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Mergers &
Acquisitions: General Tax Concerns When Structuring the Sale of a Business
By: Steven
B. Kray, Esq. and Certified Public Accountant
ALTERNATIVE TAX STRUCTURES
I.
Cash
Sale of Assets: Stock Sale vs. Asset Sale - The first
objective: The avoidance of corporation level tax
A.
Covenant
Not to Compete
B.
Employment
Agreements
C.
Past
Due Bonus Compensation
D.
Qualified
or Non-Qualified Retirement Plans
E.
Corporate
Taxes
II.
Liquidation
of Corporation, Distribution of Assets
II.
Mergers:
Taxable and Tax Free
A.
A
Taxable Reverse Triangular Merger
-
This
would be a transaction where the purchaser forms subsidiary to be merged into
Target Corp. and the shareholders of Target Corp. are "cashed out".
B.
Tax
Free Stock for Stock Merger -
This form of transaction would
tender to each shareholder of Target Corp. shares of the purchaser, in a tax
free transaction. Target Corp.'s shareholders will then pay taxes upon their
sale of the purchaser's stock, if able to be sold.
IV.
Deferred
Gain: Installment Sales Method; Use of Beneficial Interest in a Trust as
Security
INTRODUCTION
A business owner may
eventually face the prospects of selling his or her incorporated trade or
business ("Target Corp."), to a purchaser, who may be a relative,
an employee or a third party. Each transaction will have to be structured to
accommodate the relationship and business deal between the buyer and seller,
as well as the form and tax status of the business being sold.
This article
addresses some of the tax concerns for the shareholders of an incorporated
entity that operates a business that is being sold to a third party. It is
important to remember, as previously stated in other articles by STEPHENS
& KRAY, that each planning situation is different. As a result, the
client must be able to rely upon the skill of his or her attorney and advisors
who hopefully fully understand the client's objectives and the parameters of
the proposed transaction, and who can thereby devise a structure that will
accommodate most if not all of these issues, in the most cost and tax
effective manner.
Please review this
article with the idea that the solutions proposed may not be applicable to
your particular fact situation. This article is intended to provide
significant insight into how to proceed to negotiate a sale or purchase of a
business, and who to engage as part of your counsel and advisory team,
without offering an entire treatise on the subject.
Please note that the
mechanisms discussed in this article may be used to design other forms of
purchase and sale transactions, such as sales between family members, or
sales to key employees, however those form of transactions call into play a
variety of other issues that may not be specifically addressed, and as a
result, require their own independent evaluation. Similarly, structures
generally used in other forms of transactions might be just as applicable for
this form of transaction, and just because they might not be mentioned in
this article, should not be discarded.
ALTERNATIVE TAX
STRUCTURES
I. Cash Sale of Assets: Stock Sale vs. Asset Sale
A sale of assets
involves the direct sale and transfer of assets by Target Corp. to the
purchaser. This is distinguished from a stock sale, wherein the shareholders
sell and transfer their shareholdings in Target Corp. to the purchaser, who
then becomes the sole shareholder of Target Corp., and, will either operate
it as "Target Corp." or thereafter liquidate Target Corp. in order
to directly own the operating assets of Target Corp.
Stock Sale vs. Asset Sale
The stock sale is
generally more beneficial to the shareholders of the Target Corp. because it
generally enables them to report their gain from the sale as a capital gain,
which rates are typically capped at a 20% federal tax rate. This both
avoids a corporate level tax and the allows the use of the lower capital
gains tax rate. However, the stock sale is less preferable to the purchaser,
because (a) they must acquire the entire entity, inclusive of contingent and
"unknown" liabilities; and (b) they generally cannot take tax
deductions against the purchase price of assets being acquired (such as
depreciation or amortization), unless they comply with the provisions of
Internal Revenue Code ("IRC") section 338.
