Tax Considerations in M&A

25:43but theoretically, it's a very nice transaction to think about. Teach me some stuff around how I can get around this. If I can't buy companies losing money, what can I do in terms of the structure side, stock versus asset? Is there any other clever structures you've seen that have created some good tax benefits? To get the benefit of net operating losses? Yeah, or just in general. I guess the traditional is to, like you mentioned earlier, is that you buy an asset and just to try to depreciate as much as possible. I was just trying to think if there's any other creative structures to get benefit if there is a company losing money, but it sounds like there isn't.

26:17I don't know what I can offer there that's helpful. When you're thinking about just general financing transactions, I think we were going to stay a little bit away from that and go to bigger M &A, but something that like VC funds or investors are often looking for when they're thinking about tax optimizing an investment would be qualified small business stock benefits. And I don't know if you want to go into that here, but that's something you often look at in financing transactions for a tax benefit for the buyer. Yeah, why don't we come back to that one? We have post-acquisition structure. There's obviously considerations if you're running a separate entity or combined.

26:50What do you typically see there? Is it always combined into one or they're running it as a subsidiary? It totally depends on what the buyer's doing, right? So post-transaction integration is very much a function of who the buyer is and what the buyer's looking to do with this investment. So obviously, if you have a fund that's just purchasing this company as a portfolio company and not looking to have it be part of a roll-up, they might think of it more as a standalone investment, ask the management team to roll a little bit or stay on and run the business for them. On the other side, big strategic investors, a big company that's maybe thinking they want to buy this target company and operate it as part of their overall business.

27:33They see it as adding something they don't currently have. In that circumstance, sometimes you'll see they really just want the assets. They don't really want the people. Sometimes they want the people too. When they want the people too, there's often negotiations around who will run what level, how autonomous will the company be. And some of that can come back to taxes when thinking about earnouts and contingent deal consideration and how that measured and paid out. For the sellers, what they're thinking about is how do I get as much of that as possible paid to me as long-term capital gain, like the rest of my deal consideration versus as ordinary income like compensation.

28:08When does the case shape for creating a holding company to house these multiple entities? Because I'm trying to get a sense of the plus and minus that you may have between companies. And then that kind of puts you in an odd spot as well. Yeah. So for buyer, that's really dependent. I guess this goes to pre-transaction structuring considerations for the buyer. The buyer really should be thinking when they're thinking about the best structure for them from a tax perspective, where they want the target companies sit in their overall structure and whether they do need to reorganize and whether it makes sense if they, let's say they're a foreign company and they have a US subsidiary already, should that US sub buy this company or should it sit under the foreign holding company?

28:47Or if it's an asset purchase, should one of their existing businesses buy the assets or should they form a new holding company for those assets? So that's all just very dependent on buyer structure and ultimate monetization goals. You added the international component, really made it complex? Yes, the international component makes it very complex. I think most people know the U.S. seeks to tax worldwide income where it can. You do want to make sure, especially if you have a foreign buyer, that you are not going to subject them to unnecessary U.S. taxes. And it's really wise for a foreign buyer in particular to get U.S.

29:25tax advice prior to buying U.S.-based businesses, which most do. Okay, a lot of stuff to think through structure-wise, post-acquisition, The case around employee, because we may buy a founder business, keep them around and put them on some kind of compensation plan where they can earn equity in the combined organization. And then we also have a lot of retention offers that would include some equity component. Are there any specific considerations around those kind of structures? Yeah. So one issue that we see fairly commonly is you'll have key employees who are also equity holders of the target company.

30:03And oftentimes what the buyer seeks to do is subject some of their deal consideration to contingencies. Like all the other investors get all their deal consideration up front, or maybe a piece up front, a piece later. But the key employees only get their later piece if they're still employed, or they've been employed for a certain period of time. They almost have to invest into it or reverse best out of it. And you have to be very careful because generally, deal consideration can receive long-term capital gains. We can talk about seller structuring in a minute. But what you want to be careful about is that none of that seller consideration, you don't want to turn any of it into compensation income by subjecting it to contingencies like retained employment.

