How to Mitigate Taxes in an M&A Deal

Our mergers & acquisition team at Legacy Partners represented Stellar Building Technologies in the sale to Albireo Energy. The transaction allowed our client to transition into the next chapter in his life with financial freedom but every deal has its challenges and in this one it was taxes. As an S-corporation, the deal structure proposed by the buyer was a stock sale with a 338 (h) (10) election, which recharacterized a stock sale of an S corporation to a corporate buyer as an asset sale for tax purposes, thus the tax issue.

As lawmakers push to pass this multitrillion-dollar spending package, every business owner is worried about taxes. Will they only tax “the rich” like Jeff Bezos? Who exactly are “the rich”?

Well, if you are a privately held business owner you are “the rich”!

When you sell your business, at a minimum, you will pay that silent partner of yours, Uncle Sam, a capital gain tax plus a potential nifty layer for the net investment income tax (NIIT) of 3.8%. And depending upon the structure of the deal, you may also be subject to tax at the ordinary income level.

How do we mitigate taxes on the sale of a middle market business?

OUR PROCESS

When negotiating the deal structure, the focus is primarily on the tax implications and potential liabilities. A buyer most often prefers an asset sale as any future contingent liabilities, for example­–from product liability, warranty or contract issues, or employee lawsuits–will remain with the seller, reducing future risk for the buyer. Although, it’s worth noting that in the closing document, called the Definitive Purchase Agreement (DPA) or Stock Purchase Agreement (SPA), the warranties, representations, and indemnifications are negotiated, so the risk may shift back to the seller.

Also, in an asset sale, a buyer enjoys the tax benefits of a step up in basis of assets, which increases their depreciation deduction and therefore, after-tax cash flow.

Taxes for the seller under an asset structure tend to be higher because assets other than intangibles, like goodwill, may be taxed as ordinary income as opposed to capital gains. And, if your structure is a C-Corp, you’ll be subject to double taxation, which is paid at the corporate level on the transaction and then again at the personal level upon distribution of the proceeds.

Sellers, on the other hand, prefer a stock sale since it reduces their future exposure to liabilities. All the proceeds are taxed at a capital gains rate, and if you’re C-Corp, it will eliminate the double taxation conundrum. Often a seller will think they cannot agree to an asset sale if their entity is structured as a C-Corp because of the tax implications. However, your team will compute the tax impact and negotiate the price accordingly to make the seller whole in the deal in exchange for agreeing to an asset structure.

If the buyer is receiving a benefit in the structure of the deal, then the seller must be compensated for whatever concession they are making to the buyer’s benefit.

For example, a 338(h)(10) election, named after that section of the IRC, recharacterizes a stock sale of an S corporation to a corporate buyer as an asset sale for tax purposes, while the transaction remains treated as a stock sale for legal purposes. The buyer then has the benefit of a step up in basis of the assets and avoids any issues regarding the assignment of assets. The seller, meanwhile, will have a higher tax burden with this election and the deal team will negotiate accordingly to ensure additional compensation for the seller agreeing to the election, which provides a tax benefit to the buyer.

Another strategy to consider is an “F reorganization” which is applicable to corporations–not LLCs. It permits deferral of the gain on partial equity that is rolled-over. It also avoids some of the hard edges of an IRC section 338 (h) (10) election, obtaining legal consent, or incurring transfer taxes.

Our team here at Legacy Partners performs a tax impact analysis at the Letter of Intent (LOI) stage to ensure we are confident that taxes have been mitigated.

When you are ready to sell your business go with the experts.

In our next blog we are going to talk about employees:  Add Value to Your Business: How to Reward and Retain Employees

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