Key Tax Issues in Negotiating M&A Deals for Small Businesses

By:
Jordan L. Fieldstein, JD, LLM (taxation) and Michael P. Spiro, JD, LLM (taxation)
Published Date:
Oct 1, 2017

Negotiating the sale of a small business begins with striking the commercial bargain between the parties. The alternative tax structures available to effect a single transaction, however, can have a significant impact on the parties’ economic bargain. From a tax perspective, the parties must address two key issues: (i) whether to structure the sale as a taxable or tax-deferred transaction (either in whole or in part) and (ii) whether to structure the sale to obtain a step-up in the basis of the acquired assets. The purpose of this article is to give a brief overview of the tax issues at play in these negotiations and help the reader navigate the general preferences of each party with respect to each alternative.

Taxable Versus Tax-Deferred Transactions

The acquisition of an ongoing business can be structured either in a taxable or a tax-deferred manner. As a general matter, most private deals are wholly or partially taxable because sellers want to achieve a level of liquidity that renders complete tax deferral impractical (unless the buyer is a public company using marketable securities as consideration). Many taxable transactions, however, include partial tax deferral with respect to the seller’s reinvestment in the ongoing enterprise, commonly referred to as an “equity rollover” or simply a “rollover.”

In the sale of a small business, the sellers are generally the individuals who have built the business of the target and hold the key relationships, knowledge, and skills necessary to operate, conduct, and grow that business in the future. Where this is the case, it is often in the common interest of the buyer and the seller for the seller to maintain a meaningful stake in the business after the sale. The buyer will desire to retain the seller to grow the business and to avoid competition, and the seller (particularly in the context of a sale to a private equity buyer) will desire to continue participating in the growth of the enterprise in the hopes of receiving a larger payout upon the buyer’s eventual sale of the target. 

From the seller’s perspective, it is often imperative to accomplish the rollover on a tax-deferred basis. In most cases, tax deferral with respect to a rollover investment is achieved by one of two IRC sections: IRC section 721 when the purchaser is a partnership (or an LLC taxed as a partnership) and IRC section 351 when the purchaser is a corporation. Both sections provide for non-recognition treatment for the transferor and transferee on the exchange of property for equity in the acquiring entity under certain circumstances.  

The primary difference between the two sections is that IRC section 351 requires that the transferor (and any other person in the transferor’s “control group”) control the buyer immediately after the contribution in order to qualify for nonrecognition treatment.  For this purpose, control means ownership of stock possessing at least 80% of (i) the total voting power of all the shares and (ii) the number of shares of each class of nonvoting stock. Generally, the section 351 control requirement is satisfied in the acquisition context when the acquiring entity is a newly formed corporation that has been capitalized by the buyer as part of the acquisition transaction (as both the seller and the buyer can be counted as members of the same “control group”) or, if the acquiring entity is not a newly formed corporation, more than a de minimis amount of equity is contributed to the acquiring entity by the buyer as part of the transaction. Due to the control requirement of IRC section 351, tax deferral is significantly easier to achieve with respect to the rollover shareholders when the acquiring entity is an LLC or partnership.

The value of accomplishing the rollover on a tax-deferred basis is the time value of money with respect to amount of the taxes deferred until a full exit from the continuing business. The transferor/seller takes a carryover basis in his or her investment, such that the taxes that otherwise would be owed on the transaction (had it not been structured as a non-recognition transaction) are preserved in the transferor’s equity in the continuing entity. The transferor is then able to put that money to use in the interim between the sale transaction and their ultimate exit. In an environment where tax rates are expected to decrease in future years, as is currently the case, there might also be a rate benefit to the deferral. 

Step-Up in Basis or Carryover Basis

The next structural decision to make is whether to structure the transaction to deliver a basis step-up to the buyer. Generally, the acquirer will desire to structure the transaction to achieve a basis step-up, and the seller will generally prefer not to structure the transaction in such a manner if doing so will decrease the seller’s after-tax proceeds. 

When a transaction is structured as a sale of assets, or—as discussed below—is otherwise  treated as a deemed asset sale for tax purposes, the acquirer takes a basis in the assets acquired equal to the cost of such assets, referred to as a “cost basis.” Alternatively, when the transaction is structured as a sale of equity, the buyer takes a cost basis in the equity of the target (which, in the case of stock in a corporation, is not depreciable) and inherits the target’s basis in its assets, referred to as “carryover basis.” Generally, the cost basis is higher than the carryover basis in the acquired assets because the seller has depreciated the assets over their useful life and often holds such assets with little to no basis or the value of the asset has appreciated over time such that the fair market value of the asset is greater than the seller’s historic basis. When the buyer receives a higher cost basis rather than the lower carryover basis in the acquired assets, it is colloquially referred to as a “step-up in basis” to reflect the fact that the basis has been increased in the hands of the buyer.