Under IRC 338 the
purchaser of a corporation can elect to treat a stock purchase as an asset
purchase by liquidating the newly acquired Target Corp., provided that the
liquidated Target Corp. must first pay all corporate level taxes in
connection with income that is to be recognized upon its liquidation,
including any depreciation recapture (the difference between the sale value
of the asset and its depreciated book value). In many transactions
purchasers will entertain a stock sale, but will want the Target Corp. to pay
these corporate level taxes before the closing, or charge these taxes to the
Target Corp. shareholders, directly or through some form of compromise in the
purchase price.
In order to provide
to a purchaser retain some of the benefits of tax benefits that would
be available through a purchase of assets and not stock, a transaction
structured as a stock sale can in many cases characterize a good portion of
the consideration as payable as part of the purchase price, as consideration
of a covenant not to compete with the Target Corp's shareholders. This
will allow the buyer of stock to obtain tax deductions and write-offs to
eliminate for the value of the covenant, which the law will allow to be
deducted over 15 years. That portion of the purchase price that is
allocable to the shares of Target Corp., once in the hands of the purchaser,
must be capitalized by the purchaser and becomes the purchaser's basis.
This basis in the shares is available to reduce taxes if the stock is later
sold, or if the Target Corp. enters into a plan of liquidation that will
allow it to allocate this basis to depreciable assets.
Unfortunately the
purchase price allocated to a covenant not to compete, or other
"deductible" items that benefit the purchaser's desire to write off
his or her costs of acquisition as part of a stock purchase and sale, will
generally be taxable to the seller at ordinary income rates.
This will typically
become the major point of contention and negotiation between buyer and
seller. The seller wants to pay taxes at capital gains rates, and the
buyer wants to take a tax deduction for the purchase.
In the case of the
sale of a Target Corp. that is valued at $2.0 million, if the purchaser is
not entitled to any tax deduction for the price paid, the purchaser must have
earned that $2.0 million "after taxes." This in many cases means that
the purchaser must have earned some $4.0 million in order to net $2.0 million
to pay for the acquisition. It is the case that upon a subsequent sale
of the stock, the original purchaser, now a seller will be able to reduce the
taxable income from the second sale by this basis, however, this tax savings
will in most cases be delayed for many years.
In the case of an
asset sale, the purchaser and seller will negotiate the selling price for
each asset, and each asset at the purchaser level will be entitled to its own
depreciation or amortization, and at the seller level will be subject to its
own form of tax, ordinary from depreciation recapture, or capital gains
taxes. However, the selling shareholders may have to pay a second tax
to get the cash paid for the business out of their corporation, which second
tax most likely will be a capital gains tax. However, there will be two
taxes paid by these shareholders, one at the corporation level and the other
at the shareholder level.
It also has to be
noted that in an asset sale, the value attributable to items of tangible
personal property may be subject to a California sales tax, unless the sale can come within any one of
the established exemptions from sales tax. If Target Corp. does have not a California "resale" number, it is more than likely that
the "occasional sale exemption" may apply to avoid a sales
tax. If a sales tax is required, the parties then have to
negotiate who is to pay the tax.
The savings to a
purchaser by being able to take a tax deduction of the purchase price will
yield a far greater savings to the purchaser, than the possible additional
tax that the selling shareholders may have to suffer. This is because
the loss of the tax deduction means that a purchaser must gross up the actual
purchase price by the tax it will have to pay, in order to generate the
"net" cash to make the purchase. As discussed above, a $2.0
million purchase price may gross up to $4.0 million in actual pre-tax
revenues. However, the seller will suffer a tax on the net sale
proceeds, or between $400,000 to $1.0 million in total taxes, which is less
than the $2.0 million that the buyer will pay if they are not entitled to a
timely tax deduction.
The process of
negotiation and compromise over the proper structure of the purchase and sale
before the entering into any binding letters of intent or agreements will
help to eliminate the payment of any unnecessary taxes. This is not
always possible or desired, however, it is important that the parties understand
their options and the significant of taxes before agreeing in principle to
any agreement to purchase or sell. The above example illustrates
that the sale of a $2.0 million business can cause one party to net $1.0
million after tax, or cause the other party to pay $4.0 million pretax, or
anywhere in between. That is a $3.0 million spread that far exceeds the
value of the business being sold. The balance of this article discusses
ways to effect deferrals of the selling price and sales proceeds
in the hands of the seller, to defer the taxes from the sale, or to
restructure these sale proceeds to taxable ordinary income in the hands of
the seller, to possibly give both the buyer, and the Target Corp. seller a
tax deduction, and avoid a double tax to the shareholders of the Target
Corp.