30:46If there are any of those types of contingencies or additional complexities that come into play, you do need to talk to a tax advisor on the sales side to make sure that you're not really disadvantaged by agreeing to those conditions. Because as a buyer, I'd very likely do that. A lot of buyers try to do that. A lot of experienced buyers, they understand the tax issues that can come up for employees when some of their deal consideration is subject to contingencies. And oftentimes, they're willing to work with seller counsel on trying to help structure that contingent consideration in a way that's tax efficient for the seller.

31:23But it can become a really major negotiating point. And this is often a point that comes up in term sheets. Got it. Also, if a seller is supposed to be getting, and this goes to overall tax-efficient structuring for sellers, if the seller is supposed to be receiving equity in the buyer or supposed to stay on and retain equity in the target company, it's very important that the seller talk to a tax advisor and make sure that is structured tax efficiently. So the seller has tax deferral on the equity portion of the consideration. You don't want to be a seller who receives equity consideration for your equity in the target but have to pay tax because you want the cash to pay the taxes on that portion.

32:02What goes into that? The seller has a whole host of other tax efficiency goals in mind that they're thinking about when doing an M &A transaction, right? So usually, the seller's main goal is to pay as little aggregate tax as possible on their sale proceeds. So that really means that they want to structure the transaction so there's one level of tax on the cash. They also want their deal consideration to be long-term capital gains, not ordinary income. And again, they don't want to pay tax if they are getting any equity for their equity. So those are the main goals the seller has and how to structure efficiently for all of those goals is really dependent on the seller structure.

32:45So if the seller is a C-corp, it's generally always the case that it's most tax efficient for the seller just to sell their C-corp stock. One level of tax on that sale is usually long-term capital gains. If a buyer requested a seller that was a C-Corp to instead sell its assets, it could be very tax inefficient for the seller shareholder because corporations have tax paid at the corporate level, the entity level. And there's tax again when the cash comes out of the business. So there's two levels of tax on that type of transaction, which is why it's generally not the case that sellers who have C-Corp will agree for the C-Corp to sell its assets in the transaction.

33:22It's usually always a stock sale. S-corp are a flow-through entity, although they're a type of corporation. And interesting with an S-corp, again, if you sell the stock of an S-corp, if seller shareholders have one level of tax on that gain, usually it's long-term capital gain. It's just depending on the holding period in their stock. If an S-corp sells its assets, it's usually only one level of tax because it's a flow-through entity, except there's certain states that don't follow the federal income tax rules for S-corps, and they actually also impose entity level tax on that gain. Also, if an S-corp sells its asset, some of the gain might be ordinary income rather than long-term capital gain.

34:02So until very recently, it was almost always the case that shareholders of an S-corp, it was more tax efficient for them to sell the stock of the S-corp than its asset. Recently, in the past year and a half, two years, there's been a whole host of new rules that people call the PTET tax regime. So it's pass through entity tax regime. where certain states have enacted rules that basically allow S-corps and tax partnerships like LLCs to pay state taxes on behalf of their individual owners at the entity level. And then the equity holders get a deduction against their federal taxes for the state level, state taxes paid.

34:39It's like a workaround to the SALT, the lack of the SALT deduction that we currently have. So to get around not being able to deduct state taxes against federal taxes, generally these PTET regimes were enacted. And so now, whenever we have a seller that is an S-Corp or a tax partnership, we actually need to do modeling based on all of the states that are implicated in the transaction to determine whether the offset from the PTET regimes is greater than the savings by doing an equity sale. And so now, what used to almost always be the case that for an S-corp target, an equity sale was the best, sometimes we're actually seeing asset sales be more tax efficient, which is just a very big change from what we used to see.

