Practical Guide to Mergers, Acquisitions and Business Sales, 2nd Edition

Joseph B. Darby

• Publisher: The National Underwriter Company
• Year: 2017
• ISBN:
  9781945424526
• Topic: Commerce
• Subtopic: Fusions & acquisitions

A must-have for financial advisors, lawyers, CPAs, and other professionals advising clients, Practical Guide to Mergers, Acquisitions and Business Sales, Second Edition, is an easy-to-understand guide which explains the tax consequences of buying or selling a business and the art of successfully closing business transactions. Drawing on a vast 30 years of experience, author Joseph B. Darby III, J.D. – a business and transactional tax law expert – incorporates insightful, real-life examples throughout his coverage of the buying and selling of all forms of business entities, including Sole Proprietorships; Partnerships; S Corporations; C Corporations; Limited Liability Companies; Professional Corporations; and more. Broad in scope, with numerous citations to the IRS Code, rulings, and regulations, this resource covers: - How tax aspects of the sale of a business can influence negotiations, both in a positive and negative way - The areas for "give and take" in any negotiation of tax liability for the sale of a business - Strategies related to Installment Sales, Contingent Payments, Goodwill, Consulting Agreements with prior owners, and other methods that can be introduced into a business acquisition - Common pitfalls in the negotiation process, including the overlooking of critical tax issues Practical Guide to Mergers, Acquisitions and Business Sales, Second Edition, is the authoritative but concise and easy-to-understand resource you can rely on.

BASIC CONSIDERATIONS IN BUYING OR SELLING A BUSINESS

CHAPTER 1

OVERVIEW

This book is about the tax aspects of buying and selling a business—but, inevitably, it is also about the special art of closing a major business transaction successfully.

Selling a business is a challenging process. It involves rituals and interactions that are sometimes eerily similar to the courtship dynamic between a human couple that begins dating, gets engaged, and eventually marries. There is an early period of curiosity, a period of exploration and discovery, a point of infatuation when the courting relationship becomes serious, and often a rocky period when the relationship seems likely to fall apart. There are frequently family members (or at least minority shareholders) dead set against the union, and sometimes a competing suitor waiting in the wings. And finally, despite all the obstacles and travails, through hard work and perseverance the business marriage is successfully consummated.

Or not. While many business courtships end in an economic marriage, plenty of others fail, for a variety of reasons. Often, if a business deal does not satisfy rigorous business logic, it eventually becomes apparent to one or both parties. This can be viewed as a “successful” conclusion in the sense that the right outcome is achieved. But plenty of other unsuccessful business negotiations are “could haves” and “should haves”—transactions that made sense, or could have made sense, but ultimately floundered because negotiations went badly awry at some crucial point.

Practical experience shows that tax issues are often the major source of missteps in a business mating dance. Not surprisingly, the parties can get well into a negotiation before they get into a serious tax-structuring discussion. After all, you have to decide if you like each other before you start to talk about marriage. At that point, however, and to the shock and dismay of one or both sides, it can become apparent for the first time that the two parties have been operating on tax assumptions that are either fundamentally different or wrong, or both. A business deal needs to maintain a certain forward momentum to completion. An abrupt change in prevailing tax assumptions can throw a negotiation off so badly that sometimes it never recovers. This is especially true when the parties have expended a significant amount of time and effort negotiating a transaction based on a flawed tax framework. Sometimes, too much effort and energy has been expended reaching now meaningless compromises, and the parties are unable or unwilling to start the courting ritual over again.

For example, I once received an emergency telephone call from a partner who was at another law firm closing a merger in which we represented the Target. In fact, the transaction was already “closed” as far as all the participating parties were concerned. However, after all of the documents were signed, the attorney (prudently, if belatedly) decided to run the transaction past me so that I could “bless it”. (Being a tax attorney is sometimes akin to being a minister or rabbi.) The transaction was supposed to be a “reverse triangular merger” qualifying as a “tax-free reorganization”. However, the proposed transaction, which involved the acquisition of our client’s corporation through a merger into a second-tier subsidiary (a sub of a sub), did not satisfy the technical requirements to be a tax-free reorganization. It is okay to merge a target corporation into a first-tier sub in a reverse-triangular merger, but not into a second-tier sub. I had to tell the attorney (and a roomful of other people listening on the speaker phone) that the deal they had just negotiated for three months and thought was closed, based on the assumption that it was tax free, was in fact a fully taxable transaction.

The parties tore up the documents and tried to rework the deal but were unable to renegotiate a satisfactory new arrangement. Eventually they called the business wedding off. Worse than that, some of them decided I had “killed” the deal. This is an occupational hazard for a tax attorney.