The value of a basis step-up to the buyer is an increase in after-tax cash flow from the acquired business. After the acquisition, the buyer can recover the bases of certain assets through depreciation or amortization deductions over the useful life of such assets. The tax shield attributable to the depreciation or amortization deductions is increased when the buyer’s basis in the assets is stepped up—meaning that, on a comparative basis, the buyer will have more operating income on an after-tax basis when the transaction is structured to achieve a basis step-up than it would have if the transaction was not structured in such a manner.  

A transaction can be structured in several different ways to achieve a step-up in basis. The purchase of the equity of a disregarded entity provides the buyer with a basis step-up because, for tax purposes, such transaction is treated as though the parent of the disregarded entity sold assets to the buyer. In the partnership context, both an asset and stock sale provide the buyer with a step-up in basis with respect to the assets of the LLC/partnership either through a termination of the partnership as described in Revenue Ruling 99-6 or by utilizing a IRC section 754 election. In the case of an S corporation, if the target and the buyer are unrelated (both prior to the transaction and after the transaction, taking into consideration any rollover shareholders) then the parties may make an election to treat the sale of the target’s stock as an asset sale for tax purposes under IRC section 338(h)(10) or IRC section 336(e).

A buyer will not receive a basis step-up to the extent of any tax-deferred rollover. The portion of the acquired assets attributable to the equity rollover are contributed to—rather than purchased by—the acquiring entity under IRC section 721 or IRC section 351 and, therefore, the acquiring entity will have a carryover basis in such assets, rather than the higher cost basis, to reflect the tax-deferral granted to the rollover investor.

At odds with the buyer’s desire to structure the acquisition to achieve a stepped-up basis is the seller’s desire to minimize its overall tax liability recognized in the transaction. 

In the context of a corporation target, the seller might have a strong preference against structuring the transaction as an asset sale to deliver a basis step-up to the buyer. Upon a sale of the assets of the target corporation, the seller will incur two layers of tax on the proceeds from the sale, one at the corporate level and a second at the shareholder level upon the distribution of the proceeds to the seller. This double tax burden is avoided in a sale of the target’s stock. If, however, the corporation has historic net operating losses—or net operating losses are created in the sale transaction (because of the transaction expenses incurred in a short tax year)—that are sufficient to absorb the corporate level tax on the sale, the seller might be able to tolerate the sale of corporate assets, thus delivering a step-up in basis to the buyer.

Although the sale of a pass-through entity does not present the same double tax concerns for the seller, a sale of assets out of such entity, particularly in the case of an S corporation target, might still create a higher tax bill for the seller (depending on the character of the assets sold and certain state tax considerations) if the sale is structured as a sale of assets.

The buyer and seller may compromise in order to achieve both (i) the buyer’s goal of obtaining a basis step-up and (ii) the seller’s goal of minimizing the taxes on the proceeds from the transaction.  One such compromise, which is commonly used if the value of the basis step-up is sufficiently high, is for the buyer to increase the purchase price to make the seller whole for any additional tax liabilities attributable to the structure, thus neutralizing the seller’s increased tax burden (as between the alternative structures) and allowing the transaction to be structured to achieve the basis step-up. 

Conclusion

The decision regarding whether to structure a sale of a business in a taxable or tax-deferred manner (either in whole or in part) or to achieve a basis step-up can materially impact the parties to the transaction, as discussed briefly in this article. As such, it is advisable to consider and address these structural points early in the negotiating process to maximize the interests of each party.


FieldsteinJordan Fieldstein, JD, LLM (taxation) is an associate in Finn Dixon & Herling’s tax group. Her practice is focused on providing federal and state tax advice relating to the firm’s transactional and private investment practices, including mergers, acquisitions, dispositions and other strategic transactions, debt and equity financings and restructurings and private equity and hedge fund formations. Ms. Fieldstein was an executive editor of the Connecticut Journal of International Law and the vice-president of the Tax Law Society at the University of Connecticut School of Law.  Ms. Fieldstein is admitted to practice in the state of Connecticut. She is a member of the American Bar Association and the Connecticut Bar Association as well as to the  the Executive Committee of the Tax Section of the Connecticut Bar Association. She can be reached at JFieldstein@fdh.com.

SpiroMichael P. Spiro, JD, LLM (taxation),  chairs the Finn Dixon & Herling’s Tax group where his practice focuses on providing federal and state tax advice in connection with domestic and international transactions, including hedge and private equity fund formations, mergers and acquisitions, and debt and equity financings and restructurings. Mr. Spiro was a senior editor of the Journal of International Economic Law at the University of Pennsylvania Law School and was the recipient of the Faculty Award in Taxation at Temple University. Mr. Spiro is admitted to practice in the states of Connecticut and New Jersey and in the Commonwealth of Pennsylvania. He is a member of the Executive Committee of the Tax Section of the Connecticut Bar Association. Mr. Spiro also serves as an adjunct professor of taxation at the Fairfield University Dolan School of Business. He can be reached at mspiro@fdh.com.

 
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