Maximizing After Tax Proceeds in Corporate Transactions ‐ Part One
M. Vance Saunders, CPA, Director, Andrew A. LoPresti, CPA, Associate, Spencer P. Cavalier, CFA, ASA, Managing Director & Principal and Thomas E. Kelso, Managing Director & Principal, Head of Downstream Energy & Retail Group
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Introduction
While much attention is paid to the purchase price at which a business is bought and sold, the goal of any seller is to maximize the after tax proceeds it gets to keep. In this issue of Capital Markets Perspective®, we address one of the major fundamental issues in determining after tax proceeds: the seller’s corporate structure. In addition to a competitive sale process, the structure of a purchase agreement and early tax planning can each have a multimillion dollar impact on the net proceeds a seller can derive from a transaction. In fact, as reflected in the examples we provide herein, the difference in tax obligations for C corporation shareholders could be substantially higher than the tax obligations for S corporation stockholders for the exact same transaction with all other factors remaining constant.
Our focus in this article is primarily on a few key issues concerning tax planning in the context of a seller’s corporate structure, as well as how the structure of the transaction can have a material impact on a seller’s income tax liability. Specifically, we will examine how tax liabilities can differ between corporations that are structured as a C corporation or S corporation when executing either an asset or stock sale. In a subsequent issue of Capital Markets Perspective®, we will address how the structure of a purchase agreement and the allocation of the purchase price among the various asset classes can affect a seller’s total tax liability. We will look at the effects of various allocations from both a seller’s and buyer’s perspective. As with all matters relating to taxes, the information provided herein is for education and discussion purposes only. Always contact a tax professional for specific tax advice [1].
Basics of an S Corporation
Although there are many factors to consider when deciding on the form of organization of a new entity, we will focus on some of the key differences between C corporations and S corporations and highlight the material tax implications for shareholders. When deciding on how to best structure your company, it is important to understand the advantages and disadvantages of each type of corporation and the criteria for making the S corporation election. As the needs of the corporation and the shareholders change over time, the form of the organization should be evaluated periodically to ensure that the form of the corporation is aligned with the shareholders’ long term goals.
By default, an entity that files for incorporation is automatically a “C” corporation unless it makes an election under Chapter 1, Subchapter S, of the Internal Revenue Code. The “S” election provides shareholders with the same legal protections as a C corporation but the treatment of income for tax purposes is much different.
[1] The examples provided herein are for demonstration purposes only and have not been derived from confidential information about any particular Matrix client.
C corporations are taxed at the corporate level, and distributions to shareholders are then taxed at the shareholder level. In contrast, an S corporation is considered to be a pass-through entity, which is taxed once at the shareholder level and not taxed at the entity level [2]. Similar to many general partnerships and limited liability companies, all income, credits, deductions, losses and gains flow through the company to its shareholders on a pro rata basis and are taxed at their individual tax rates. Unlike a C corporation, the stock basis of a shareholder of an S corporation increases by the amount of taxable income attributable to the shareholder and decreases by the amount of distributions to the shareholder. Conversely, losses decrease the stock basis of an S corporation shareholder.
The key tax advantages of the S election include:
• The avoidance of double taxation as earnings are subject to a single level of taxation at the individual shareholder level; distributions to shareholders are not considered taxable events, unlike dividends from a C corporation
• Losses from the corporation can be used to offset other sources of taxable income for shareholders who materially participate in the company
• Gains on the sale of corporate assets (in excess of depreciation taken) are taxed at individual capital gains rates rather than ordinary income rates
• Shareholders can elect to use the cash method of accounting
The conversion from a C corporation to an S corporation does not trigger a taxable event and is simple to execute as long as the entity meets the following requirements:
• Must be a domestic company
• Can have a maximum of 100 shareholders
• Shareholders must be natural persons (exceptions for certain charitable organizations, estates, and trusts)
• Can only have one class of stock that gives all shareholders identical rights to distribution and liquidation proceeds; however, differences in voting rights between shareholders are allowed
• Non-resident aliens may not be shareholders
The current tax rate for the highest corporate income tax bracket is 35% versus the maximum individual income tax rate of 39.6%. For a corporation that is reinvesting all of its earnings into growing the business, the C corporation structure may offer some tax savings due to the lower corporate tax rates. The issue of double taxation only arises when you are actually distributing funds out of the company. Additionally, certain fringe benefit plans are fully deductible for C corporations and only partially deductible for S corporation shareholders, and C corporations are subject to reduced capital gains taxes on the sale of qualified small business stock, as defined in Sec. 1202 of the IRS Code. The C corporation structure may also be more appropriate for a company that needs to raise capital due to the restrictions placed on S corporation equity holders. Despite the advantages that C corporations offer in some situations, it is our experience that the S election (or other pass through entities like a limited liability company) provides a better structure for most closely held petroleum marketing companies due to tax advantages and the simple nature of a closely held company’s capital structure.
[2] S corporations are not taxed at the entity level for Federal income taxes; however, certain states impose taxes at the entity level for S corporations. Consult your tax advisor for the rules in each state where you are required to file. Other corporate structures that also provide the pass through benefits of an S corporation include limited liability companies, limited liability partnerships and general partnerships.
