Whose Ox Gets Gored
A brief look at choices in the M&A process
Understand the basic motivations parties bring to the transaction.
The first step in proper deal planning and structuring is to understand the basic motivations parties bring to a particular transaction. From the sell side, the primary goal is to maximize the after tax proceeds (or as my colleague would say, “money in fist”). To meet this goal, a transaction needs to be structured so that its proceeds are subject to taxation at the lowest rate possible. On the other hand, buyers are looking for ways to maximize their return on investment. One of the easiest ways to maximize a return on investment is increasing the ability to generate tax write-offs; this is a time value of money concept. These conflicting goals engender a “who’s ox gets gored” mentality approach to deal making.
A common example of this “who’s ox gets gored” mentality occurs when a seller insists on selling stock because he or she wants to get long-term capital gain treatment (currently the long-term capital gain rate for U.S. Federal tax is 15 percent). While this transactional methodology will certainly qualify for my colleague’s “money in fist” concept (exposing the transaction proceeds to the lowest tax rate), it provides no return on investment for buyers. The purchase of stock provides no tax write off for the purchaser. It does provide a tax free return of the amount paid if the buyer eventually sells the stock. This then begs the question, “What financial neophyte would agree to conduct a transaction where there is no return on the investment instead of just a mere return of the investment?” Clearly, the failure to understand these basic concepts puts the entire process of deal planning and structuring in jeopardy.
While there are numerous traps to be avoided in the deal making process, the range of available forms (e.g., taxable sales of stock or assets and tax-free methods such as those found in §§ 368 and 355 of the Internal Revenue Code), coupled with the variety of legal, accounting and tax options can prove to supply deal makers with useful tools which allow them to appropriately respond to the complexities of deal planning and structuring. Proper use of these tools will allow for the structuring of a deal which will survive the test of time by creating value for all parties involved.
Deal planning and structuring is a process that brings together sellers, buyers and taxing autorities
Deal planning and structuring should be thought of as a process which brings the following three parties together: sellers, buyers and taxing authorities. In a typical transaction, buyers and taxing authorities prove to be the winners with sellers being the losers left holding the proverbial “bag.” Proper deal planning and structuring seeks to convert both buyers and sellers to winners. How then is proper deal planning and structuring best defined?
Appropriate deal planning and structuring will seek to provide methodologies which can be used to bridge the buyerseller valuation gap by taking into consideration the seller’s need to maximize after tax proceeds and the buyer’s need to maximize return on investment. Typically, privately held company transactions are structured as taxable transactions because of a seller’s desire to cash out, or accept only traded securities from a public company acquirer. Successful deal planning is therefore driven, at least in part, by the tax implications associated with the transaction. Obviously, Uncle Sam always wants his cut. With individual ordinary income tax rates from 10 percent to 35 percent, corporate ordinary income tax rates from 15 percent to 35 percent and alternative minimum tax rates from 26 percent to 28 percent, the solution to the quandary of proper deal planning is to understand and take advantage of the tools and techniques available in the tax code to reduce or eliminate Uncle Sam’s cut. State and local taxes should also be considered in taxable business sales.
Depreciation is commonly overlooked
One of the most commonly overlooked aspects of structuring for taxable transactions is depreciation. In general, taxpayers may deduct a reasonable allowance for the wear and tear on tangible property used in a trade or business, or if the property is held for the production of income. Depreciation is not allowed for inventories, land and property used for personal purposes. Technically, the Modified Accelerated Cost Recovery System (MACRS) is the primary method used to depreciate tangible property placed in service following 1986 (a 200 percent declining balance calculation). Why does this make a difference in deal planning and structuring? Because depreciation and depreciation recovery is the most overlooked aspect of deal planning and can cause transactions to fail. The negative tax implications are an unwelcome surprise.
A better understanding of these negative tax implications requires a quick review of the disposition of depreciable property. IRC § 1245 property is property that is or has been depreciable (or amortizable under § 197), and is essentially tangible or intangible personal property. On the other hand, § 1250 property is any real property that is or has been depreciable under § 167, but is not subject to recapture under § 1245. A gain on the sale or other disposition of § 1245 property is taxed as ordinary income to the extent of all depreciation deductions previously claimed on the property. If there is any gain remaining, and the assets have been held for more than one year, it will be taxed as capital gain. It is important to note that favorable capital gains rates are solely for individuals and do not apply to corporations. There is no recapture of depreciation as ordinary income regarding § 1250 property for acquisitions following 1986 because all residential and nonresidential real property is computed under the MACRS straight-line method. However, the straight-line depreciation taken is considered unrecaptured §1250 gain and is taxed at a 25 percent rate; the balance of the gain is taxed at a maximum 15 percent capital gains rate. Remember that these rates do not apply to C corporations. Lastly, under IRC § 453(i), when there is a recapture of depreciation as ordinary income in an installment sale, the entire amount of ordinary income recapture is taxable in the year of sale regardless of what payments are received in the first year.