35:27And that, again, could change if the SALT deduction cap is lifted. LLCs, which are generally tax partnerships, so I'm going to use the term LLC interchangeably with partnership to mean the same thing. Generally, the sale of equity or assets from an E is subject to one level of tax. So So whether you structure it as an entity, an equity sale or an asset sale, there won't be two levels of tax. And likewise, when a partner of a partnership or a member of NLC sells its equity, certain of the long-term capital gains is recharacterized as ordinary income, something called the hot asset rules. So generally, inventory items and depreciation recapture are recharacterized as ordinary income.

36:07If an NLC or a partnership sells its assets, there are also some ordinary income. But now, again, because the PTET regime, if an LLC sells its assets, there could be the benefit of the ability to deduct state taxes against federal taxes on the gain, which could be a big tax saving. So again, there's a need now to model out what is better when you're a seller and you hold equity in an LLC, whether you should be selling the assets or the equity would be more tax efficient. And the buyer can receive basis step up in an LLC transaction, whether equity or assets are sold. So there's a lot more flexibility in structuring.

36:48Leslie, my notebook is one big blur right now. Who's got the leverage in negotiating this between buyer and seller? So much of it's just dependent on who needs to get the deal done. It really depends on the deal. I'd say there are certain fundamentals. If there's a C-corp target, it's usually the case that the shareholders just can't do the deal if it structures an asset purchase because it's so tax inefficient. The seller just can't have the deal structured that way. But if the target's an S-corporation or an LLC, there really is often some negotiation that occurs regarding optimal structure.

37:27It's usually fairly easy to find a structure that works for both parties. One of the bigger issues we see is with S-corp targets. S-corps are really finicky. An S-corp can only have certain types of shareholders, specifically like U.S. individuals. So if the buyer was a corporation or a partnership fund, if it purchased the equity of an S-corp, the S-corp turns to a C-corp automatically. automatically it's typically not the case that buyers are going to want to buy the equity of an S-corp and if you have any rollover sellers they're not going to want it either but there can be a real tax efficiency for a seller of an S-corp to sell the equity because again they can get all long-term capital gains versus there's an asset sale portions ordinary income and so sometimes there's negotiations around like a gross up and whether the buyer will gross up the seller for any tax leakage for not getting their optimal structure and this can come into play with any number of transaction structures.

38:25But sellers will sometimes, depending on leverage, ask for gross ups to do the transaction in a way that's tax advantageous for the buyer. So the buyer wants a structure that's just not best for the seller. If the seller has some leverage, they can say, gross me up for the taxes that I will owe that are additional because of the structure you want. And the little tricky part there is because that gross up is actually additional deal consideration. What you really need is a gross up on the gross up because it's tax. So it's an iterative calculation. So what you think might be in a million dollar difference in taxes can be like a$2 million gross up.

39:02And so that could become a pretty big negotiating point in some transactions. That's my new vocab word of the day, gross up. Oh, yeah. This is a gross up on the gross up. Oh, I like that. Do tell. Is that a thing? Yes. To calculate the gross up, you need to take into account that taxes are going to have to be paid on the growth step. So it's an iterative calculation. I'm not going to complain about my hourly bill for me next time. I'm worth every penny. Case in point at this point. How much of this is spelled out in the LOI? So it's a really great question. This is why I like to get involved very early in LOIs.

39:38I'll say this. Firstly, it really depends on who's negotiating, what the positions of the parties are, what the structures are, and what the big deal points are. Let's just take an easy example. There's going to be some contingent consideration in the form of equity. Sometimes we'll just put in a sentence that says, this will be structured in a manner that's tax efficient for the sellers so that the equity is received on a tax deferred basis. And we'll just put in a sentence rather than figuring out exactly what the deal structure is going to be. Sometimes we'll figure out the whole deal structure because it's that important or it's that tricky.

