A Penny Saved?
As a novice tax adviser, you learn certain basic principles by which to live your professional life. Among these are the following: read, then keep on reading; try to always get two bites at the apple; and don’t allow yourself to be surprised. With experience, you come to understand and to appreciate these guidelines, and you learn how to implement them in your practice.
Eventually, you realize that while the first two are largely within your control, the third is more difficult to secure, in no small part thanks to your client.
I am not implying that clients do not always provide their advisers with the relevant information[i] – it is up to the adviser to pose the appropriate question that will elicit that information.
Inspector Clouseau: “Does your dog bite?”
Hotel Clerk: “No.”
Clouseau: [bending over to pet the dog] “Nice doggie.”
[Dog bites Clouseau’s hand]
Clouseau: “I thought you said your dog did not bite!”
Hotel Clerk: “That is not my dog.”[ii]
I am saying that clients can be very cost conscious[iii] – especially in the case of the closely held business – perhaps irrationally so where professional fees are concerned, such that these clients will often fail to consult their professionals until some loss has already been incurred, or until a “transaction train” has already left the proverbial station.
At that point, the adviser may find themselves playing catchup. What’s more, they are in reactive (and sometimes damage-control) mode, rather than in planning mode.
Although I understand the owner’s motivation, there comes a time when the concern over professional fees may cost the owner far, far more. In particular, I am thinking about the sale of the business, and the owner’s not infrequent failure to engage their tax adviser at the very beginning of the sale process, even before they embark on shopping the business and negotiating the terms of its sale. And this is where the surprise is sprung on the tax adviser.
Client: “Good morning, Lou.”
Adviser: “Good morning, Bob. Been a while. How’s everything?”
Client: “I have some great news to share with you.”
Adviser: “I could use some good news. What’s up?”
Client: “I’m selling my business.”
Adviser: “Ah, so you’ve finally decided to sell. Good for you, though I wonder what you’ll do with your free time – I pray you don’t turn into a golfer.
“We should get together with your accountant to talk about various deal structures, and how much you would net on an after-tax basis under each. As I recall, you’re operating through an S corporation,[iv] right?
“Do you have an idea of what you’re looking for, in terms of a dollar figure, in order to make this happen?”[v]
Client: “I already have a buyer.”
Adviser: “Really? Wow, OK. What kind of discussions have you had? Is there a nondisclosure in place?”
Client: “We’ve signed a letter of intent.”
Adviser: “Come again, please.”
Client: “There’s a signed LOI. I’ll send you a copy.”[vi]
Adviser: “When did this happen?”
Client: “About three days ago. The buyer is a PE firm. They’ve already acquired a couple of my competitors, and I don’t want to miss out. We’re scheduled to close in two months. [Long silence] Lou? Are you there? You OK? Hello-o! Lou?”
Adviser: “I’m still here. Two months, huh?
“Are you selling your stock or is the corporation selling its assets?
“What’s the purchase price, and how is it being paid? Cash at closing, any promissory note or earnout?
“Are they expecting a rollover of any equity?
“Do they expect you to stay on?
“What about the real property? As I recall, the property is in a separate LLC that you own with a trust for the kids, right?”
Client: “Slow down, and don’t sound so miffed.[vii]
“Yes, the buyer wants me to invest 10-percent of my equity – it’ll give me a chance to participate in the growth of the business after the sale, including that of any other businesses that may be acquired. A second bite at the apple, you might say.
“I’m selling assets. The buyer mentioned that it was important that they have a step-up in basis for the assets.”
Adviser: “You mean your corporation is selling its assets.
“Yes, the step-up enables the buyer to recover their purchase price through amortization, depreciation, and immediate expensing, which makes the deal less expensive for them, but generally more expensive for you.
“Was there any discussion of a stock sale? What about a gross-up of the purchase price to account for any ordinary income?
“Was there any discussion about your rollover being on a tax-deferred basis? What does the LOI say?”
Client: “A gross-up? No. As for taxes on the rollover, no, I don’t think it’s addressed, but why would there be any? You’ll see when I send you the LOI.
“Listen, I want this deal. I’m not getting any younger. I’m still healthy. I’ve got no one to take over the business.”
Adviser: “I hear you. When can we expect to see a draft of the asset purchase agreement?”
Client: “I think they said next week.”
Next week arrives, as does the draft APA. Pretty standard, thankfully. Cash plus an interest-bearing term note; unfortunately, the note will trigger the interest charge for large installment obligations.[viii] Interestingly, the buyer is a C corporation, and the APA makes no mention of a rollover, notwithstanding that it is referenced in the LOI, albeit in little detail.
Adviser contacts the buyer’s counsel (“BC”) regarding the rollover.
BC: “We never represented to your client that the rollover would be tax-deferred. We did explain that we wanted a basis step-up for the assets being acquired.