The first objective
for a successfully structured cash sale of the assets of Target Corp. would
be to avoid to the extent possible any and all taxes at the
corporation level (commonly known as the "double tax"), and instead
pass all taxable income and tax liabilities directly to the ultimate
recipients and beneficiaries of the cash proceeds, i.e. the shareholders,
free of the intermediary corporate level tax.
A second objective to
a successfully structured asset sale for Target Corp. would be to defer to
the extent possible any and all tax obligations that are finally required to
be paid. Generally, this type of deferral is very difficult in a cash sale of
assets, and will be discussed below at, "IV.
Deferred Gain: Installment Sales Method; Use of Beneficial Interest in a
Trust as Security."
The first objective:
The avoidance of corporation level tax in an asset sale. In order for Target
Corp. to avoid taxable income, it must either:
1.
reduce the amount of cash
proceeds that it is to receive from the sale and/or
2.
increase its tax
deductible expenses in the period(s) that it receives cash proceeds from the
sale of the assets.
Briefly, all proceeds that Target Corp. receives
will generally constitute gross income. In addition, any depreciated assets,
to the extent sold and valued at greater than their book value, will
generally create income characterized as depreciation recapture (the
difference between the sale value of the asset and its depreciated book
value). When conducting an asset sale, a tax paying purchaser will want
depreciable tangible assets to be valued as highly as possible, to give the
purchaser a shorter time to effect a tax write-off. Intangible assets, such
as covenants not to compete and customer lists, will generally only give the
purchaser a 15 year amortization schedule for write-offs. These tax matters
may be of less importance for a not for profit purchaser who will be more
interested in justifying the consideration paid for the assets, in
particular, the fair market values associated with the property being
acquired. As a result, Target Corp. shareholders will have to evaluate its
own tax impacts based upon how its purchaser is willing to acquire the
business, write-off the costs of the acquisition, prepare and present its own
financial statements, and justify the consideration paid for the assets being
acquired.
A. Covenant Not to Compete
Covenants not to
compete negotiated directly with significant Target Corp. shareholders, will
reduce the proceeds payable directly to Target Corp. These are legitimate
devices to shift the income burden directly to the shareholder, in situations
where the shareholders are available to work and/or consult and where their
competition can injure the value of the assets being acquired by the
purchaser. Any income generated from the covenant not to compete would become
payable directly to each shareholder and taxable to them as ordinary income.
A for-profit purchaser's ability to deduct this payment will generally be
over a 15 year period. Payments characterized as covenant not to compete will
generally not be subject to payroll tax nor the 2.9% social security medicare
tax.
The value placed on
the covenants not to compete will enable Target Corp. to allocate the selling
price in accordance with any formula for extraordinary and previously accrued
bonus compensation that its board of directors has adopted that may be
different from the respective percentage interests of its shareholders. That
portion of the purchase price properly allocated to the covenant not to
compete will avoid any taxation at the corporation level, since the covenant
monies will not be paid to the corporation, but directly to the shareholder-
employees.
As noted above, the
purchaser would book the covenant as a capital asset amortizable against
taxable income over a 15 year period. This would be the case for all
"intangibles" acquired by the purchaser, including customer lists.
However, the ability of the purchaser to accept a substantial allocation to a
covenant not to compete may be a point of further negotiation with your
purchaser.
As mentioned above,
the covenant not to compete is an appropriate device to achieve write-offs
for the purchaser in a stock sale, as well as for the seller in an asset
sale. However, in a stock sale, the seller trades capital gain's tax rates
for ordinary income tax rates, in order to accommodate the purchaser's tax
write-off.
