Many people who get into the world of merging and acquisition pay little to no attention to various tax consequences and how to optimize them. Despite the different experiences between sellers and buyers, how can we bridge the gap here? Joining Domenic Rinaldi to delve into this matter is CPA and attorney, Ed Castellani. Together, they talk about the right way to approach a seller demanding stock transaction with no optimal tax outcome, the specifics of the letter of intent, the buckets of allocation, and how sellers can overall minimize their tax burden. Ed also dives deep into the world of C Corp, particularly on how they can be utilized to defer tax.
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Ed Castellani: Getting Around Tax Consequences In M&A Transactions – Ep. 095
Ed, welcome to the show. It’s nice to have you here with us.
I’m happy to be here, Dom. Thanks for having me.
I appreciate your time. You have such a unique skillset and experience, having practiced the law for over 30 years, but you’re also a certified public accountant. What a benefit that is to your clients. I know you focus a lot on M&A transactions. They must appreciate the fact that you can look at a deal from both of those lenses.
When you’re structuring a deal, one of the most important things of the deal is the tax consequences. The buyer and the seller have certain interests, which are sometimes different, but I can help them with that. I know what the tax consequences are. I know how to plan for tax consequences and that somehow affects how the transaction is structured and how the documents are then prepared.
You’ve been doing this for a long time. I’ve been doing this for a long time. My experience has been that people don’t spend enough time thinking about the tax consequences and how to optimize them, whether you’re a buyer or a seller. I’m assuming your experience is the same.
Sometimes, they don’t start thinking about it until we get into the document. Drafts are going back and forth. Clients start understanding what this does to them tax-wise and what it doesn’t do. The best thing for a tax practitioner to do is to have that conversation up front. What kind of transaction are we going to have? Are we going to have an asset sale? Are we going to have a stock sale? Those types of questions. It should be some of the first fundamental decisions that are made before you start passing documents around.
The best practice is you should be contemplating at least broadly these things in the letter of intent. You might not be getting down to the actual details, but at least assimilating what you’re looking for from a tax structure in the LOI so that you don’t wind up with a complete renegotiation at the closing table or in the definitive agreement.
That’s one of the purposes of the letter of intent. It is a preliminary agreement that’s usually a non-binding agreement. Either side could walk away from it. One of the purposes of it is to get the main points of the deal out on the table. Those main points include whether it’s going to be an asset transaction or a stock transaction, what the price is going to be, how the price is going to be paid. There’s usually a provision that everything’s going to be kept confidential. Those fundamental questions are what’s addressed in a letter of intent. That’s a good point. They have to be addressed there.
Maybe we start at the beginning. The obvious first place is the parties, both the buyer and the seller, because the tax consequences are there for both parties, whether or not it’s an asset sale or sale of the stock. Maybe you can help us think through the ramifications for people and when should they be thinking about one or the other.
For the sake of a seller’s perspective first, what the seller wants in a transaction is a long-term capital gain. That’s the best tax consequence they can get. The best way for them to do that is to do a stock sale where they have a stock sale. Whatever sales proceeds they get in excess of their basis in this stock is taxed to them as a long-term capital gain. That’s great for the seller. Sellers love selling stock. Buyers don’t always like buying stock for a couple of important reasons. Buyers would prefer to buy assets from the corporation. We then got a whole different set of tax consequences for the seller, depending on whether they’re a C corp, S corp, LLC, and whether they’re going to have a long-term capital gain or ordinary income. Things get interesting and planning becomes important.
We often say to our clients from this perspective, “What’s good for you from a tax perspective is maybe not necessarily good for the other party.” In the scenario you described, when the sellers sell a stock or getting long-term capital gains, which is at 20%, plus the 3.8% surcharge, but the buyers then have to put that on their books and amortize it. That’s a big tax hit when you think about the fact that they can’t immediately start depreciating those assets over a five-year schedule. It could get more complicated than that. I’m very simplistic here, but there’s a big difference for both of the parties. How do you bridge the gap there for the parties?
It depends on whether you’re representing the buyer or the seller. When I’m representing a seller, I persuade them to try to get the buyer to buy stock. If I’m representing a buyer, I tell the buyers, “You don’t want to buy stock. You want to buy assets.” It’s a question of what those two parties can negotiate and who’s the more motivated person? Is the seller more motivated to sell or is the buyer more motivated to buy? They may come together, try to compromise and work out what they can work out.
It always comes down to motivation. If you’re on the buyer’s side though, how might you coach the buyer through that? If the seller is demanding a stock transaction, knowing that’s not the optimal tax outcome for them, what are some strategies that you may talk a buyer through in that case?