Context of a Sale Process
Sales of companies structured as asset deals are more prevalent than sales structured as purchases of equity in the downstream energy industry primarily because acquirers prefer to obtain assets at a stepped-up tax basis and to carve out unwanted or unknown legacy liabilities. In an asset deal the buyer’s basis in the assets is the fair market value, which is typically higher than the depreciated tax value of the assets carried by the seller. This difference in tax basis is considered a “step-up” that provides the buyer a greater future tax shield over the depreciable life of the assets than would remain if the buyer assumed the seller’s basis in the assets. Conversely, in a stock deal, assets are transferred at the depreciated tax basis of the seller, so the buyer receives no step-up in basis and inherits only the seller’s remaining tax shield on the depreciated assets, thus lowering future after tax cash flows to the buyer. Stock deals also require a significant amount of additional in-depth due diligence to ensure that the buyer is comfortable it is not assuming unwanted or unknown liabilities. Additional due diligence can be expensive and prolong the time that the selling company is exposed to the market, both of which are not preferable for the seller. Further, stock sales require much more expansive contractual representations, warranties and indemnities from the seller to protect the buyer from unwanted or unknown liabilities.
Asset Sale
At the time of an asset sale, the difference of being structured as a C corporation or S corporation could result in a significant difference in after tax proceeds to a seller due to the double taxation for C corporation shareholders and the higher tax rates applied to gains on the sale of C corporation assets. A C corporation is taxed on the difference between the selling price of the assets and the company’s tax basis of the assets at ordinary corporate income tax rates. Shareholders are then responsible for taxes on dividends at the time of liquidation or distribution of proceeds from the C corporation. In effect, sale proceeds are taxed twice; once at the corporate level and once at the shareholder level. In addition to this double taxation, a C corporation is disadvantaged by having its full taxable gain taxed at its ordinary corporate tax rate, while an S corporation can have a portion of its gain taxed at more favorable individual capital gain tax rates and reduced rates for gains on real property. When an S corporation sells its assets, a portion of the gain will be subject to depreciation recapture up to the amount of depreciation previously taken on the assets, and the remaining gain in excess of the original cost of the assets will be a capital gain. Depreciation recapture on equipment is taxed at ordinary income tax rates as is depreciation recapture on real property, which is comprised of the excess of accelerated depreciation over straight line. Any remaining gain on real property up to the amount of depreciation previously taken (un-recaptured Section 1250 gain) is taxed at a maximum rate of 25%, and any gain in excess of original cost is taxed at individual capital gains rates. Similarly, any gain on non-depreciable assets is treated as a capital gain and receives favorable tax treatment.
The following example in Exhibit 1 illustrates the resulting difference in tax liability between a C and S corporation resulting from an asset sale, with all other assumptions constant. For the purpose of this example, we conservatively selected the highest tax rates applicable under current federal statues, although lower federal income tax rates and lower tax rates on Section 1250 Assets could apply. Please note that if the S corporation shareholder did not materially participate in the operations of the S corporation, he could possibly be subject to an additional 3.8% Medicare tax as mandated by the Affordable Healthcare Act. C corporation dividends are subject to the additional 3.8% Medicare tax regardless of a shareholder’s participation. Further, state level tax considerations can vary significantly between states and therefore are not addressed in the example shown in Exhibit 1. The example also assumes a working capital ratio of 1.0 (current assets are equal to current liabilities), there is no long term debt that would need to be paid off from the sale proceeds, and that the shareholder’s tax basis in its stock is $0.
Exhibit 1 above clearly illustrates the benefit of the S corporation status at the time of a sale as the owner of the S corporation would have walked away with more than $5.4 million of additional after tax proceeds than if the entity had been structured as a C corporation. Although the S corporation has a $400,000 greater initial tax liability, its shareholders are not further subjected to $5,831,000 of taxes on liquidating dividends.
Both the buyer and seller must submit a Form 8594 to allocate the entire purchase price of the business into the various classes of assets (including depreciable and non-depreciable assets) on their tax return that covers the period an asset sale was completed. Although both parties can agree to determine separate allocations, each party must be able to defend its allocation in the event of an IRS audit. This prevents a seller from shifting too much value to non-depreciable assets to take advantage of favorable capital gain tax rates, while at the same time inhibits a buyer from over allocating value to depreciable assets in order to increase the amount of its future depreciation tax shield.
As mentioned previously, the gain on non-depreciable assets is taxed at favorable capital gain tax rates so the composition of a company’s balance sheet could have a significant impact on its tax liability. This is most evident in our industry when comparing a retail convenience store company with a motor fuels distributor. A retail convenience store company is much more likely to have a larger allocation of depreciable assets while the majority of a distributorship’s value could be associated with intangible assets / goodwill (supply contracts). For this reason and all else being equal, the S election would have a more significant impact on distributors as more value would be taxed at favorable capital gain tax rates although retailers also benefit significantly from proceeds allocated to goodwill.