B. Employment Agreements
Sign-up bonuses can
also be negotiated, for services to be rendered by shareholder employees who
will continue to work for the purchaser. This form of consideration will work
well if the shareholder employee will work directly for the purchaser, or if
they form a new entity that will work for the purchaser. However if Target
Corp. is to remain in existence and its shareholder employees are to consult
or otherwise tender services to the purchaser through Target Corp., an
allocation of this form of consideration ultimately payable to these
individuals, in order to effectively reduce the tax impact of the
transaction, may have to be handled differently, such as in the form of
qualified or non-qualified deferred compensation for past or future services,
or a past accrued bonus. The fact that there would be a continuity of
employment between Target Corp. and these individual may render the use of a
"sign-up" bonus difficult to justify. Further, the concept of a
sign-up bonus was designed to avoid payment of monies to Target Corp., to
avoid the need for Target Corp. to find a legitimate "expense"
against the income, and if these monies have to be paid to Target Corp.
because of the structure of future services, an alternative to this form of
allocation should be considered.
It should also be
noted that any form of "sign-up" bonus regardless of how allocated,
when ultimately paid to the shareholder employee, will be subject to social
security and medicare taxes and therefore the significance of these taxes, in
particular, the unlimited nature of the medicare tax, should be evaluated. If
the compensation payable is generally "reasonable", they should
afford the purchaser an immediate tax deduction at the time paid.
While there is tax
authority that supports the position that when consulting and employment
services are integrated as part of a covenant not to compete agreement, the
consulting and/or employment services are generally held reasonable. In the
case of a for profit purchaser, the Internal Revenue Service
("IRS") may attempt to challenge efforts by the purchaser to
recharacterize significant proceeds, that should otherwise be amortizable
over 15 years, into payments that are immediately deductible. As noted, this
potential problem will primarily be of concern to a purchaser.
In summary, the use of sign-up bonus compensation
or consulting or employment agreement compensation is an appropriate device
to achieve write-offs for the purchaser in a stock sale, as well as for the
seller in an asset sale. The fact that Target Corp. may want to be the
recipient of the "sign-up" bonus, may defeat the purpose of its
implementation. It must also be noted that in a stock sale, Target Corp.
would receive the lower capital gain's tax rates, whereas, although these
alternatives can mitigate the impact of the "second" corporate
level tax, the shareholder employee will receive ordinary income, taxable at
ordinary income tax rates, plus social security and medicare taxes, in order
to accommodate the purchaser's desire to avoid a stock purchase.
C. Past Due Bonus Compensation
Past due bonus compensation would consist of
compensation actually payable and paid by Target Corp. out of the proceeds
from the sale to its key employees (such as the shareholder employees), to
achieve a tax deduction and comply with the adopted allocation formula. The
payment would constitute a deduction to Target Corp. and therefore reduce the
tax impact of otherwise taxable cash proceeds from the asset sale. These
payments would constitute ordinary income subject to both social security and
medicare taxes.
As noted above, if the "sign-up" bonus
is to be paid to Target Corp., the use of the sign-up bonus loses its impact
as a means to create tax deductions, in that Target Corp. must still find a
form of deduction when it pays these proceeds to its employees. As a result,
Target Corp. may have to utilize this form of deduction to justify the
distribution of proceeds to its shareholder employees in a manner that
offsets the income with a legitimate expense.
When the total amount of bonuses sought to be
paid approach and/or exceed 100% of the ordinary compensation of the
shareholder employees, or are substantially greater than historic
compensation levels, the corporation and the board of directors would be
advised to obtain a salary survey or compensation study that can justify the
compensation sought to be paid. It is not unrealistic to be able to justify a
payment that may be a substantial multiple of current compensation through
the engagement of a reputable salary consultant firm.
This form of expense is probably the most
significant expense available to the corporation, to eliminate any and all
taxable income that may remain, after allocating proceeds to the covenant not
to compete and to any sign-up bonuses and avoid double taxation.
D. Qualified or Non-Qualified Retirement Plans
The general benefits of a qualified retirement
plan, such as a defined benefit plan or a profit sharing plan, are that it
offers the corporation a tax deduction and at the same time, defers the
taxable income to the participant employees. However, the dilemma of the
qualified plan is that it must generally cover and benefit all employees of
the employer and, in the case of "professional service
corporations" and "affiliated service groups," both the entity
hiring the shareholder employee possibly the employees of the purchaser, to
whom the shareholder employees will render services.