This situation is repeated with depressing regularity in merger and acquisition (M&A) transactions. Another time, just as I arrived at work one morning, one of my partners pulled me into a conference room and asked if I would take a quick look at a deal that was about to close and “bless it”. Fifteen people were in the conference room for the signing, and it turned out that my firm’s primary role was to provide the conference room (and coffee) for the closing. Nonetheless, my partner, to his credit, wanted a quick final review of a transaction that was supposed to be “tax free” to our client. This deal was another reverse triangular merger and, once again, I could see almost immediately that the transaction was in fact going to be taxable. The reason this time was that the transaction provided 50 percent cash and 50 percent stock to the target shareholders, which is okay in a forward triangular merger, but not in a reverse triangular merger.

I quietly pulled my partner into the hallway outside the conference room and told him my concerns. It turned out that our client had been relying (it sounds idiotic just to say it) on the tax attorney for the other side to structure the transaction, even though our client was the one seeking the tax-free treatment. After we explained the situation to our client, he insisted that we call the tax attorney for the other side immediately (he was conspicuously absent at the closing). I will never forget the tax attorney’s response after I explained the situation: “I merely told your client the transaction was structured as a reverse triangular merger. I never said it was going to be tax free!” The discussion, and the deal, degenerated from there.

Unfortunately, there are a myriad of examples of negotiations that go on for weeks and months—even actually close—before the parties discover that the tax assumptions underlying their deal have been wrong. Trust me; you never want to be in the position I have been in—explaining to a room full of people that, because they made fundamental mistakes of tax law, all their work has been a complete waste of time and the negotiations they thought were over need to start over, almost from scratch.

THE ROLE OF GOVERNMENTS (AND TAXES) IN AN ACQUISITION

Every merger and acquisition transaction has a buyer (Buyer), also referred to as an “Acquirer”, and a seller (Seller), also referred to as a “Target”. There are also two other parties with a major economic stake in the transaction: the federal government and (usually at least one) state government.

The Internal Revenue Code (the “Code”) is more than just the law of the land; it is a sophisticated partnership agreement between the U.S. government and every U.S. person. This partnership is one of the most technically complex arrangements imaginable, but the basic thrust is actually easy to summarize. The U.S. government is your mandatory partner in all economic and business endeavors. For the most part it is a very uncongenial and ungenerous partner. The government is quick to claim a share of profits in the good years, but far less willing to share losses in the bad years. For example, if you generate a loss or, even worse, if you have losses from capital transactions, the government is slow to help mitigate the burden. Net operating losses (NOLs) can be carried back only two years, which means that the government keeps its taxes from the good years (subject to the two-year carryback) and offers only a prospective form of relief—your losses translate into a benefit if, and only if, you return to profitability in the future. Capital losses cannot be carried back at all. With limited exceptions, they can only be used against future capital gains. It is, in short, a very asymmetrical and unfair partnership.

It gets worse. Your “partner” has the right to change the partnership arrangement at any time, without your consent, and even make these changes retroactively. You may not like the partnership (or your partner), but there isn’t much you can do about it. You are bound by the pact until you die or emigrate.¹

The role of a tax attorney advising on an acquisition transaction is to make everyone aware that there are two silent partners in the room at all times and that the Buyer and Seller have a common interest in cutting the silent partners out of the deal—or, at least, cutting them as small a slice of the economic pie as possible. The good news is that such conduct on your part is both ethical and expected. In the immortal words of Judge Learned Hand, “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose the pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”

The Code may be an unequal and unfair partnership, but it does have the considerable redeeming virtue of being known or knowable—which is to say you can read it carefully and organize your affairs accordingly. If the Code permits a method of reducing, deferring, or avoiding taxes, you may exploit it. If there is a way to shave the tax costs from a transaction, the parties are free to employ it. The purpose and mission of this book is to teach people how to pare the tax costs of a transaction to the absolute minimum, within the boundaries of ethical and appropriate tax reporting.

BASIC DECISIONS IN PLANNING THE SALE OF A BUSINESS

It is an axiom of tax planning that “corporations do not pay taxes, people pay taxes”. This observation reflects the fact that individuals are ultimately the persons who pay taxes, no matter how complex the corporate structure may be. In this same vein, it is individuals who ultimately own and sell businesses. These individuals invariably want legal advice on how to minimize the taxes ultimately borne by them, as individuals, when a sale, exchange, or other transfer of an incorporated business takes place. For Sellers, the operative question is, “How can I get the most money and/or value after paying the required taxes”? For Buyers, it is the equivalent query: “How do I pay the least amount possible after taking into account tax benefits from the purchase”?