“We expect your client to reinvest some of the cash received for the assets.”
Adviser: “In other words, no tax deferral. Obviously, Client did not fully appreciate that when the LOI was executed.
“Tell me, is there a parent or holding company that owns the acquiring corporation? If so, how is it treated for tax purposes? As a corporation or as a partnership?”
Adviser learns that there is no holding company in place, and there are no plans for establishing such a holding company for the immediate future; thus, the rollover will have to be into the same corporation that is purchasing Client’s “corporate assets.”
Client: “What do you mean there’s no way for me to have a tax-free rollover? Why would I roll over any part of my business and take back a minority interest if I couldn’t do it on a tax-free basis?”
Adviser: “Let me explain again. First of all, your S corporation is the seller here, not you. What’s more, if anyone is going to make a tax-deferred rollover here, it is the S corporation – it owns the assets being transferred, and it is receiving the consideration from the buyer. Not you.[ix]
“When one or more persons transfer property to a corporation in exchange for stock in the acquiring corporation, the exchange will be treated as a taxable event for the transferors unless they are in control of the corporation immediately after the exchange, or unless the exchange qualifies as a reorganization, which yours doesn’t do.[x]
“By ‘control’ I mean the transferors, as a group, own stock that represents at least 80-percent of the total voting power of all classes of voting stock of the corporation and at least 80-percent of the total number of all other classes of stock.[xi]
“Your S corporation’s interest in the acquiring corporation won’t be anywhere near that figure after the exchange.”
Client: “You said ‘persons,’ plural. What if others joined me in contributing property?”
Adviser: “If those who currently own all of the stock of the acquiring corporation – i.e., the vehicle through which the PE firm’s investors own their equity in the corporation, plus the former owners of the target companies already acquired by the buyer – if these shareholders were to contribute their stock to a new holding corporation,[xii] in exchange for stock in the holding corporation, and if your S corporation were to contribute some of its assets (the rollover portion) to this holding corporation solely for stock, then the transferors as a group would be in control, and their respective exchanges would be accorded tax-deferred treatment.”
Client: “Can’t we ask them to do that?”
Adviser: “I already did, when I spoke to BC, but the buyer isn’t willing to accommodate your deal – they said it isn’t large enough.”
Client: “What about a gross-up? Can they pay me more cash to cover the tax on the rollover?”
Adviser: “We’ve been through this. We were fortunate that they agreed to cover the spread between capital gain and ordinary income on the depreciation recapture.[xiii] They will move only so far beyond the terms of the LOI. They also want to wrap this up because they have another, larger deal in the wings.”
Client: “So I ask you again, should I do this deal?”
Adviser: “Again? You never asked me, remember? You agreed to terms without speaking to me. Besides, that’s your call, not mine.
“From a tax perspective, you will already be reporting 90-percent of the gain, part of it on the installment basis.
“You would take the acquiring corporation’s stock with a basis equal to its fair market value, which means less gain on any subsequent disposition of that stock.[xiv]
“I will also remind you that this equity affords you that ‘second bite at the apple’ you mentioned, though as a minority shareholder who has no ability to compel or influence decisions or policy, including distributions or a sale.
“If your S corporation adopts a plan of liquidation, and completes it within a twelve-month period, the note may be distributed to you, individually, without accelerating the gain inherent in the note.[xv] In this way, you’ll receive the cash, the note and the stock, and you will have eliminated the S corporation.
“Let me end with this: if you try to back out now, you’re inviting a lawsuit. They’ll come after you for all the costs they’ve incurred.”
How Bad Is It?
Client’s S corporation, in the above dialogue, will recognize all of the gain realized on the transfer of its assets to the acquiring corporation – that includes the gain attributable to the receipt of stock in the acquiring corporation, as well as the gain attributable to the cash received at closing; the gain associated with the note will be recognized as principal payments are made on the note.[xvi]
Client will have to report on its tax return the gain arising from the S corporation’s receipt of stock in the acquiring corporation.[xvii] Client will pay the resulting tax on such gain using the net cash proceeds from the asset sale; meaning from the proceeds remaining after all transaction expenses[xviii] have been paid, and after any corporate-level taxes have been satisfied; for example, transfer taxes and sale taxes on the sale of certain assets, as well as income taxes where the corporation is subject to the built-in gain tax.[xix] The S corporation will have to distribute these proceeds to Client, whether in liquidation or otherwise.
Query how much cash will be left in the hands of Client after all is said and done? Stated differently, how secure will Client’s financial future look?[xx] This is the key to Client’s financial wellness considering their income-generating business assets will have been converted into, or exchanged for, such cash plus an installment note (a credit risk until it is satisfied) plus a minority equity interest in the acquiring corporation (the transfer of which is likely restricted, and which may appreciate in value or even become worthless).