In many cases an actuary would have to be engaged
to evaluate the benefits of a plan and the existence or non-existence of an
affiliated service group. The matter of comparability will affect the type of
plan that any separate entity hiring Target Corp. physicians can implement
and the size of annual contributions that are available to benefit Target
Corp. physicians.
The most advantageous qualified plan for older
employees is the defined benefit plan. This plan bases its annual
contributions on the level of benefit that the retiree is to receive at
retirement, which is directly related to current levels of compensation (and
sometimes historic levels of compensation). However, the formula becomes
fixed and as a result, changes in events, such as death, disability or
retirement, or other changes in levels of current compensation while they
will affect the amount of annual contribution that must be set aside for a
particular shareholder employee, may not affect that contribution and
deduction "prorate". What this means is that it may be difficult to
adopt a formula allocating proceeds from the sale among shareholder employees
that will be fixed in concrete, and that events can occur that could
significantly affect how those proceeds are ultimately and finally divided
up.
In addition, the use of any qualified retirement
plan must be based on actual compensation that has been paid and reported as
social security and medicare wages. In addition factors such as age, and
actual compensation paid, that will limit annual contributions that may be
available, there are significant annual limits as to how much money can be
put aside for each employee physician. Therefore the use of a retirement plan
will generally require a several year commitment. If use of a plan is
intended to defer proceeds from the sale received beyond the initial year's
cash proceeds, the purchaser may have to defer the making of cash payments
against the purchase price in accordance with a schedule that will defer the
payments over a several year period, so that Target Corp. can time income
with tax deductible plan contributions. An actuary will have to analyze these
various issues to help achieve both:
i.
the proper timing of income with
ii.
the proper timing of contributions and
iii.
the equitable division of the proceeds from sale, to
the extent possible
The use of the retirement plan to
effect deductions against proceeds from the sale may conflict with other
forms of achieving deferral or tax deductions, discussed in this article. In
addition, the continued solvency of the purchaser and its ability to make
installment or deferred payments can increase the risk to Target Corp. that
it may not be able to collect the entire purchase price.
E. Corporate Taxes
It must be noted that the above analysis
discusses ways to reduce and hopefully eliminate the potential
"double" tax that could be imposed from an asset sale by a C
corporation. The term "double" generally tax refers to both
i.
the corporate level tax discussed above, and
ii.
the second tax that is imposed at the shareholder
level, assuming that property is distributable to the shareholder as a
dividend
Target Corp., its shareholders
and accountant must also be cognizant of the possibility that there could be
an additional tax as the result of "phantom" income at the
corporate level, with no distributable cash available for shareholders, and
possibly no available cash at the corporation level to pay that tax.
"Phantom" income is generally:
1.
the result of corporation monies having been previously
withdrawn and expensed in a prior tax period, as salary, other deductible
form of compensation, or as loans
2.
the result of the sale of depreciable or other
assets, that are encumbered by debt in excess of their adjusted basis, or
from
3.
depreciation recapture upon the sale of a depreciable
asset
II.
Liquidation of Corporation, Distribution of Assets
This structure would entail liquidating the
assets of the corporation and have the shareholders separately enter into
agreements with the purchaser for employment agreements, covenants not to
compete and a sale of their respective undivided interests in the
assets.
This form of structure does not add any
significant benefit to the structure described in Alternative
I. "Cash
Sale of Assets" and may in fact add more confusion and
complication due to the basic nature of a liquidation in advance of a
sale.
Under this structure, Target Corp. would suffer
taxable income at the time it distributes its assets to its shareholders,
equal to the difference between its adjusted basis in the assets and their
fair market value. Target Corp. will also have to incur depreciation
recapture income upon the transfer to shareholders of any depreciable assets
that have fair market values in excess of their book value. Fair market
values can either be established by appraisal (the most prudent means if a
liquidation is pursued), and/or by the agreement entered into with the purchaser.