40:11There's that many nuances or we know it's going to be because buyer isn't going to like what we need from a seller's perspective. Sometimes if we represent an S corporation target, we'll put in language that says, hey, if you want full basis, step up on the assets and you're going to want an asset purchase, we're going to want to receive a gross up for the additional tax we'll have to pay because we didn't structure the transaction as a stock sale. And that'll be a sentence in there. But that's enough because if it's a really material point for the seller, you need to get it in there because you can't bring it up later.

40:42Or it's hard to bring up later and win the point. So those are material issues you want to get in at the term sheet stage. I've had a client before where they've come to the firm after they've signed an LOI. And the term sheet has said, even though they're a C-corp, that they're selling the assets of the corp. And although LOIs are often non-binding, if the seller is already pregnant with the deal, are they already going to do it? You can't walk back from that after you agreed to it. It's really hard to renegotiate and still get the deal done. You want to start talking about these issues early.

41:12I agree. I also see the dynamics of leverage and negotiation where seller has more leverage, pre-LOI, buyer has more leverage, post-LOI. Fair to say? Yeah, that does often happen. And that's why you do, again, want things in the term sheet. Weren't there be things you wouldn't want just because that may, and I guess depending on level of sophistication and who you're buying the business from, they may not want it until you bring it up? The buyer might not want it in there, We've seen many times where buyers really have the upper hand in the term sheet stage because they've dictated the structure and the sellers hasn't engaged counsel to help negotiate on those points.

41:53Like if a buyer has said 25 % of the deal consideration is completely contingent on these three guys working and they end up with disproportionately more of that contingent consideration, whatever it is, it's really hard to later negotiate different terms. The terms that we're negotiating the term sheet might end up in some of the purchase price being compensation rather than long-term capital gain deal consideration. And it's really hard after you already have a signed LOI to say, hold on, that's not what I thought I agreed to. That's a zombie long-term capital gains. It's like, okay, well, that's not what you signed in the term sheet.

42:25You signed terms that just wouldn't result in that. It's hard to unpregnate a deal, but then how do you do it if you have to? It just goes to who has the upper hand and at what point. If the management team decides that the structure just doesn't work for them and they're needed to operate the business going forward, buyer might be much more inclined to negotiate those points than if the sellers, or most of them aren't really needed and the buyer has all the leverage. Then you advise your client to play hardball, walk away and... All dependent. Each client decides. What I can say is, And I always have to remind myself this.

43:04You just need to give your client the information and some guidance. But ultimately, a lot of these decisions are business-level decisions. You have to help them have enough knowledge so they know what they're signing and understand the ramifications. But ultimately, a client might decide that even though it's not most tax-efficient, it makes most sense to do a deal a certain way for other reasons. And that's okay too. Can we go back to QSBS and expand on that more? So QSBS stands for Qualified Small Business Stock. The real tax benefits of QSBS is this. If you hold QSBS stock for more than five years, and then you sell that stock, you can exclude from income tax the greater of$10 million or 10 times your basis in that stock.

43:49Okay. So simple example, if you invested$2 million into a C corporation and your stock qualified as QSBS stock. And six years later, you sold that stock, you can shield$20 million of that gain from tax. 2 million times 10 times your basis. That's the real benefit of QSBS is a total exclusion from tax. The minimum was 10 million and then 10x the basis. Yeah. You get to exclude the greater of$10 million or 10 times your basis in the stock. Bootstrap from scratch. Got it. Your founder,$10 million. $10 million. But if I threw in$5 million, it could be up to$50 million. Yes. Okay, I got it. Not all stock in corporations is QSBS stock, or you'd hear about this a lot more.

44:39QSBS is stock in a C corporation. So it has to be a C corporation. And it has to have been issued when the corporation was a qualified small business, meaning it's aggregate gross assets at all times before the stock was issued and immediately after the issuance does not exceed$50 million. And generally, aggregate gross assets for that purpose means cash and tax bases of the assets of the corporation. So if you had a C corporation, new startup started as a C corporation, and let's say it's operated for a year or so, and let's say an investor decides to put in$3 million at a$65 million post-money valuation.