These are not the kinds of decisions that the owner of a closely held business should be considering for the first time under the pressures and time constraints of an active transaction.
Although the actual sale may not have been foreseen – at least as to the timing and the identity of the buyer – the elements and process of the sale should not be foreign to the business owner. In fact, the owner of a mature business, in consultation with their advisers – accountant, attorney,[xxi] and financial adviser – should periodically review their situation and plan accordingly.
For example, has a particular employee become vital to the well-being of the business? Does the business need to reward or entice that employee in order to keep them, perhaps through a deferred compensation plan that is tied to a “change-in-control?” Or, has the owner embarked on a new line of business, in addition to the core business? Should it be removed and placed into a separate entity? [xxii]
That being said, it is too often the case that the owners of a closely held business are too busy managing and operating their business to spend the time necessary to educate themselves on the “do’s and don’ts” of selling a business.
That is why it is imperative that they bring their advisers into the picture well before the terms for the sale of the business are agreed upon. These advisers should be experienced with planning, memorializing, and managing such transactions. With their input, the owner – who may never have been involved in the sale of another business – will be able to level the playing field for negotiating deal terms, including the purchase price, and will avoid getting into an untenable situation from which it may be difficult (and expensive) to extricate themselves.
In other words, it will behoove the owner not to surprise their advisers.
[i] There are definitely instances in which information is withheld, usually because the client has determined that the information is not relevant to the issue at hand.
[ii] From The Pink Panther Strikes Again, 1976.
[iii] An admirable quality. Why spend the funds of the business needlessly?
[iv] IRC Sec. 1361.
[v] While the client owns the business, the business finances their lifestyle, and perhaps that of other family members. Wages, distributions, cars, life and health insurance, clubs, charitable giving, and many other items are provided or made possible by the business. After the business is sold, the after-tax proceeds will bear the burden.
[vi] It’s amazing how often this happens. What’s more, the LOI will sometimes be so detailed that, arguably, it may itself constitute a purchase and sale agreement – a result that is only avoided by the inclusion of language that the parties intend to enter into a “final definitive agreement,” or words to that effect.
[vii] Can you really blame the adviser?
[viii] IRC Sec. 453A. There are ways to address this.
[ix] In this scenario, we are assuming that there is no so-called “personal goodwill,” and that the client is not licensing any intellectual property to the business. We already know that the client’s LLC leases real property to the business. The client may receive compensation for consulting services to be provided over some transition period. If any family members are genuinely employed by the business, they may be retained by the buyer for some period of time.
[x] IRC Sec. 351.
If the exchange – specifically, the transfer of the assets of the business to the acquiring corporation in exchange for stock plus cash – had somehow qualified for tax-deferred treatment under Sec. 351, each item of the total consideration received (the stock and the cash) would have been allocated among all of the assets transferred according to their relative fair market values; in that way, the gain or loss from the transfer of each asset would be determined separately.
Client’s transaction will not qualify as a reorganization; for one thing, there’s way too much cash, and the structure doesn’t satisfy the statutory definition of a reorganization. See IRC Sec. 368(a)(1) and Reg. Sec. 1.368-1 and 1.368-2.
[xi] IRC Sec. 368(c).
[xii] Instead of a corporation, an LLC, treated as a partnership for tax purposes, would be preferable from the perspective of a seller who was also rolling over a portion of its equity in the business; that’s because there is no “control immediately after the exchange” requirement in the case of contributions to a partnership. See IRC Sec. 721.
[xiii] IRC Sec. 1245. A sale of stock will generate capital gain.
A sale of assets will generate some ordinary income as well as capital gain.
For example, a portion of the gain from a sale of depreciable tangible personal property will be treated as ordinary income that is taxable at a maximum federal rate of 37-percent – the tax benefit from the depreciation deductions previously generated by the property is “recaptured” as ordinary income on the sale of the property.
The gain from the sale of goodwill is treated as capital gain that is taxable at a federal rate of 20-percent.
[xiv][xiv] For a discussion of gain recognition in “tax-free exchanges,” see https://www.taxlawforchb.com/2017/02/when-a-tax-free-exchange-may-not-be-free-of-tax/
[xv] IRC Sec. 453(h) and 453B(h).
[xvi] IRC Sec. 453. Of course, the interest payments received will be taxed as ordinary income. The imposition of the excise tax on net investment income, under IRC Sec. 1411, will also have to be considered.
[xvii] IRC Sec. 1366.
[xviii] Including those damned professional fees.
[xix] IRC Sec. 1374. Of course, depending upon the local jurisdiction, there may be other corporate-level income taxes (NYC, for example).
[xx] See endnote iv.
[xxi] Including their estate planner.
[xxii] See IRC Sec. 355(e) and Reg. Sec. 1.355-7. See also Reg. Sec. 1.355-3 for the active trade or business requirement under IRC Sec. 355.