By Charles A. Wry, Jr.
The after-tax consequences of buying or selling a business can vary dramatically depending on how the transaction is structured. Often, what’s good for one party is bad for the other. The structure of the transaction, therefore, can be driven by the relative bargaining positions of the parties and, in any event, should be taken into account in determining the price. The consequences of the transaction to employees and other service providers should be considered as well.
I. Taxable Transaction.
As described below, the owners of a business can sell the business “tax-free” if the business is organized as a corporation and the price to the owners is paid in the form of stock of an acquiring corporation. Otherwise, the sale of the business generally will be taxable to the owners. If the transaction will be taxable, the tax consequences will depend primarily on (i) the form of organization of the business being purchased (the “Target”) and (ii) whether the buyer (the “Acquiror”) purchases (x) the equity interests in the Target from the Target’s owners or (y) the assets of the Target from the Target.
a. Target is a Corporation.
1. Stock Purchase.
If the Target is a corporation, the shareholders of the Target will generally prefer to structure the transaction as a purchase and sale of their stock in the Target. That way, the gain on the transaction is taxed only once (at the shareholder level) and at capital gain rates. The Acquiror, on the other hand, may not want to purchase stock because, except as described below under “Stock Purchase Treated as Asset Purchase,” a stock purchase has no effect on the tax bases of the Target’s assets. Instead, the Acquiror takes a basis in the stock purchased equal to the amount it pays for the stock (and the taxable income inherent in Target’s assets remains inherent in the assets). Stock is not amortizable.
The Target shareholders may also prefer a stock sale from a non-tax standpoint because the Acquiror assumes the economic burden of any Target liabilities except to the extent that the Target shareholders agree to remain responsible.
A stock purchase may be effected by a direct purchase of the Target’s stock or by a “reverse subsidiary merger.”i In a reverse subsidiary merger, the Acquiror forms a transitory subsidiary, capitalizes the transitory subsidiary with the cash or other assets to be used as the purchase price (including any borrowed money if the purchase will be leveraged), and then merges the transitory subsidiary into the Target. When the dust settles, the Target shareholders have the cash or other assets used as the purchase price, and the Target is a subsidiary of the Acquiror.
If the Target stock is “qualified small business stock,” individual Target shareholders who have held their shares for more than five years may be able to exclude portions of their gains.ii
If the Target is an S corporation and owns “collectibles,” a portion of the gain may be taxable at a higher capital gain rate than would otherwise apply.
A stock sale may also be desirable if the Target has assets (such as non-assignable contract rights) that would be difficult to transfer.
2. Asset Purchase.
If the Target is a corporation, the Acquiror generally prefers (at least for tax purposes) to structure the transaction as a purchase and sale of the Target’s assets so that the Acquiror may “write up” the tax bases of the assets. By writing up the bases of the purchased assets, the Acquiror can report greater depreciation and amortization deductions with respect to, and smaller amounts of gain (or greater amounts of loss subject to any applicable limitations) upon re-sales of, the purchased assets. The Target shareholders, on the other hand, may not want to structure the transaction as an asset sale because (i) if the Target is a C corporation (or an S corporation with assets acquired while it, or any corporation it acquired in a tax-free transaction, was a C corporation), the gain on the sale may be taxable to both the Target and the Target shareholders, and (ii) if the Target is an S corporation, some or all of the gain may be reportable by the shareholders as ordinary income (depending on the Target’s assets and the allocation of the purchase price).
The Acquiror may also prefer an asset purchase from a non-tax standpoint so that the economic burden of the Target’s liabilities remains with the Target’s shareholders.
An asset purchase may be effected by a direct purchase of the Target’s assets or by a merger of the Target into the Acquiror or a subsidiary of the Acquiror.
In an asset purchase, the Target is treated as selling, and the Acquiror is treated as buying, the various Target assets separately for allocable portions of the aggregate purchase price. The aggregate purchase price is allocated among the various Target assets in accordance with certain tax rules (essentially, by class and fair market value). Particularly if the Target is an S corporation, the Target’s shareholders will prefer to allocate the purchase price so as to maximize the amount of long-term capital gain to be reported by them on the sale. The Acquiror, on the other hand, will likely want to allocate as much purchase price as possible to assets that are likely to turn over in the short term or that have short depreciation or amortization schedules.
3. Stock Purchase Treated as Asset Purchase.
If the Acquiror is a corporation, the Target is an S corporation or a subsidiary of another corporation, and the Acquiror purchases at least 80% of the outstanding stock of the Target, the Acquiror and the Target shareholders may join in making a special tax election to treat a purchase and sale of the stock of the Target as a purchase and sale of the Target’s assets.