45:21It still could be QSBS stock, Because that valuation is not the valuation used when determining whether the aggregate gross assets of the company exceeds$50 million. You look at instead the cash and the tax basis of the assets. So if you're an investor, you don't just rely on the pre or post money valuation for determining whether it's still a qualified small business. You have to do a little more work to figure it out. When you have assets contributed to a corporation or if an LLC converts to a corporation, you have to use the fair market value of those assets when determining whether it's a qualified small business and whether the$50 million value has been exceeded.

46:05The same with S-Corp. So S-Corps are really funky because if you own S-Corp stock and then you convert your S-Corp to a C-Corp, you can't get QSBS because when you originally received the stock, it was S-Corp stock. So if you are a shareholder in S-Corp and you want potential QSBS for your corp, we actually do a special type of reorganization to get you that stock tax efficiently. And that's a whole other topic I'm happy to talk about, but it might be beyond the scope of this conversation. But there is a way to make that happen so long as all the other requirements are met. But it's not as simple for that S-Corp founder as just converting to a C-Corp.

46:43Not only does the C-Corp stock have to be acquired at original issuance, which means you have to have received your QSBS for an investment into the company. You can't have bought it in a secondary. It also can be disqualified if there have been any significant redemptions within the year prior or year after you purchased your QSBS stock. So there's special disqualifying redemption goals you have to look at. And then the corporation during substantially all of the holding period for the relevant shareholder and their stock of the corporation has to have met the active business requirement, which means at least 80 % by value of its assets needs to have been used in the active conduct of a qualified trader business.

47:28and the code defines by exclusion what a qualified trader business is. So basically it says what is not a qualified trader business is leasing, financing, investing, or similar businesses, businesses where the reputation or skill of the employee is the principal asset of the business, like law, health, consulting, those can't be QSBS businesses, or hotels, motels, or restaurants. So there's certain types of businesses that can't be QSBS businesses, But generally, tech startups are okay because those are usually software versus surface business and technology businesses. Although the area can get a little gray if you have like fintech business, which straddles technology and finance.

48:08So that's the quick and dirty on QSBS stop. So this is a big deal in startup financing transactions. Why did the tax code get so complicated? It's a really great question. I don't know, but every year, there's someone who's saying, I'm going to make it so your whole income tax return can be on one page. It's never going to happen. Are there certain politicians that get paid for a tax law they put out there? I don't know. It is very complicated. And there are a lot of things you have to think about at every turn, but you're well advised. You save a lot of money. I agree. I agree. I'm always looking at the broader infrastructure and figure out where you can apply some lean, agile models, I guess, here, Leslie.

48:47How many people do you see relocate prior to their exit or tax savings, specifically to Texas and Florida? We have a lot of clients who have relocated to Texas, Florida in the past couple of years. Certain states have provisions that fall back on the savings one could have by moving to a different state. And some of it's dependent on if they're moving after they've gotten their original closing consideration before contingent payout has been made. Okay, so that's a big personal consideration. I'd say more often than people moving before an M &A event, we're just seeing people wanting to move for just general tax savings on their everyday income.

49:30We're seeing a lot of that. People are just sick of not getting the benefit of the SALT deduction. And we're seeing a lot of people just move saying that's the reason they're moving, not necessarily because they had a big deal coming to fruition, although we've seen that as well. And in that circumstance, I have a colleague who advises on all the ways to make sure that you are actually giving up state tax residency because these states are aggressive. Yeah, how far ahead do I need to do that? This is all top of mind while I'm taking this call from Miami today. You have to really move to get any benefits from actually moving.