In analyzing and structuring an acquisition transaction from a tax perspective, it is natural to assume that both the Buyer and Seller will want to evaluate the projected results based on a present-value, after-tax basis. Any tax analysis of a transaction structure must take into consideration tax consequences to both the Seller and Buyer. To the extent that the tax consequences of a transaction stretch beyond the current tax year (as they almost always do), the Buyer and Seller will need to use present-value concepts to put a price tag on the deferred aspects of the transaction (from deferred payments to the tax benefits of long-term depreciation or amortization). This involves making a variety of assumptions about future tax rates, and about the appropriate interest rate to use in a present-value computation. These projections about future economic conditions and events are necessarily of a squishy nature and, like all forays into the dismal science, must be done with trepidation—but, in all events, must be done.

Although the purchase and sale of a business is an unavoidably complicated transaction, the fundamental tax objectives are actually easy to articulate. There are three basic decisions that the parties need to make:

1. Is the transaction going to be tax-free or taxable?

2. If it will be taxable, is the Buyer going to purchase stock (equity) or assets?

3. Is the purchase price going to be paid entirely up front, or is some portion (or all) of it going to be paid on a deferred basis?

The three decisions are easy to identify, but far less easy to make. These choices are often nuanced and complex. There is often no clear or correct answer. In structuring acquisition transactions, the famous dictum is this: “The rule of thumb is there is no rule of thumb.” Each of these three seemingly simple questions requires a sophisticated analytical answer, and the correct choice is usually the accretion of many small and nuanced decisions.

DECIDING WHETHER A SALE SHOULD BE TAXABLE OR TAX-FREE

The first decision that Buyers and Sellers have to make is whether to structure the transaction as a “taxable” or a “tax-free” transaction. I can assure you that, described in this manner, and without more information, every client wants to hear all about the “tax-free” option first.

“Tax-free” and partially tax-free transactions are discussed in considerable detail at various points in this book. The fundamental characteristic of such transactions is that the owners of the Target are swapping their Target equity for equity in another, larger entity that is almost certain to be controlled by someone else. The immediate concern, therefore, is whether the owners of the Target want to give up control of their business in exchange for a minority position in a larger, combined business. As a practical matter, the answer to this question usually turns on the degree to which the new equity interests can later be sold or liquidated at the unilateral discretion of the former Target owners.

In some cases, such as when the Acquirer is a publicly traded corporation and the post-transaction equity is (or shortly will be) readily marketable, the Target owners will be interested, even eager, to participate in a tax-free or partially tax-free transaction. However, if the equity of the Acquirer is not highly liquid, the owners or Target may be reluctant to pursue a tax-free transaction. Reasons why an individual might opt for a taxable instead of a tax-free transaction include the following:

1. The consideration received in a tax-free reorganization consists predominantly or entirely of stock in a different corporation. Such stock may be relatively unattractive to an individual for the following reasons: (1) the stock may be subject to restrictions on transferability, whether imposed by securities laws or through a buy-sell agreement; (2) even if the stock is not subject to restrictions on resale, the stock may be difficult to sell; (3) even if a buyer for the stock can be found, the stock may have to be sold at a significant minority and marketability discount; (4) the stockholder may lack meaningful control or input in the operation of the reorganized corporate entity; and (5) ultimately, stock is not cash and therefore is subject both to greater economic risk and lesser liquidity than cash.

2. The total tax cost of a “taxable” transaction may not be unduly onerous. For example, even a “C” corporation may have sufficient tax basis in its assets or sufficient net operating losses to make a sale of corporate assets relatively inexpensive in terms of tax costs, and the shareholders may have a sufficient basis in their stock to avoid having to incur a substantial “double tax” cost. Alternatively, shareholders may be able to negotiate a structure for the transaction that involves a sale of stock at favorable capital gains rates or may be able to negotiate employment agreements, consulting agreements, and noncompetition agreements that reduce the amount of double taxation involved in the transaction.

DECIDING WHETHER A SALE SHOULD BE OF BUSINESS ASSETS OR EQUITY

Taxable acquisitions can usually be divided into two basic categories: (1) a sale of the business assets or (2) a sale of the business equity.

In the case of a C corporation, a frequently stated “truism” about taxable acquisitions is that a Buyer wants to buy assets while a Seller wants to sell stock. The problem with this simplistic formulation is that obviously both of these objectives cannot be met; otherwise, no business acquisition would ever be completed. True, a Buyer may be looking to buy assets rather than the stock of a corporation because the Buyer would like to get a step-up in the tax basis of depreciable and amortizable assets and would also like to avoid the Seller’s legal liabilities that would accompany a stock purchase. Also true, the Seller would in theory like to sell Target stock and pay a single tax at capital gains rates. However, the truism conspicuously omits the factor that ultimately makes it possible to bridge the differences between Buyer and Seller: the price!

The tax consequences to a Buyer and Seller can vary dramatically between an asset sale and an equity sale. However, both types of sales can be valued in terms of money, and the comparative attractiveness of one acquisition structure versus another can be determined on an after-tax, present-value analysis. The Seller wants to receive the greatest possible after-tax return, after taking into account all tax costs and ...