If a buyer has to buy stock, either they’re buying an asset that’s non-depreciable, nondeductible. That raises the price of the acquisition because they’re buying it with after-tax dollars. We tell the buyer, “This is going to cost you more. You may want to work on that purchase price. You may want to try to bring that purchase price down because you’re buying a non-depreciable asset. It’s going to cost you a few more dollars” There are another couple of techniques you can do. You can use a non-compete where the seller agrees not to compete, and the buyer pays for a non-compete. The buyer can buy that. It’s going to write that off over fifteen years. The buyer could also buy the personal goodwill of the seller. You can write that off over fifteen years. Those are a couple of things we look at in that situation.
There are some ways to bridge the gap potentially. Your point is that they’re buying this with after-tax dollars, and there may need to be some accommodation in the purchase price if the seller is adamant on selling the stock.
That’s common. That is usually where the conversation goes.Tax rates are going to go up these days, so now's a good time to act. Click To Tweet
Let’s spend a little bit of time on the letter of intent. From a tax perspective, there are some things that should be contemplated upfront. One, the parties and their advisors are clear. Two, you don’t wind up with a complete renegotiation somewhere down the road. I’m thinking of things like allocations. You already talked about the potential for a non-compete. Could you talk us through the letter of intent and what the parties should be contemplating there as it relates to the tax outcome?
There are two kinds of letters of intent. There’s a non-binding letter in which either party can walk away at any time, or there’s a binding letter of intent, in which case the buyers are stuck with the terms in the letter of intent, which are later incorporated into a purchase agreement. The important provisions like the tax consequences and whether it’s an asset sale or a stock sale, and maybe even how the purchase price is going to be allocated to the assets, those should be addressed in the letter of intent, whether it’s binding or non-binding because that establishes the tax consequences. Those are the types of things that should be included in the letter of intent. That’s the first step that the parties go through to flush out some of these important issues.
Can we dive a little bit into the allocation for people who haven’t gone through this before? Can you give some examples of allocations and the impacts there, so people are clear about that?
When a buyer buys assets from a seller, the purchase price has to be allocated to the various assets that the buyer is buying. Usually, that’s done by an appraisal, the seller or both parties will pay for an appraisal that will value the assets. That appraised amount is usually the price that’s used for the assets, to the extent that the assets are equipment, the buyer can write those off immediately, or the buyer can write those off over five years if there’s goodwill involved. If there’s goodwill above the value of the assets, that’s something the buyer writes-off over fifteen years. It’s something that the seller has a long-term capital gain on. The allocation of the various assets in the agreement is important because that’s what determines the tax consequences.
In the case of assets, furniture, fixtures and equipment, that’s an ordinary income hit versus goodwill, which is long-term capital gains. What are the buckets of allocation? You’ve got assets, goodwill, non-competes potentially.
You may have intellectual property. You may have receivables. Sometimes a buyer will buy receivables, but the primary assets are the hard assets, the furniture, fixtures and equipment. Intangible personal property like copyrights and trademarks and any purchase price above those goes to goodwill. That’s a bit of a simplified version, but those are the main.
An inventory could be a category as well, but a non-taxable category, as long as the inventory is being transferred at cost.
The inventory is another important asset. That’s usually sold at cost. There are no tax consequences to the seller.
Nonetheless, as we’re talking through this, lots of categories, lots of things to be considered, and they should be considered upfront. Even if you can’t agree to the total values, at least identifying the buckets and knowing what you need to address as you get an appraisal is critically important so that the parties and their advisors have the landscape.
It’s also important if there’s real estate involved. Usually, always there’s an appraisal on real estate. That takes care of the real estate. The thing that the seller or a buyer should do is to talk to their CPA. The CPA has to be involved at this point on this asset allocation because the CPA will know what the basis in the assets is, how much the depreciation recapture, all of those tax issues. The CPA will know about that. They’ve got to be included.
Have your team in place very early and talk to them well in advance of contemplating these transactions. We oftentimes hear from sellers and the question comes up like, “How can I defer, reduce, forgo tax liabilities in a transaction? What are the strategies? What can I do?” I’d like to dive into that a little bit with you. What are the things that sellers can do to defer or forgo or reduce? We’ve talked about one of those things as far as the stock sell goes, but what other things can sellers contemplate in order to minimize their tax burden?
If a seller is getting a cash deal, the only thing they can do is be careful on how they allocate the purchase price. Try to allocate it to the basis in their assets and anything above their assets, allocate the goodwill. That’s the best thing a seller can do. When you’re getting cash, there’s not a whole lot of tax planning that goes on after that. I mean, cash is taxable. There’s not a lot we can do about that. If the seller is an LLC or S corp, that’s the case because it passes right through on the seller’s individual tax return. If the seller is a C corp, we got a whole different situation. A lot of tax planning has to be done.