The process of M&A structuring comes down to a matter of choices
Like many situations in life, the process of M&A structuring comes down to a matter of choices. “We are free up to the point of choice, then the choice controls the chooser,” said Mary Crowley, author and successful businessperson. This becomes quite evident in M&A structuring. For example, if an M&A transaction is to be structured as a taxable asset acquisition, both the buyer and seller will have certain advantages. Advantages appearing on the buyer’s side of the ledger include: choosing which assets to purchase, “step-up” in the asset’s tax basis and assets are purchased free of contingent liabilities. Advantages appearing on the seller’s side of the ledger include: the ability to maintain corporate existence, continued ownership of non transferable rights (e.g., licenses, franchises, patents, etc.) and, among others, the ability to keep the corporate name (unless sold as a part of the asset sale).
As with any business decision, there are tradeoffs or choices to be made. While a buyer does have certain advantages in a taxable asset sale, there are distinct disadvantages to the buyer in structuring an M&A transaction in a taxable asset sale manner. The disadvantages would include the inability to carryover the seller’s tax attributes (e.g., NOL and capital losses), the loss of worker’s compensation, and other preferred ratings, as well as the loss of non transferable rights. The disadvantages for the seller will be most obvious in the area of taxation. For example, if the seller is structured as a C corporation for tax purposes, the result would be that of double taxation. Under any scenario the seller will, more than likely, be subjected to taxation at higher ordinary income rates. Lastly, for both the buyer and seller, selling individual assets is more complex and often requires lender approval.
“Our lives are a sum total of the choices we have made,” said Dr. Wayne Dyer. A classic example of this can be found in stories of the Canadian Northlands. It is said that this area experiences only two seasons, winter and summer. As the backroads begin to thaw, they become muddy and vehicles traveling through the backcountry leave deep ruts. The ground freezes hard during the winter months and the highway ruts become part of the traveling challenges. For vehicles entering this undeveloped area during the winter, there is a sign that reads, “Driver, please choose carefully which rut you drive in, because you’ll be in it for the next 20 miles.” Those opting to participate in an M&A transaction should be very careful in choosing its structure because the choices made will be present for a lengthy period of time.
How then are these choices to be made? Clearly, the business owner has important needs which must be satisfied (e.g., saving taxes). A well-versed M&A intermediary will recognize strategies which will satisfy the needs of the business owner as well as find ways to implement those strategies. Choices made with the assistance of a properly trained and well-versed M&A intermediary would appear to prove to be more successful in the long run. The next quandary would be how to choose a well-versed M&A intermediary.
There are two primary organizations which offer education, experience and testing for those who desire to become well-versed M&A intermediaries. The International Business Brokers Association, commonly known as the IBBA, was founded in 1983. It is a non-profit association which operates exclusively for the benefit of those engaged in the various aspects of business brokerage. IBBA has members in all 50 states, in addition to Australia, Brazil, Canada, China, England, Greece, Hong Kong, New Zealand, South Africa, Spain and Thailand. In addition to the IBBA’s focus on general business brokerage, the M&A Source, established in 1991, addresses issues found in the world of mergers and acquisitions. For more information on these groups please visit: www.ibba.org and www.masource.org.
These organizations offer professional certifications which assist a business owner in choosing the right intermediary. Following the completion of this certification process, the IBBA awards an individual with the Certified Business Intermediary (CBI) designation. The M&A Source awards an individual with the Merger and Acquisition Master Intermediary (M&AMI) designation following the completion of this process. Therefore, it would appear that the first step for a business owner contemplating an M&A transaction would be to choose a professional with a CBI and/or M&AMI.
As noted, structuring for an M&A transaction is all about the choices made. Like being stuck in the same Canadian Northland rut “for the next 20 miles,” M&A choices have long lasting effects. “There are two primary choices in life; to accept conditions as they exist, or to accept the responsibility for changing them,” said Denis Waitley. In M&A, a business owner also has two primary choices: accept the transaction and its consequences as it exists, or accept the responsibility for changing them by associating with M&A professionals who bring value to the table and provide substantial assistance to the business owner.