However, these two methods may conflict with each other, thereby adding
greater confusion when pursuing this alternative.
This structure may also create a logistical
problem as to when and how the extraordinary benefits payable to certain of
the shareholder employees are to be handled, whether prior to the liquidation
(when there are no cash assets to distribute), or after the liquidation (when
each shareholder is technically entitled to a pro rata share of the
proceeds). These logistical issues can be overcome through the use of
appropriate documentation. However, unless an apparent benefit can be
identified to pursue this alternative, in most typical forms of transactions
it does not appear to be worth pursuing.
III. Mergers: Taxable and Tax Free
A merger is a transaction that generally combines
two companies into one. The surviving entity can be a new company, or either
of the companies that are parties to the merger. Shareholders of the merged
companies can either become shareholders of the survivor company, or
depending upon the form of merger, can be cashed out.
A tax free merger generally involves an exchange
of shares, which is essential to make either the entire transaction or a
portion of it tax free. A taxable merger will generally involve the payment
of cash or other consideration to the shareholders of one of the merged
companies, which would be the case in a taxable merger involving Target
Corp.. The following discussion briefly analyzes the taxable and tax free
forms of merger.
A. A Taxable Reverse Triangular Merger: This
would be a transaction where the purchaser forms subsidiary to be merged into
Target Corp. and the shareholders of Target Corp. are "cashed
out".
As a taxable transaction, this form of merger
achieves the same purposes and generally the same results as a stock sale.
This form of transaction would be used to simplify the form of the
transaction because this form eliminates the need to purchase directly from
each shareholder their shares in Target Corp. Instead, this form of merger
will rely upon the majority shareholder approval at a duly called shareholder
meeting.
The first and most important question to be asked
if pursuing this form of structure is whether or not the purchaser is even
interested in a stock purchase. These considerations are more fully discussed
above under, Alternative I. "Cash
Sale of Assets; Asset Sale vs. Stock Sale."
This alternative creates a logistical problem for
the shareholders of Target Corp. that must be overcome with analysis and
proper documentation, concerning if there is to be a disproportionate sharing
of proceeds from sale among the shareholder employees in the form of past due
compensation, and when and how any form of additional compensation benefits
are to be made payable to certain of the shareholder employees. Some of these
issues may require that these matters be addressed prior to merger (so that
they remain liabilities of the newly formed entity and payable by the
purchaser controlled entity). Other allocation issues can be handled by the
use of covenants not to compete and consulting agreements, that have to be
executed concurrent with the merger.
Other issues presented when considering this
alternative include the benefits that it will have to the purchaser and
whether or not the purchaser wants to acquire the shares of Target Corp. As
mentioned above, in order to obtain deductions and depreciation of Target
Corp.'s assets, the purchaser will have to undertake the costs of liquidating
Target Corp. and presumably pay the taxes and deal with the depreciation
recapture, discussed under Alternative
II, above. The purchaser may therefore want to discount the purchaser
price to take into account these additional expenses and taxes.
B. A Tax Free Stock for Stock Merger:
This form of transaction would tender to each shareholder of Target Corp.
shares of the purchaser, in a tax free transaction. Target Corp.'s
shareholders will then pay taxes upon their sale of the purchaser's stock, if
able to be sold.
However, this form of transaction will also have
to address the logistical problem if there is to be a disproportionate
sharing of proceeds from sale among the shareholder employees in the form of
past due compensation. Here again, as with the taxable merger, some of these
issues may require that these matters be addressed prior to merger (so that
they remain liabilities of the purchaser or its wholly owned subsidiary
payable either by the purchaser or its subsidiary). Other allocation issues
can be handled by the use of covenants not to compete and consulting
agreements, that can be executed concurrent with the merger. Any
consideration other than stock is considered "boot" and taxable to
the recipient, regardless of the tax free status of the underlying
transaction.
IV. Deferred Gain: Installment Sales Method; Use of
Beneficial Interest in a Trust as Security
The traditional deferral method for the sale of a
business is the installment sale method. This method will generally defer the
payment (and taxes attributable thereto) of the proceeds from sale, whether
they are identified and allocable to a covenant not to compete, the sale of
assets or the sale of stock.