Although making such an election allows the Target to step up its bases in its assets, the election may be disadvantageous to the Target’s shareholders for the reasons noted above (possible taxabililty of the Target if the Target is a C corporation or an S corporation with assets acquired while it, or any corporation it acquired in a tax-free transaction, was a C corporation; possibility of ordinary income for the Target’s shareholders if the Target is an S corporation). In addition, if the Acquiror is not purchasing all of the outstanding stock in the Target, the Target is nonetheless treated as having sold all of its assets.
b. Target is a Tax Partnership.
1. Purchase of Interests.
If the Target is a limited liability company (“LLC”) or other form of entity classified as a partnership for tax purposes and the Target’s owners sell their equity interests in the Target to the Acquiror, the Target’s owners are required to report the ordinary income they would have had to report if the Target had sold any “unrealized receivables” (which include, among other things, depreciable property to the extent of any inherent depreciation recapture) or “inventory” (which includes, in addition to traditional inventory, property income from the sale of which would be ordinary) it may have at fair market value.iii Any remaining gain or loss a selling owner of the Target may have on the sale is generally capital gain or loss. The Acquiror, on the other hand, is treated as having purchased the Target’s assets if the Acquiror purchases all of the outstanding interests in the Target. Alternatively, if the Acquiror does not purchase all of the outstanding interests in the Target but the Target has a special tax election in effect, the Acquiror will be able to write up its share of the basis of each of the Target’s assets.
2. Asset Purchase.
As described above, in an asset purchase, the Target is treated as selling, and the Acquiror is treated as buying, the various Target assets separately for allocable portions of the aggregate purchase price. Thus, because the Target’s owners report their shares of the Target’s income or loss directly, the mix to the Target’s owners of capital gain and ordinary income will depend on the Target’s assets and the allocation of the purchase price. Like S corporation shareholders in an asset sale, the Target’s owners will prefer to allocate the purchase price so as to maximize the amount of long-term capital gain to be reported by them on the sale. The Acquiror, on the other hand, will likely want to allocate as much purchase price as possible to assets that are likely to turn over in the short term or that have short depreciation or amortization schedules.
II. Tax-Free Transaction.
If the Acquiror and the Target are corporations, the transaction may be “tax-free” entirely or in part to the Target shareholders if it qualifies as a “reorganization.” In that case, the Target shareholders generally report their gains only to the extent of any of their purchase price that is not paid in the form of stock of the Acquiror (or the Acquiror’s parent corporation). Any gain they avoid reporting remains inherent in the Acquiror stock they receive in the transaction. The Acquiror writes up the tax bases of the Target’s assets only to the extent of any gain reported by the Target.iv
There are a limited number of ways for a transaction to qualify as a reorganization. A detailed discussion of those ways is beyond the scope of this article. Each way, however, requires (among other things) that a minimum percentage of the price paid for the Target be paid in the form of qualifying stock of the Acquiror (or its parent). The minimum percentage ranges from 50% (or even lower under judicial authorities) for a straight (i.e., not a reverse subsidiary) merger (an “A” reorganization) to 100% for a simple stock-for-stock swap (a “B” reorganization).
If the Target stock is “qualified small business stock,” the stock of the Acquiror (or its parent) received by a Target shareholder in the reorganization is also treated as qualified small business stock (if it otherwise would not have been) received by the Target shareholder on the date he acquired his Target stock. The amount of gain that may be treated as gain from the sale of qualified small business stock upon the subsequent sale of the stock of the Acquiror (or its parent) by the Target shareholder, however, is limited to the amount of gain built into the Target stock as of the time of the exchange of the Target stock for the Acquiror stock.
III. Deferred or Contingent Payments; Holdbacks and Escrows.
It is not uncommon for a portion of the purchase price to be paid over time or as certain performance goals are met (the deferred payment obligation may be evidenced by a note or by the purchase and sale agreement.) In addition, a portion of the purchase price may be held back or placed into escrow to secure obligations of the Target or its shareholders to indemnify the Acquiror for breaches of representations, warranties and covenants.
a. Original Issue Discount.
If a deferred portion of the purchase price does not bear an adequate interest rate, part of the deferred portion may be re-characterized as interest. In addition, interest that is not payable at least annually as it economically accrues may have to be reported as it accrues on the basis of a constant yield to maturity rather than as it is actually paid (so that the Target or its shareholders may have to report interest income for a year in which they receive no payments).
In the case of a contingent deferred payment, the portion of the payment that is interest is generally the amount by which the payment exceeds the present value of the payment discounted back to the closing date at a “test rate” applicable to the sale (with the present value of the payment being principal). Contingent interest is generally reported as it becomes fixed (subject to some special rules that apply when the contingent interest is payable more than six months after becoming fixed).
b. Installment Method.