Let’s hold off that C corp discussion because I want to come back to that. It’s an important one. You’ve got a scenario where they receive all cash. It’s going to pass through. You’ve got limited opportunities. Can they structure the deal in a way so it defers some compensation, but they’re still protected and it reduces their potential tax liability?
They can do some things like getting a consulting agreement with the buyer, employment agreement or non-compete agreement. A non-compete agreement is an ordinary income. We try to stay away from that if we can, and that can defer some of the tax, put it off to later years. It may or may not be a benefit, but it’s an option. There’s also an installment sale instead of getting cash up front. You get the payment over 5 or 7 or 10 years. That defers the tax, which may or may not be a benefit depending on what tax rates are going to be like in the next 5 or 10 years. You’ve also got the risk of non-payment, the default by the buyer. That’s something you don’t want to have to deal with if you can avoid it. We can defer some tax to later years, which sometimes is a benefit, sometimes isn’t, depending on what rates are going to be in later years.
If you do defer, you’re then expecting installment payments, which are at risk. I don’t even know if legally this is possible, but can those monies go into an escrow account and it’s released over some period of time, so you know the monies are there, and not have it be taxable on day one to the owner? Is there still a risk that money, because it’s been put into an escrow by a buyer, is still going to be taxable?
There is a risk that it will still be taxable. If it’s set aside and it’s guaranteed to go to the seller, that there’s no way that it can’t go to the seller, it’s probably going to be what we call constructive receipt and taxable at that time. That may not do it. That would probably still be taxable.
Let’s go back to the C corp situation. You’ve got a C corp and as you referenced, there may be some ways to defer tax. Can we dive into that a bit?
When a seller has a C corp that’s not the ideal entity to be selling a business, the reason for that is a C corp is a taxable entity. It’s not a pass-through entity to the shareholders. The C corp makes the sale, those sales proceeds are taxable in the C corp. That money will be taxed twice, one is in the C corp and one is to the shareholder when it’s liquidated. We want to try to eliminate the double tax. Some ways we do that is by paying bonuses out to the owner. If the C corp has a pile of cash from the sale, they can pay bonuses for compensation or past years under-compensation to avoid an unreasonable compensation issue.
As we said before, we can get payments in the form of a non-compete to the seller shareholders so that money doesn’t go into the corp consulting agreement, employment agreement. There’s also a concept that’s become popular called personal goodwill. It is a technique to use when their seller is a C corp. In that case, the shareholder sells their personal goodwill. If they can document that there is personal goodwill of the seller, sells their personal goodwill to the buyer. That money goes directly to the shareholder for the shareholder’s personal goodwill. That’s taxed as long-term capital gain to the seller. A combination of those techniques should be considered.
Let me dive into the personal goodwill issue for a second. In this instance, when somebody sells their business as a C corp, rather than the monies being received into the C corp and taxed in the C corp, there’s a separate personal goodwill agreement with the owner. Those proceeds are coming directly to the owner in that case. You’re bypassing that tax in the corporation, comes directly to the owner, and because it’s goodwill by the mere nature, it’s getting long-term capital gains treatment.
Long-term capital gain to the seller, and the buyer would amortize that over fifteen years. It’s a good technique, but you got to be able to justify that there is seller personal goodwill in that situation.
In your experience, what’s the bar in order for the owner to reasonably state that they’ve got personal goodwill in the business?
It depends on the facts, but it’s a question of whether the seller has personal contacts with customers, and customers are buying products from that corporation because of the personal goodwill, like in auto dealership. Auto dealership has the name of the individual. A professional like a dentist or a doctor’s office. Those have a lot of personal goodwill. It depends on how much the individual’s personal influence on the buyer, whether they buy products from them or not.
This is clearly an area where you need and want a professional to analyze this and give you their best advice. The last thing you want is an audit from the IRS and you couldn’t pass the litmus test and not have a professional ready to back you up.
Personal goodwill is not authorized by the Internal Revenue Code. It’s a contract matter between the buyer and the seller like anything else.
There is case law around personal goodwill.
There are a couple of cases on it.
In favor of personal goodwill where the courts recognized it and it’s approved.
It’s heavily determined by the facts of each particular case.
Anything else about C corp? I want to move on to current events and the landscape of taxation, and what might be coming?