Stock Sale
Selling a corporation’s stock is most often viewed as a more difficult transaction than an asset sale from both a buyer’s and seller’s perspective primarily related to legacy liability issues and the loss of future tax shield, which affects the gross purchase price paid by the buyer. To reflect the loss of future tax shield, buyers will most often offer reduced prices for the equity of a company than the price that would be paid for the assets of the same company. In a stock sale the seller is responsible for the full tax liability of the transaction, all of the assets and liabilities of the selling company are conveyed at the seller’s tax basis and the buyer does not receive any “step-up” for future depreciation savings. Actively participating shareholders can receive slightly more favorable tax treatment under the S election, but C corporation dividends are subject to a 3.8% Medicare surtax regardless of their participation status.
The following example in Exhibit 2 shows that all else being constant, the shareholders of an S corporation will generally exit with more after tax proceeds in a stock sale when certain conditions are met [3]. This example assumes that the stock basis of the S corporation has been increased to account for retained earnings that were not distributed to shareholders and instead reinvested in the company. This increased stock basis results in a smaller capital gain on the stock sale [4]. This example also assumes that all shareholders are active participants in the company, which allows S corporation shareholders to avoid the 3.8% Medicare surtax. Without these two assumptions the tax liability for the C and S corporations would be the same.
[3] Please note again that we have not considered the effect of individual state level taxes. State level taxes are in addition to Federal taxes and decrease the amount of sale proceeds retained by sellers. Also, the purchase price in this example has been reduced by 20%, as compared with the purchase price of an asset sale, to adjust for the inherent discount that purchasers typically require to forfeit a stepped-up tax shield and to assume the risk of unknown liabilities.
[4] Please note that the shareholders of the S corporation have already paid taxes on profits retained by the company.
Other Considerations
338(h)10 Election
Both C and S corporations can also choose to make a 338(h)10 Election at the time of a sale to allow the transaction to be treated as a stock sale for legal purposes and as an asset sale for tax purposes. If this election is made, the acquirer is able to step up the basis in the acquired assets and the seller bears the full tax cost of treating the transaction as an asset sale for tax purposes. The Section 338(h)10 election only makes sense if the benefit to the buyer (the present value of the increased depreciation and amortization write-offs) is greater than the seller’s increased tax liability from an asset sale. If this benefit exists, the buyer will typically agree to cover the costs of the additional taxes for the seller, thereby creating a win-win benefit for both parties. However, the calculation of the benefit of the tax shield to a buyer is directly related to the buyer’s expected holding period for the acquired assets. An expected holding period is typically shorter for private equity buyers, who may have a fund mandate to exit an investment before the tax-shield is fully utilized, than it is for strategic buyers with a longer term investment strategy. In Exhibit 3 below, you can see how the holding period affects the buyer’s benefit with all other factors being constant. With a hypothetical additional tax liability from a 338(h)10 election of $5,000,000, in this example, a buyer would have to hold the acquisition approximately 12 years before the value of the stepped-up tax-shield would outweigh the resulting additional tax liability to the seller. It should also be noted that the transaction will otherwise be treated as a stock sale which raises the issues of undesirable and legacy liabilities discussed above.
Built-In Gains
Section 1374 of the IRS Code prohibits a recently converted S corporation from avoiding double taxation on the sale of assets during the 10 year period following its S election. During this window any assets sold that were part of the company prior to the S election generate built-in gains that are taxed at the corporate level. The amount of the built-in gain is determined by the difference between the tax basis and fair market value of the company’s assets at the time of the S conversion and is taxed at corporate tax rates. The total gains realized on the sale of assets, reduced by the amount of built-in gains taxes, are then subject to taxation at the shareholder level. However, for each year between 2011 – 2014, Congress has passed temporary legislation (under various names) that reduced the 10 year waiting period to 5 years for sales of assets that occurred in each of these tax years. As of this writing, Congress has not extended the 5 year waiting period beyond 2014, and as a result, the 10 year window is in effect for tax year 2015 and future tax years. In 2014 Congress did not pass enabling legislation until December to retroactively extend the 5 year recognition period for 2014, so clear guidance on built-in gains for 2015 may not be provided until the end of this year. Since the calculation of built-in gains is based on the fair market value at the time of conversion, it is highly recommended to have a business valuation done at the time of the conversion to document the fair market values.
Concluding Thoughts
Early planning with your tax advisor is key for a future exit process that maximizes after tax proceeds. Unfortunately, many companies never think to reexamine their corporate structure after incorporation. As companies mature, shareholder needs evolve and tax rules change. Also, tax rates for ordinary income and capital gains change periodically and can affect the decisions shareholders may desire to make. It is important to periodically revisit whether you are currently operating under an optimal corporate structure, especially if you are planning for a major transaction in the foreseeable future. From our experience, we strongly suggest that calculating anticipated after tax proceeds should also involve your investment banker, particularly on possible transaction structures and purchase price allocation.
Disclaimer
The contents of this publication are presented for informational purposes only. While Matrix Capital Markets Group, Inc. and Matrix Private Equities, Inc. (“Matrix”) believe the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non-infringement. Matrix assumes no responsibility for errors or omissions in this publication or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.
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