Mergers & Acquisitions–Key Issues in Purchase Agreements (Pt 2)30 Oct, 2015 By: Michael Dudek
This is the second in a series of articles about key issues for a business owner in a purchase and sale agreement when buying or selling a business. Caution: This article is not intended nor should not be construed as legal or tax advice.
- Carefully review your purchase and sale agreement
In the October issue of imageSource, I explained that a purchase and sale agreement for your business might be the most important legal document in your lifetime, so approach with caution to gain a good understanding of the provisions in the binding agreement and their implications if everything does not proceed as anticipated after closing.
a. Post Closing Risk
In last month’s issue, we explored post-closing risk and how every business purchase and related purchase agreement is fraught with post-closing risk for both the buyer and seller; especially the seller. Therefore, before you place your John Hancock on a purchase agreement, make sure your purchase agreement properly addresses your issues, and determine if the purchase agreement properly describes how issues will be resolved which might occur after closing. In addition, you should hire an attorney with business and M&A transaction experience along with experience in your industry, to draft or review your purchase agreement.
- Deal structure - Stock versus asset deal
As discussed, remember there is a difference between an asset deal and a stock deal and the common misconceptions about assumption of liabilities by the buyer and related risks.
- Basic tax implications of an asset versus a stock deal
To determine the tax implications of your particular transaction, you need to consult your tax advisor. For certain common legal entities such as sole proprietorships, partnerships, S-Corporations and LLCs, the most common form of acquisition is an asset purchase and sale.
For S-Corporations which could sell either their assets or capital stock and for LLCs which could sell either their assets or membership interests, an asset purchase is generally the form of transaction elected by the buyer, and acceptable to the seller because, in most cases, a sale of capital stock or an LLC’s membership interests would not yield a more favorable tax outcome to the seller.
In addition, most buyers prefer asset purchases over stock purchases because buyers perceive less risk associated with the seller’s liabilities. Since most recently formed privately-held and closely-held businesses formed are S-Corporations, LLCs or similar legal entities and not C-Corporations, an asset deal becomes the default deal and most common acquisition transaction structure.
However, for purchases of businesses which are C-Corporations, these corporations almost always desire to sell capital stock sellers to avoid double-income tax consequences; the first tax to the C-Corporation and the second to the individual stockholders upon distribution of the purchase consideration.
- Computing your business sale gain and tax
Many business owners often ask how the purchase price will be taxed. The taxability of your purchase consideration depends on your particular facts and circumstances, and you need to consult your tax advisor which should be able to satisfy your curiosity here without running up a big tax advice fee, especially if the tax advisor has been doing your regular tax work.
In short, a part of your portion price (the size depending on your particular facts and circumstances) will not be subjected to federal income tax because it will be a return of your tax basis in your business. And in a nutshell, if you realize a gain on the sale of your business, your gain, absent special rules which may apply to your situation, is eligible for long-term capital gain treatment rather than ordinary income treatment; therefore your gain is taxed, at least for federal income taxation purposes, at favorable lower rates. Since state tax laws vary extensively by state, this article does not address any state tax implications.
So in summary, if your business sale results in a gain, a portion of the purchase consideration equal to your tax basis will not be subject to federal income tax and the portion of the purchase consideration above your tax basis will be eligible for favorable capital gain treatment.
To get a quick and dirty estimate of your tax basis in order to compute your gain under various purchase price scenarios, just compute the owner’s equity in your recent business sheet – owner’s equity equals your assets less liabilities - and for many small, closely held businesses, your equity is likely to approximate your tax basis. However, caution; when you are dealing with tax law which can be very complex, the equity in your books and records might be very different from your tax basis because there are many difference between “book and tax accounting.” Again, your tax advisor who performs your regular tax work should be able to explain the specific differences in your situation.
There are many other potential exceptions to the summary tax concepts being explained in this article. For example, depending upon your tax practices and the structure of your business purchase and sale, and allocation of purchase consideration, various portions of the purchase consideration could result in ordinary income treatment for federal income tax purposes - which income is taxed at rates higher than for long-term capital gain rates.
Any loss from a sale of a business raises a different set of tax issues for which you should consult your tax advisor.
- Deductibility of goodwill for tax purposes
In many business purchases, the buyer pays an amount for the business which exceeds the net asset value of a business. For book accounting purposes, the purchase consideration in excess of net assets generally gets recorded as “goodwill” on the buyer’s balance sheet.
On asset transactions, the buyer is then allowed to deduct the goodwill for federal tax purposes over a 15-year period. On certain transaction, there might be buyer opportunities to write-up certain assets such as fixed assets to fair market value to enable the buyer to write-off such written-up amounts quicker than 15 years for federal income tax purposes. However, since the seller and buyer must agree to use the same purchase price allocation for tax purposes, the seller may not want to agree to any asset write-ups if adverse tax consequences would result.
For example, if the seller had recorded accelerated depreciation (such as Section 179 deductions) to write off fixed assets, and the buyers wants to record a higher fair market value for those written off assets, the write-up to fair market value could result in what is called a recapture of accelerated depreciation which would result in ordinary income treatment to the seller which otherwise would have been treated as goodwill by the seller, and taxable at capital gain rates lower than ordinary income rates.
On generic stock deals, a buyer may not be able to write-off the goodwill premium for tax purposes unless the buyer elects an exception which would allow the buyer to treat the capital stock purchase as an asset purchase for tax purposes; which election is permitted only in certain circumstances.
- Taxability of non-compete consideration
Another word to the wise is that non-compete consideration is ordinary income to the seller and treated as goodwill by the buyer for tax deductibility purposes – that is, the non-compete consideration can only be written off over 15 years by the buyer - even though many folks believe such non-compete consideration can be written over the life of the non-compete. Consult your expert tax advisor for any exceptions to this rule.
Like most U.S. tax laws, all of these aforementioned tax rules are extremely complex with various twists, turns, exceptions and special treatment which only an advanced tax physicist can understand.
Once again, as a reminder, this article is not intended as generic or specific tax advice to you and you need to consult your own tax expert for expert advice. In the next featured article on Key Issues in Purchase Agreements, we will start to explore key provisions in a standard purchase agreement. Contact me anytime with any related questions.
Mike Dudek, Esq., CPA, is owner of Zygoquest Group -"seeking to unite" which provides customized merger & acquisition services to buyers and sellers of businesses. Dudek also owns the Law Office of Mike Dudek which provides owners affordable legal services on mergers and acquisitions and other complex business transactions. At email@example.com or (610) 873-6555. Visit www.zygoquest.com for more info.