your client the information and some guidance, but ultimately, a lot of the decisions are business-level decisions. Give them enough knowledge to understand what they’re signing and the ramifications. 

Qualified small business stock

If you hold QSBS stock for more than five years and that stock, you can exclude from income tax the greater of $10 million or 10 times your basis in that stock. So if you invested 2 million into a C corporation and you're stock qualified as QSBS stock, and six years later you sold that stock, you can shield 20 million of that gain from tax.

But not all stocks and corporations are QSBS stocks. QSBS stocks is stock in a C-corp so it has to be a C-corporation and it has to have been issued when the corporation was a qualified small business. 

Meaning its aggregate gross assets at all times before the stock was issued and immediately after the issuance do not exceed 50 million. And generally aggregate gross assets for that purpose means cash and tax bases of the corporation's assets.

When you have assets contributed to a corporation or if an LLC converts to a corporation. You have to use the fair market value of those assets when determining whether it's a qualified small business and whether the 50 million value has been exceeded.

S corps are really funky because if you own S-Corp stock, and then you convert your S-corp to a C-corp, you can't get QSBS because when you originally received the stock, it was S-Corp stock. 

So if you are a shareholder in S-corp and you want potential Q S B S for your corp, we do a special type of reorganization to get you that stock tax efficiently, but it's not as simple for that S corp founder as just converting to a C corp.

Not only does the C Corp stock have to be acquired an original issuance, which means you have to have received your QSBS for investment into the company. You can't have bought it in a secondary.

It also can be disqualified if there have been any significant redemptions within the prior year after you've purchased your QSBS stock. So there's special disqualifying redemption rules you have to look at.

And then the corporation has to have met the active business requirement, which means at least 80% by value of its assets needs to have been used in the active conduct of a qualified trader business. 

So basically, leasing, financing, investing, or other similar businesses is not a qualified trader business. Businesses where the reputation or skill of the employee is the principal asset of the business: like law, health, and consulting. Those can't be QSBS businesses.

Relocation for Tax Savings

We have a lot of clients who have relocated to, uh, Texas and Florida in the past couple of years. Certain states have provisions that claw back on the savings by moving to a different state. And some of it's dependent on how contingent the further payments are.

But more people are moving because they want to save on general taxes on their everyday income. People are just getting sick of not getting the benefits of the deduction. 

Tax considerations during diligence

It all depends on the structure of the deal. If you’re buying equity in an entity, you’re assuming tax liabilities. You might have indemnifications or rep and warranty insurance to cover yourself financially, but it's still your headache.

If you’re doing an asset purchase, a little less of a headache because tax issues will stay at the selling entity, except for some state and local taxes. 

And if you're acquiring equity in an LLC or an S corp, some of those preexisting taxes could naturally flow through somewhat to the prior owners, but still your headache because you own the company.

But you always want to do fulsome tax diligence. Have an accounting firm come in and diligence the company, look at all its tax returns, and make sure it's been doing everything correctly. Usually, it’s an accounting firm putting together a diligence report, and then lawyers will look at the big ticket issues that need to be negotiated on the tax side.

And then lawyers will decide what needs to make it into the purchase agreement regarding the obligations of the buyer and seller with respect to taxes, and any cleanup that needs to be done or indemnity that ask needs to be asked for 

Lessons Learned

Do get a tax advisor involved early on. It just saves you a lot of money later on and ensures that you are structuring the transaction tax efficiently. And then, as a buyer, do your diligence on the target company. That would be my big buyer's advice.

Also, for sellers, if there’s going to be equity in the buyer moving forward, their interests are not always going to be aligned. Depending on how the negotiations proceed, those shareholders or equity holders might need special counsel.

People who can structure smartly do well. As a seller, structure the deal where you get most of your gains as long-term capital gain. And also, really importantly, structuring your go-forward incentive equity tax efficiently. 

If you're a founder of a startup, or you are a shareholder of an earlier stage company, you should start thinking about overall tax structuring for you and your family. Thinking smartly about how to use trusts and grants and eventual estate planning can pay off.

That goes again to why sellers, in particular, should get tax involved really early is because you do need to start thinking about some of those tax-efficient structures earlier on, rather than at the time you're trying to sign an LOI.

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