Generally, a taxpayer’s gain on a deferred payment sale is reported under the installment method unless the taxpayer elects not to use the method. Under the installment method, the taxpayer computes the percentage which his overall profit on the transaction represents of the overall amount he will receive in the transaction (other than from the purchaser’s assuming or taking subject to certain “qualifying indebtedness”). He then multiplies each “payment” he receives by that percentage to determine the portion of the payment that is gain. Payments of interest (including amounts re-characterized as interest) are disregarded in applying the installment sale rules.
The contingent payment provisions of the installment sale rules make some unfriendly assumptions (including that the full amount of any capped contingent payments will be received). Accordingly, they may distort the reporting of the gain on the sale.
Care must be taken to ensure that escrow and other security arrangements do not result in deemed “payments” to the Target or its shareholders.
Recapture and gains from sales of inventory and publicly traded stock are not eligible for reporting under the installment method. Care must be taken in structuring deferred payment sales of interests in LLCs and other entities classified as partnerships for tax purposes that hold assets to which the installment method would not apply.
A taxpayer who holds more than $5 million in installment obligations may be subject to an interest charge on the deferred tax liability with respect to the balance in excess of that amount.
Deferred payment sales of stock or assets of S corporations may raise certain special issues or present certain special opportunities related to installment method reporting. For instance, in an asset sale by an S corporation for cash and an installment obligation of the purchaser, it may be more advantageous to have cash that would otherwise be paid at the closing of the sale instead be paid on the installment obligation shortly after the S corporation has sold its assets and liquidated.
c. “Tax-free” Reorganization.
If the transaction is intended to qualify as a “tax-free” reorganization, care must be taken to ensure that the arrangement does not jeopardize that qualification.
IV. Outstanding Options and Restricted Stock.
Often, employees and other service providers of the Target have Target options or shares of restricted Target stock. The consequences of their participation in the purchase and sale transaction can vary significantly depending on the circumstances.v
a. ISOs.
The tax consequences of the transaction to a holder of an incentive stock option (“ISO”) of Target will depend on what the holder receives for the option.
The holder of a Target ISO is generally not taxable on his exchange of the ISO for a new option of the Acquiror unless (i) the value of the stock underlying the new option exceeds the exercise price of the new option (that is, the new option is “in the money”) when he receives the new option and (ii) the new option fails to qualify for treatment as an ISO.vi
For the new option to qualify as an ISO, (i) with certain exceptions, the terms of the new option must not be more favorable to the option holder than those of the old option, (ii) the spread (the amount by which the value of the underlying stock exceeds the exercise price) on the new option as of the time immediately after the exchange must not be greater than the spread on the old option as of the time immediately before the exchange, and (iii) the value of the shares subject to the new option as of the time immediately after the exchange must not be greater than the value of the shares subject to the old option as of the time immediately before the exchange.
If the holder receives cash or stock for the option, he reports the amount of cash and the value of any stock he receives (less any amount he pays to exercise the option) as ordinary income (unless he receives the stock in a “tax-free” reorganization in exchange for stock of the Target acquired by exercising the option).vii If any new stock received by the holder is restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.
If the holder exercises the option for stock of the Target and then exchanges the Target stock for stock of the Acquiror in a “tax-free” reorganization, the holder has only a potential alternative minimum tax liability based on the spread at the time of exercise if he holds the stock of the Acquiror for at least a year after exercising the option (and for at least two years after being granted the option).
b. NQSOs.
Like the consequences to a holder of a Target ISO, the tax consequences of the transaction to a holder of a non-qualified stock option (“NQSO”) of Target depend on what the holder receives for the option.viii
The holder is generally not taxable on his exchange of the Target NQSO for a new Acquiror option unless (i) the Acquiror option is in the money upon its grant to the holder and (ii) the Acquiror option fails to satisfy the substitution test that would be applicable in determining its qualification as an ISO if the Target NQSO were an ISO.ix
If the holder receives cash or stock for the option, he reports the amount of cash and the value of any stock he receives (less any amount he pays to exercise the option) as ordinary income.x If any new stock received by the holder is restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.
c. Restricted Stock.
The consequences of the transaction to a holder of restricted Target stock will likely depend on whether or not the holder made a timely Section 83(b) election with respect to the Target stock.
If the holder did not make a timely Section 83(b) election with respect to the restricted Target stock, he reports ordinary income on the transaction equal to (i) the amount of cash and the value of any stock he receives for the restricted Target stock less (ii) the amount he paid for the restricted Target stock. If any new stock received by the holder is itself restricted upon receipt, however, the income with respect to that stock is deferred until the restrictions lapse (at which time the income is determined with reference to the then value of the stock) unless the holder makes a timely Section 83(b) election with respect to the stock.