50:01But yeah, you usually have to do it before. Oftentimes, and it's really state specific, but you usually have to do it before you have a signed deal. And you have to establish a residency. You have to have time to establish the residency. Literally go over there, rent an apartment, then go sign the deal. Yeah, it doesn't really work that way. You're going to probably subject yourself to an audit that you're not going to win. Okay. I appreciate that insight there. In terms of diligencing for the tax considerations as a buy side, what are the big ticket items that I as a deal person should be asking about ahead of time just to understand what some of those things are?

50:37Part of this, again, depends on the structure, right? So if you're buying equity in an entity, you're assuming tax liabilities. If you buy the stock of a C-Corp, whatever tax issues that C-Corp has travels to you as owner of the company. Now, you might have indemnifications or rep and warranty insurance to cover yourself financially, but it's still your headache. Now, if you're instead just doing an asset purchase, a little bit less of your headache, what tax issues are at the target company that's the seller? because those issues should primarily stay with the selling entity and an asset purchase, except maybe some state and local taxes.

51:14And if you're acquiring equity in LLC or S Corp, some of those pre-existing taxes will naturally flow through somewhat to the prior owners, but still have your headache because you own the company. So you always want, if it makes sense, given the deal to do fulsome diligence. That's always my recommendation is fulsome tax diligence. You have an accounting firm come in and actually diligence the company, look at all its tax returns, and make sure it's been doing everything correctly. And so we always do recommend bulsome tax diligence. Bring in the experts. Bring in the experts, get it done. Yeah.

51:47And as law firms don't do the tax diligence, usually it's an accounting firm. And then the accounting firm typically will put together a due diligence report, like a tax due diligence report. And then the lawyers will look at that to figure out what are the big ticket issues that need to be negotiated on the tax side. and we'll decide what needs to make it into the purchase agreement as far as obligations of buyer and seller with respect to taxes and any cleanup that needs to be done or indemnity that needs to be asked for. Any big do's and don'ts, lessons learned from experience? Do get a tax advisor involved early on.

52:22It saves you a lot of money later on. The juice is worth the squeeze. I'd always say get a tax advisor. All just to make sure you are structuring the transaction tax efficiently. And then as a buyer, do your diligence on the target company. That'd be my big buyer advice. And then another just piece of advice, I guess, for sellers, if there's a target company and some of the sellers are going to be rolling and have equity in the buyer going forward or equity in the target going forward, and some are selling, their interests are not always going to be aligned. So sometimes, depending on how the deal negotiations are proceeding, those rollover shareholders or equity holders might need special counsel.

52:59Sometimes we counsel management teams of private equity portfolio companies and represent the management team specifically in negotiating their rollover and their incentive equity that they're to receive for go forward services once the company has been purchased by the private equity fund. I like to think of the broader stakeholders. What's the most creative strategy you've ever seen to avoid paying taxes? You know, subentities in Bermuda, what's the most creative? The IRS has done a pretty good job shutting down anything that would be a tax shelter. So I haven't seen anything crazy as far as structuring.

53:37I just say I've seen smart structuring. People who can structure smartly do well. That again goes to typically just structuring as a seller to get most of your gain as long-term capital gain. If you need to, structuring into the PTET deductions that we now have available. and also really importantly, structuring your go forward incentive equity tax efficiently. So I wouldn't say there's any real tips for sheltering the gain, but I'd say you can structure efficiently. And then we set up trust in Wyoming. I would say this, if you're a founder of a startup or you are a shareholder of a earlier stage company, you should start thinking about overall tax structuring for you and your family.

54:23thinking smartly about how to use trusts and grats and eventual estate planning pay off. That goes again to why sellers in particular should get tax involved really early is because you do need to start thinking about some of those tax efficient structurings earlier on rather than at the time you're trying to sign an LOI. Because some of it is it's a little too late to get into some of the tax efficient structures once you've signed an LOI and have a real valuation on the table. Wow. This has been great. Leslie, thank you so much for joining us. Those of you still tuned in. Until next time, here's to the deal.

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