The traditional deferral method for the payment
of compensation, whether previously accrued or "sign-up" bonus
compensation, is through the use of a non-qualified deferred compensation
plan.
While the deferred obligations of the purchaser
can be fully secured under any form of the installment sale, any proceeds
allocated to a non-qualified deferred compensation arrangement, may pose some
risk to the ultimate recipient that his or her payment will be tendered on
the date or dates provided under their agreement, if the obligor, in this
case the purchaser becomes insolvent and unable to pay its debts. This is
because under the Internal Revenue Code, in order to obtain a deferral of
"compensation", the obligation of the purchaser to pay the deferred
compensation must constitute a general and unsecured debt of the purchaser.
Any assets, even if set aside in a trust, must be characterized as general
assets of the purchaser and therefore, subject to claims of all of the
purchaser's creditors.
However, these concerns can be easily overcome by
allocating to the deferral mechanism those proceeds that are derived from the
covenant not to compete, which can constitute the major consideration payable
by the able by the purchaser. As long as the covenant not to compete comports
with normal business practice and common sense, the courts have approved
allocations constituting up to 96% of the total contract consideration. See Molasky
v. Comr., 897 F.2d 334 (8th Cir. 1990).
Therefore, if a deferral is sought, our initial
recommendation would be to maximize the value of the covenant not to compete
proceeds. As to any shareholders who are interested in a cash payment, they
would then be can be allocated that part of the purchase price that is paid
directly to the Target Corp. as some form of tax deductible compensation, so
that Target Corp. can receive a current tax deduction upon distribution of those
sums (payable to these employees, as accrued bonus compensation or some form
of tax deductible severance or bonus).
Alternatively, those shareholders who will
continue to work for the purchaser, but are interested in cash only could
also receive the larger "sign-up" bonus. The covenant not to
compete for these shareholders could then be reduced to reflect their
ultimate distributable percentage of the sale proceeds.
Most traditional deferral techniques, including
those that are fully secured, generally utilize a note that bears a fixed or
variable interest rate. The interest rate itself limits the investment or
opportunity value of the sums that remain due and payable under the note. In
many cases the purchaser will not want to bind itself to a note with a high
rate of interest, but would prefer to pay cash if the interest rate is too
great. However a capped interest rate, clearly limits the growth potential
and investment opportunities of the beneficiary of the note.
The clear benefit of the installment form is that
the interest rate, although limited, is based upon the entire note
obligation, pre-tax. The beneficiary of the note is able to receive interest
on that portion of the principal that would otherwise be payable to the
Internal Revenue Service, if an all cash transaction were closed.
In order to maximize the tax benefits of the
installment form, in an effort to take advantage of investment opportunities
and the ability to benefit from the tax deferred portion of the installment
obligation, we have designed a hybrid form of the installment deferral method
that allows the note to bear a rate of interest commensurate with underlying
investments managed by one or more major investment bankers and thereby allow
the note to participate in value with those underlying investments under
management by the brokerage facility. Since managed portfolios can go up and
down, it is possible that the note could bear "negative" interest
as well as significant "positive" interest.
The installment note attributable to the deferred
purchase price could be fully secured by a fully funded investment or
portfolio of investments, selected by Target Corp. and the shareholders
participating in the deferral; provided that the investment fund is not
considered a cash or monetary equivalent. As the investment portfolio
increases in value, distributions from the investments, after expenses to
administer the same, are taxable to the note holder, as interest
payments.
In this way, the beneficiary of the note can have
both the benefits of using the tax deferred share of the proceeds from sale
and the benefits of an interest rate that participates as if it were an
investment portfolio.
There may be some logistical issues to overcome
if the transaction is pursued as an "asset sale" and the deferred
payment is for anything other than the covenant not to compete. Given the
latitude in structuring the transaction as mostly a covenant not to compete,
this concern may be unlikely in any event. However if for any reason deferred
sums must be made payable to the corporation under the final transaction
approved by your purchaser, the issue can be resolved by the use of either
two or more notes, one for each purchaser's non-corporate covenant not to
compete and the other for the purchasers obligation to Target Corp., or a
single note in joint name.
