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Caveat Venditor: Seller Beware

D. Joshua Elliott

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Basic premise

• A host of legal, familial, operational and economic considerations drive the timing of when an owner may decide to sell their business

• Tax is rarely the #1 consideration

• However, tax considerations have a significant impact on the cash flow that may be realized upon sale

• Preparation and knowledge will enhance your return of investment

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Session goals

• Introduce you to tax considerations that

will impact your after-tax cash flow

• Encourage you to be methodical in

preparing for sale – to help you maximize

your return

• Start you thinking!

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M&A deal volume

Deal volume

down but price

per deal is up

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M&A activity multiples

Multiples are up –

partially due to

increase in IT

and healthcare

deals

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Topics

• What does the buyer want?

• What does the seller want?

• Legal and structure considerations

• Common problem areas

• What you can do now

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Who Wants What?

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What does the buyer want?

• Strategic buyers

– Looking for market share or to remove

competition

– May be adding vertical integration

– Very knowledgeable about your industry

– Integration opportunity and risks

– Little interest in back office function

– May have limited interest in retaining

management

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What does the buyer want? (cont.)

• Financial buyers

– Frequently focus on a particular niche and roll

up companies

– Looking to use more sophisticated leverage

and borrowed funds to accelerate growth

– Concerned with cash flow and EBITDA

– Want quick flips and opportunities for return

on investment

– More sensitive to business cycles (trending

industries vs. mature businesses)

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What does the buyer want? (cont.)

• In general

– Stepped-up tax basis in acquired assets

– Limited carryover of liabilities

– Key management retention

– Comfort about Target’s historical tax practices

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What does the seller want?

• Capital gains tax rates (vs. ordinary)

• Tax efficient sales (avoiding leaving cash inside a shell company)

• Opportunity to participate in future growth (rollover) without paying current tax

• Maximum sales price with minimal purchase price adjustments

• To get paid for Buyer’s asset step-up

• FINALITY! Transfer of liabilities to buyer with no residual

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Legal and Deal Structure Considerations

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Target entity type

• C corporation

– If sell assets inside Target

• Tax inside Target

• Tax on distribution of cash to shareholders,

generally at capital gain tax rates

– If sell stock

• Shareholders pay capital gain tax rates

– Eligible for IRC §§338 and 336(e) only if a

subsidiary in a consolidated group

– May be eligible for very favorable IRC §1202

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Target entity type (cont.)

• S corporation

– If sell assets inside Target

• Target has a combination of ordinary and capital

gains income that flows through to owners

• Generally no further gain on distribution of cash

(assuming shareholders have basis)

– If sell stock

• Shareholders pay capital gain tax rates

– Eligible for IRC §§338 and 336(e)

– Not eligible for IRC §1202

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Target entity type (cont.)

• Partnership or LLC– If sell assets inside Target

• Target has a combination of ordinary and capital gains

income that flows through to owners

• Gain at partner level to extent cash distribution exceeds

basis

– If sell partnership/LLC interests• Partners/members pay capital gain tax rates

– Sale of greater than 50% may cause a

partnership termination

– Not eligible for IRC §§338 and 336(e)

– Not eligible for IRC §1202

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Potential forms of sale

• Straight sale of stock

– Attractive to sellers because all gain is taxed

at capital gains rate

– Less attractive to buyers because it does not

allow for a step-up of assets inside the target

– Legal or operational benefits/detriments

– May require a change in the form of the entity

(i.e., harder to maintain S corp status if PEG

buyer)

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Potential forms of sale (cont.)

• Straight sale of assets– Attractive to buyers because it allows for a step-up in

the acquired tax basis

– Less attractive to sellers if a C corp because of two

layers of tax

– May be less attractive to S corp sellers due to

additional ordinary income (vs. all capital for a stock

sale) or additional double tax (if a C corp within past 5

years)

– Could be more difficult if some sellers want to stay in

and some want to sell out

– Administratively more difficult (asset title transfers,

contracts, etc.)

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Potential forms of sale (cont.)

• Hybrids– IRC §338(h)(10)

• Allows for the legal sale of stock which may be

attractive for legal reasons

• Target must be an S corp or a corporate subsidiary in a

consolidated group

• Both parties elect to tax the deal as a sale of assets

• Seller will pay taxes consistent with an asset sale

• Parties will likely need to “negotiate” for payment of the

additional tax liability (make sure seller is getting their

“fair share” – do not just negotiate for the tax

equalization; argue for a piece of the buyer’s benefit in

stepped up basis!)

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Potential forms of sale (cont.)

• Hybrids (cont.)

– IRC §336(e)

• A limitation of IRC §338(h)(10) is that it requires a

corporate buyer

• IRC §336(e) has a very similar tax treatment but allows

for any form of buyer

• Seller must make the election (as opposed to buyer

and seller)

• Adds some flexibility but not as well known

• Note that holdover owners may have to pay current tax

on the gain even though they are carrying over

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Common Problem Areas

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Common problem areas

• Sales and use tax

– Failure to file in necessary states – statute of

limitation never closes

– Protections afforded to the sales of personal

property are not available for sales of services

• State income tax

– Nexus issues and failure to file in necessary

states

– Improper apportionment

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Common problem areas (cont.)

• Employee vs. independent contractor

• S corporations – non-pro rata distributions

• S corporations – deduction for composite

state tax payments (which are

distributions)

• Reasonable compensation issues for

closely-held businesses

• Owner personal expenses deducted inside

the company

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Common problem areas (cont.)

• Loss companies – failure to track ownership changes under IRC §382

• Debt refinancing issues

• Multinationals – transfer pricing

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What Can You Do Now?

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What can you do now?

• Twelve months or less

– Repair the termite damage before the buyer finds

it (cheaper than he will adjust the purchase price)

– Preparatory due diligence

• Risk assessment and amelioration

• Historical document accumulation

• Data room preparation

• Preemptive Quality of Earnings report (huge)

– EBITDA trend analysis

– The more prepared you are, the more credibility

you will have with a buyer

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What can you do now? (cont.)

• Twelve months or less (cont.)– Trim the fat and get paid for it instead of leaving

for the buyer to realize• Optimize head count

• Accelerate tough decisions

• Dump underperforming accounts

• Eliminate personal expenses in the business

• Maximize EBITDA

– Think through steps the buyer would take in the first 6-12 months and do them now (so you get paid for them)

– Anticipate Buyer options so you are better prepared for negotiations

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What can you do now? (cont.)

• More than twelve months

– Structure planning – isolating salable and non salable assets

– Maximize holding period to obtain long-term capital gains tax rate

– Create incentive comp for management to drive value

– Consider S corporation election (significant reduction in after-tax savings)

– Estate planning considerations

– Identify key markets for expansion to enhance value

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Quick S corp example

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Quick S corp example (cont.)

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Other Considerations

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Common terminology

• Earnouts

• Working capital adjustments

• IRC §409A

• Contingent liabilities

• Cash-free, debt-free

• Installment sales

• Inside vs. outside tax basis

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Other considerations

• Preparatory diligence

• Transaction costs

• Parachute payments (C corporations)

• Pending tax law changes (tax rates)

• Management retention

• Limitation on use of NOLs

• Estate tax planning

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D. Joshua Elliott

Tax Partner – Leader of FTSS

Dixon Hughes Goodman LLP

Greenville, SC

864.213.4027

joshua.elliott@dhgllp.com