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1
Caveat Venditor: Seller Beware
D. Joshua Elliott
2
Basic premise
• A host of legal, familial, operational and economic considerations drive the timing of when an owner may decide to sell their business
• Tax is rarely the #1 consideration
• However, tax considerations have a significant impact on the cash flow that may be realized upon sale
• Preparation and knowledge will enhance your return of investment
3
Session goals
• Introduce you to tax considerations that
will impact your after-tax cash flow
• Encourage you to be methodical in
preparing for sale – to help you maximize
your return
• Start you thinking!
4
M&A deal volume
Deal volume
down but price
per deal is up
5
M&A activity multiples
Multiples are up –
partially due to
increase in IT
and healthcare
deals
6
Topics
• What does the buyer want?
• What does the seller want?
• Legal and structure considerations
• Common problem areas
• What you can do now
7
Who Wants What?
8
What does the buyer want?
• Strategic buyers
– Looking for market share or to remove
competition
– May be adding vertical integration
– Very knowledgeable about your industry
– Integration opportunity and risks
– Little interest in back office function
– May have limited interest in retaining
management
9
What does the buyer want? (cont.)
• Financial buyers
– Frequently focus on a particular niche and roll
up companies
– Looking to use more sophisticated leverage
and borrowed funds to accelerate growth
– Concerned with cash flow and EBITDA
– Want quick flips and opportunities for return
on investment
– More sensitive to business cycles (trending
industries vs. mature businesses)
10
What does the buyer want? (cont.)
• In general
– Stepped-up tax basis in acquired assets
– Limited carryover of liabilities
– Key management retention
– Comfort about Target’s historical tax practices
11
What does the seller want?
• Capital gains tax rates (vs. ordinary)
• Tax efficient sales (avoiding leaving cash inside a shell company)
• Opportunity to participate in future growth (rollover) without paying current tax
• Maximum sales price with minimal purchase price adjustments
• To get paid for Buyer’s asset step-up
• FINALITY! Transfer of liabilities to buyer with no residual
12
Legal and Deal Structure Considerations
13
Target entity type
• C corporation
– If sell assets inside Target
• Tax inside Target
• Tax on distribution of cash to shareholders,
generally at capital gain tax rates
– If sell stock
• Shareholders pay capital gain tax rates
– Eligible for IRC §§338 and 336(e) only if a
subsidiary in a consolidated group
– May be eligible for very favorable IRC §1202
14
Target entity type (cont.)
• S corporation
– If sell assets inside Target
• Target has a combination of ordinary and capital
gains income that flows through to owners
• Generally no further gain on distribution of cash
(assuming shareholders have basis)
– If sell stock
• Shareholders pay capital gain tax rates
– Eligible for IRC §§338 and 336(e)
– Not eligible for IRC §1202
15
Target entity type (cont.)
• Partnership or LLC– If sell assets inside Target
• Target has a combination of ordinary and capital gains
income that flows through to owners
• Gain at partner level to extent cash distribution exceeds
basis
– If sell partnership/LLC interests• Partners/members pay capital gain tax rates
– Sale of greater than 50% may cause a
partnership termination
– Not eligible for IRC §§338 and 336(e)
– Not eligible for IRC §1202
16
Potential forms of sale
• Straight sale of stock
– Attractive to sellers because all gain is taxed
at capital gains rate
– Less attractive to buyers because it does not
allow for a step-up of assets inside the target
– Legal or operational benefits/detriments
– May require a change in the form of the entity
(i.e., harder to maintain S corp status if PEG
buyer)
17
Potential forms of sale (cont.)
• Straight sale of assets– Attractive to buyers because it allows for a step-up in
the acquired tax basis
– Less attractive to sellers if a C corp because of two
layers of tax
– May be less attractive to S corp sellers due to
additional ordinary income (vs. all capital for a stock
sale) or additional double tax (if a C corp within past 5
years)
– Could be more difficult if some sellers want to stay in
and some want to sell out
– Administratively more difficult (asset title transfers,
contracts, etc.)
18
Potential forms of sale (cont.)
• Hybrids– IRC §338(h)(10)
• Allows for the legal sale of stock which may be
attractive for legal reasons
• Target must be an S corp or a corporate subsidiary in a
consolidated group
• Both parties elect to tax the deal as a sale of assets
• Seller will pay taxes consistent with an asset sale
• Parties will likely need to “negotiate” for payment of the
additional tax liability (make sure seller is getting their
“fair share” – do not just negotiate for the tax
equalization; argue for a piece of the buyer’s benefit in
stepped up basis!)
19
Potential forms of sale (cont.)
• Hybrids (cont.)
– IRC §336(e)
• A limitation of IRC §338(h)(10) is that it requires a
corporate buyer
• IRC §336(e) has a very similar tax treatment but allows
for any form of buyer
• Seller must make the election (as opposed to buyer
and seller)
• Adds some flexibility but not as well known
• Note that holdover owners may have to pay current tax
on the gain even though they are carrying over
20
Common Problem Areas
21
Common problem areas
• Sales and use tax
– Failure to file in necessary states – statute of
limitation never closes
– Protections afforded to the sales of personal
property are not available for sales of services
• State income tax
– Nexus issues and failure to file in necessary
states
– Improper apportionment
22
Common problem areas (cont.)
• Employee vs. independent contractor
• S corporations – non-pro rata distributions
• S corporations – deduction for composite
state tax payments (which are
distributions)
• Reasonable compensation issues for
closely-held businesses
• Owner personal expenses deducted inside
the company
23
Common problem areas (cont.)
• Loss companies – failure to track ownership changes under IRC §382
• Debt refinancing issues
• Multinationals – transfer pricing
24
What Can You Do Now?
25
What can you do now?
• Twelve months or less
– Repair the termite damage before the buyer finds
it (cheaper than he will adjust the purchase price)
– Preparatory due diligence
• Risk assessment and amelioration
• Historical document accumulation
• Data room preparation
• Preemptive Quality of Earnings report (huge)
– EBITDA trend analysis
– The more prepared you are, the more credibility
you will have with a buyer
26
What can you do now? (cont.)
• Twelve months or less (cont.)– Trim the fat and get paid for it instead of leaving
for the buyer to realize• Optimize head count
• Accelerate tough decisions
• Dump underperforming accounts
• Eliminate personal expenses in the business
• Maximize EBITDA
– Think through steps the buyer would take in the first 6-12 months and do them now (so you get paid for them)
– Anticipate Buyer options so you are better prepared for negotiations
27
What can you do now? (cont.)
• More than twelve months
– Structure planning – isolating salable and non salable assets
– Maximize holding period to obtain long-term capital gains tax rate
– Create incentive comp for management to drive value
– Consider S corporation election (significant reduction in after-tax savings)
– Estate planning considerations
– Identify key markets for expansion to enhance value
28
Quick S corp example
29
Quick S corp example (cont.)
30
Other Considerations
31
Common terminology
• Earnouts
• Working capital adjustments
• IRC §409A
• Contingent liabilities
• Cash-free, debt-free
• Installment sales
• Inside vs. outside tax basis
32
Other considerations
• Preparatory diligence
• Transaction costs
• Parachute payments (C corporations)
• Pending tax law changes (tax rates)
• Management retention
• Limitation on use of NOLs
• Estate tax planning
33
D. Joshua Elliott
Tax Partner – Leader of FTSS
Dixon Hughes Goodman LLP
Greenville, SC
864.213.4027