A second logistical issue to overcome in the case
of an asset sale when the Target Corp. is the recipient of any portion of a
deferral or installment note, is that Target Corp., as a C corporation, will
have to establish a means to eliminate any of its taxable income, including
interest, that it receives as the note holder. In this case, any monies
payable to the shareholder employees as a result of the accrued bonus
compensation would have to be timed so that they are to be paid at the time
that principal is paid under the terms of the note. In addition, as a C
corporation, Target Corp. can only deduct from its taxable income legitimate
expenses, such the timed payment of the deferred bonus compensation, and
directors' fees or compensation. Therefore, any form of deferred compensation
arrangements would also have to bear interest equal to the note interest.
Annual director's fees could exhaust any remaining interest income. Each of
these logistical issues if they are found to even exist, can be solved with
appropriate documentation, however, one cannot deny that it would be much
simpler if Target Corp. is not a note holder at all.
A "stock sale" would not pose these
problems. This is because, any monies paid under a stock sale, or a covenant
not to compete that is part of a stock sale (or an asset sale) is payable to
each shareholder.
Assuming that this the status of Target Corp. is
handled appropriately, the note secured by the portfolio should perform for
the benefit of the note holders (presumably the shareholders holding
covenants not to compete), in such a way that the ultimate note holders do
not lose out on missed investment opportunities as a result of the
deferral.
This type of deferral enables the note holders to
defer the taxes which may amount to 40% to 50% of the purchase price. This
could be equivalent to an interest free loan to the note holders from the
government, because the note holders have the ability to generate income on
the entire sum, only remitting taxes attributable to the income or gain from
the original proceeds, when principal payments are actually paid. Principal
payments can be deferred for 5, 10, 15 years and possibly longer. They can be
made payable at such a time that when the note holder may be in a lower tax
bracket, or can offset his or her income against legitimate business
deductions.
There are certain expenses associated with this
form of deferral and are recommended to be incurred. They can include the
cost of life insurance on the note beneficiary (that will be used to cover
the income taxes payable in the event of death) and trustees fees to
administer the assets held in trust, in addition to brokerage charges in
connection with the investment portfolio. As noted above, increases in the
value of the portfolio are distributable annually as interest payments and
taxable at that time.
The deferral mechanism also requires the
cooperation of the purchaser, as they in essence create the trust to hold the
sale proceeds, which are fully secured in favor of the Target Corp.
shareholders. In essence the monies in the trust account remain the property
of the purchaser, but are titled in the name of an independent trustee of an
irrevocable trust. The use of this mechanism also requires that the purchaser
retain some interest in the monies held in the trust. This is in order to
achieve a legitimate business purpose for the purchaser in compliance with
the Internal Revenue Code. However, these interests of the purchaser can be
handled in a manner that eliminates any one party from having an unexpected
advantage over the other, that was not contemplated at the inception of the
contract.
In summary, this deferral mechanism employs the
traditional installment sale device, but eliminates a rate of interest in
favor of investment performance of a portfolio, which is a result that was
not contemplated under the rules applicable to installment sales. The
installment sale rules attempt to limit use of the deferral device when the
seller has various elements of "constructive receipt" and
"control" over the ability to get paid from the note. As a result,
this mechanism was developed to avoid these elements of "constructive
receipt" and "control".
The mechanism is a relatively novel structure and
although it may be difficult for the IRS to challenge if properly structured
and documented, the form of its implementation and the adherence to formality
that prevents "constructive receipt" is important to avoid a
violation of the tax laws. For this reason, it should not be pursued by
counsel not skilled in the unique and peculiar aspects of the Internal
Revenue Code, Trusts, Mergers and Acquisitions and Secured Instruments.
Depending upon the size of the transaction and its timing, a seller may want
to consider obtaining a private letter ruling from the Internal Revenue
Service.
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© Copyright 1996-2002 Stephens & Kray
AssetLaw is a proprietary mark of Stephens &
Kray
Changes last made on: February 20, 2002
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