If the holder made a timely Section 83(b) election with respect to the restricted Target stock, he generally reports capital gain equal to (i) the amount of cash and the value of any stock he receives for the restricted stock less (ii) the amount he paid for the restricted Target stock plus the amount of any income he reported upon his receipt of the restricted Target stock. If, however, the transaction is a “tax-free” reorganization, the holder reports gain on the transaction only to the extent of any purchase price he receives other than in the form of stock of the Acquiror (or the Acquiror’s parent corporation).
d. Golden Parachute Issues.
Special rules apply to payments (referred to as “parachute payments”) in the nature of compensation by a corporation to a “disqualified individual” that (i) are contingent on a change of control of the corporation and (ii) have an aggregate present value equal to at least three times the disqualified individual’s “base amount.” A “disqualified individual” is an individual who performs personal services for the corporation and who is either an officer or shareholder of the corporation or is among the highest paid 1% or, if less, 250 employees of the corporation. An individual’s “base amount” is his average annualized compensation from the corporation during the five year period before the year of the change of control. Under the rules, an “excess parachute payment” (the amount by which any parachute payment exceeds an allocable portion of the disqualified individual’s base amount) is non-deductible by the corporation and is subject to a 20% excise tax in the hands of the disqualified individual.
The acceleration of the vesting of Target options or restricted stock can give rise to parachute issues. Often, however, the amount that must be taken into account as a payment contingent on the change of control of the Target is limited to the time value of the acceleration (plus an amount reflecting the lapse of the obligation to continue performing services).
If the Target is a private company, the applicability of the parachute rules can be avoided by subjecting what would otherwise be parachute payments to approval by the Target’s shareholders. Unfortunately, for the approval to achieve its purpose, the right of the disqualified individual to receive the payment must be made contingent on the approval.
V. Covenants Not to Compete; Consulting and Employment Arrangements.
Key personnel of the Target may be asked not to compete, either individually or on behalf of another entity. Alternatively, they may be asked to remain employed or available for consulting.
a. Consequences to the Acquiror.
The Acquiror amortizes the amount payable for any non-compete agreement over fifteen years. Any employment or consulting payments are deductible by the Acquiror under its regular method of accounting so long as the payments are bona fide and reasonable in relation to the services the Acquiror receives for them. The Acquiror is generally required to amortize any employment or consulting payments that are not bona fide and reasonable over fifteen years.
In Massachusetts, reasonable non-compete agreements are generally thought to be enforceable so long as legitimately necessary to protect the interest of the payor. Reasonableness is usually measured in terms of geography and duration.
b. Consequences to the Recipient.
Non-compete, employment and consulting payments are ordinary income in the hands of their recipients.xi
“From a standpoint, the reverse subsidiary merger generally allows for the purchase of all of the Target’s stock without the approval of all of the Target’s shareholders. Generally, though, dissenting shareholders have “appraisal” rights entitling them to receive a judicially determined fair price.
ii The maximum excludible portion has historically been 50%. The recently enacted American Recovery and Reinvestment Tax Act of 2009, however, increased the maximum excludible portion to 75% for “qualified small business stock” acquired after February 17, 2009 and before January 1, 2011. Currently, the portion not excluded is taxed federally at a rate of 28%.
iiiEntities classified as partnerships for tax purposes include LLCs, limited partnerships, limited liability partnerships and general partnerships (so long, in each case, as they have more than one owner and that have not elected to be classified as corporations).
iv Because any gain is usually reported by the Target’s shareholders rather than by the Target, the Acquiror generally gets no basis increase in the Target’s assets.
v To keep things simple, unless otherwise noted, we’ll assume that holders of options will receive only new options, cash and/or stock, and that holders of restricted stock will receive only cash and/or stock, of the Acquiror in the transaction.
vinThe potential taxability of the receipt of an in-the-money option is the result of the enactment of Section 409A of the Internal Revenue Code by the American Jobs Creation Act of 2004. Among other things (and with an exception for ISOs), Section 409A subjects a service provider who is granted an option at an exercise price below the then fair market value of the underlying stock to tax and a 20% penalty as the option vests.
viiSection 409A of the Internal Revenue Code should be considered in structuring deferred option cancellation payment arrangements.
viii It is assumed that Target NQSOs were not already subject to Section 409A of the Internal Revenue Code.
ix Again, the potential taxability is the result of the enactment of Section 409A of the Internal Revenue Code.
x Again, Section 409A of the Internal Revenue Code should be considered in structuring deferred option cancellation payment arrangements.
xi Care must be taken to avoid Section 409A of the Internal Revenue Code in structuring deferred payment arrangements.
For more information, please contact Charles Wry at cwry@ mbbp.com.
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