One quick thing about C corp is it can turn into an S corp by electing S corp status, but it’s got to wait five years before it can get the benefit of S corp. You can’t elect S corp status a month before the sale and say, “I’m an S corp. Everything passes through to the shareholder.” You only get that five years after you make the sale. You’ve got to plan that in advance if you’re contemplating a sale and you’re a C corp.
In that five years, is it all or nothing? You convert from a C corp to an S corp, so you don’t have the issue of double taxation, do you have to wait the full five years? Let’s say, you sell 2.5 years in your conversion, do half the proceeds treated as a C corp and half as an S corp, or it’s an all or nothing?The allocation of the various assets in an M&A agreement is important because that determines the tax consequences. Click To Tweet
That’s an all or nothing. It’s like falling off a cliff. It’s either 0 or 100%.
It came down. At one point in time, it was ten years. Now, it’s five. Let’s talk about the current landscape. We’ve been talking to owners a lot about the market, in general. The M&A market has been incredibly hot, with tons of buyers, lots of money chasing deals. It’s a good time to be a seller. On top of that, long-term capital gains still happen to be 20%, but there’s some looming talk of tax increases. We don’t know what that means potentially, but what is your perspective on all of that?
Biden has always said he’s going to raise taxes. He said that before he was elected. Some rumblings have been coming out of the White House about what they’re looking at. Some of those things include changing the corporate rate from 21% to 28%. They want to increase the capital gain rate and the income tax rate on people with incomes over $400,000. They also want to increase and expand the estate tax. It’s about every tax we have. They’re talking about raising it.
The capital gains tax, which is a particular concern to anybody looking to sell, my understanding is they’ve been talking about going from 20% to somewhere in the neighborhood of 39% to 40%.
I’ve heard 40%. We don’t know what’s going to happen until the bill is passed and signed, but they’re talking about 40% long-term capital gain rate.
We’ve been thinking that maybe this was something that was going to happen in 2022. Are you starting to think that maybe this is gaining steam and could get in front of Congress for passage in 2021?
They’re now talking about putting these tax increases in this from billion-dollar infrastructure bill that they’re talking about. They’re including it in that bill which might come up and then start being talked about.
That would most likely be retro in January of 2021.
It would probably be prospective from the date of the law forward.
We’ve been on the bandwagon, talking to owners. Our comment has been, “If your window is in the next few years, you might seriously want to think about pulling the trigger now.” For the combination of things that I talked about. One, lots of buyers, lots of money. Multiples are still very high. Two, you’ve got these looming tax increases that could take a bite out of your proceeds.
I have clients that have done deals now because of that coming tax increase.
What about buyers? We’re talking about sellers here and get out while the getting is good. What should buyers be thinking about in regards to this? They’re probably sitting there thinking, “I’m walking into a hornet’s nest. My taxes are going to go up immediately.” What’s the wisdom around what buyers should be thinking?
It’s more a salary issue. Salary is the one that is going to have the gain. It’s going to have to pay the tax. Not so much a buyer issue, other than once they buy this business, the tax rate is going to increase. They’re going to be paying more income tax that’s going to reduce their cashflow. It may mean the business price has to come down.
I have not seen that creep into any negotiations yet. Have you?
Not from a buyer’s perspective, but it’s probab0ly because we don’t know what that new tax rate is going to be.
We don’t know what the date of it’s going to be and whether it’s going to be retro or prospective. This is great information. What advice would you have for people in the M&A Unplugged community, buyers or sellers around deals, whether it’s a tax or not?
You’ve mentioned some of those that it’s a good time to buy. There’s a lot of money around. Money is cheap and tax rates are going to go up. Now’s a good time to act.
If people want to get in touch with you, how could they best reach you?
They can reach me at Fraser Trebilcock. Our phone number is (517) 377-0845 or [email protected].
Ed, I appreciate you being here and visiting with us. It’s a pleasure to have you on the show.
I enjoyed it. Thanks, Dom.
Thank you. I appreciate it.
About Ed Castellani
Edward J. Castellani is a certified public accountant and attorney. This dual background and experience provides his clients a unique insight into business transactions, such as business entity formations, mergers, acquisitions, tax audits and appeals, and general business and tax planning for both profit and non-profit corporations.
Ed has developed industry specialization in health care law, automobile dealer law, nonprofit and trade association law, and alcoholic beverage law for suppliers, wholesalers and retailers. He is the current Chair of the Business and Tax Department, and has previously served several terms on the firm’s Board of Directors. He was one on 20 lawyers in the State of Michigan selected by Michigan Lawyers Weekly as a Go To Business Lawyer in the State of Michigan, has a pre eminent ranking with Martindale Hubbell and is a Leading Lawyer.
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