Purchase Price versus Proceeds: The Importance of Tax Structuring in M&A Transactions

By: William J. O’Flaherty, Managing Director & Matt C. Oldhouser, CPA, Vice President
Broad Sector Advisory Investment Banking Group

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Over the past decade, as buyers have added immense sophistication and resources for direct outreach to acquisition targets, an increasing number of our dialogues with prospective clients have their origins in what we refer to as a “direct approach.” While the type of buyer can vary, typically a direct approach occurs when a strategic buyer[1] (or, more likely, a strategic buyer backed by a financial sponsor) approaches a business (oftentimes, one that is family or entrepreneur-owned) to entice them to sell their business. The goal of the buyer is to acquire the business at a discount compared to what could be achieved in a full marketing process, by promising a number of things that could be valuable to the seller– such as a highly confidential and straightforward sale process.

For the sellers, beyond the perceived benefits of a quieter and quicker sale process (although we’d argue these discussions often take much longer for a variety of reasons), they sometimes are able to achieve a valuation that meets their objectives, without having to pay an advisor to manage the transaction. In their minds, they just saved themselves a tangible cost (a meaningful fee to an advisor) while embracing the risk that they may have missed out on an even higher valuation yielded from a structured process seeking full market discovery[2].

Perhaps stating the obvious, the economics of a transaction are far more nuanced than a headline number. Putting the legal protections associated with the sale aside (which effectively secure the proceeds and are of exceptionally high importance), there are a number of economic factors related to a transaction that can potentially create “surprises” for a seller after the dust settles. Among the handful of highly-negotiated, proceeds-impacting items that are typically foreign to sellers are: (i) definition of working capital and its target; (ii) definition of indebtedness; (iii) form of consideration; and (iv) transaction structure, among many others. In this issue of Capital Markets Perspective, we will focus on how transaction structuring can positively or negatively impact proceeds to a seller based on how the sale is interpreted for tax purposes.

As an institution, we understand that certain sellers want a quiet, direct process, but it is puzzling when the combination of a skilled M&A banker and lawyer are not used even in those limited processes. Unfortunately, many times we see instances where a seller thought they were signing up for one transaction, and after the deal closes, are presented a reality in which the proceeds are negatively impacted due to a lack of professional oversight and counsel. Pre-transaction planning and positioning during the sale process is imperative to achieving the highest potential after-tax proceeds and limiting post-closing claim risk.

Differences in Proceeds – Stock[3] Sale versus Asset Sale
There really isn’t a one-size-fits-all formula for transaction structures in M&A. Typically, though, transactions tend to either be structured as a sale of assets or a sale of stock[4]. The primary difference lies in what is being acquired by the buyer and the legal and tax implications for both the buyer and the seller.

We have left many of the legal nuances aside for this document, but, needless to say, there are a number of important non-proceeds impacting distinctions that are worth carefully assessing when considering the differences in structure.

In both stock and asset deals, sellers realize proceeds from the sale of their business interests. However, the tax treatment of these proceeds differs significantly between the two types of transactions, impacting the seller’s ultimate tax liability, and therefore, their proceeds. Let’s explore how seller proceeds change between a stock and asset deal for tax purposes.

In a stock deal, the buyer purchases the seller’s ownership interest in the target company directly from the seller and assumes the seller’s tax basis in the company’s assets[5]. For tax purposes, the entire gain or loss from the sale is typically treated as a capital gain or loss to the seller as long as the seller owned the equity securities for more than one year. The tax consequences of a stock sale are often more favorable to sellers compared to asset sales, primarily due to: (i) capital gains tax rates being lower than ordinary income tax rates that are applied to a portion of the gains in an asset sale; and (ii) a single layer of taxation at the shareholder level.

Conversely, in an asset deal, the buyer acquires specific assets and liabilities of the target company, rather than purchasing the company’s legal entity. As a result, the seller typically sells individual assets comprising the business, such as real property, tangible personal property, intellectual property, and other intangible assets (e.g. goodwill), along with assuming certain liabilities. The proceeds from the sale of these assets are allocated among the various assets and are subject to different tax treatments depending on their character.

For instance, gains attributable to tangible personal property assets such as equipment may be treated as ordinary income or capital gains, depending on factors such as depreciation recapture and holding period. Proceeds related to intangible assets, such as goodwill and intellectual property, originated at closing are generally treated as capital gains. However, a portion of the proceeds allocated to goodwill may be subject to ordinary income tax rates under certain circumstances (such as when goodwill or intangible assets were on the sellers’ balance sheet before the transaction and would therefore create a recapturing event up to the original cost value).

It’s important to note that in asset sales, the seller may also incur tax liabilities associated with the disposition of certain assets, such as recapture of depreciation or recognition of built-in gains[6]. Obviously, these tax implications should be carefully considered when structuring the transaction.

Illustration of Structuring Difference – Stock vs. Asset 
To better articulate the impacts to proceeds, we have outlined a handful of scenarios that compare and contrast asset and stock transactions. We have used two distinct business structures / legal entity types: S-Corporations[7] and C-Corporations. There are a number of differences between S-Corps and C-Corps that aren’t particularly relevant for the focus of this document, but one area of distinction that is of importance is how they are taxed.

Again, without getting too far into the weeds, C-Corporations are separate taxable entities, file a corporate tax return (Form 1120) and pay taxes at the corporate level. In addition to corporate taxes, when distributions are paid to owners, those are taxed as personal income for the individual, although this treatment depends on specific circumstances. This is commonly referred to as “double taxation”.

S-Corporations are pass-through entities. They file an informational federal return (Form 1120S); however, no federal income tax is paid at the corporate level[8]. The profits (or losses) are passed-through and reported on the owners’ personal tax returns and are due at the individual level.

As you might suspect, these differences in how C-Corporations and S-Corporations are taxed can further distinguish the attractiveness of an enterprise value when accounting for what proceeds will be delivered to a seller.

C-Corporation Scenarios
Tax considerations are typically the main economic reason that C-corporation sellers tend to prefer to sell their stock. With an asset sale, the C-Corporation seller will be taxed twice: once to pay tax at the entity level on any gains realized when the assets are sold, and then the shareholder(s) will pay capital gains tax when the corporation is liquidated[9]. In contrast, if the owner(s) sell the stock, they will simply pay capital gains tax on the profit from the sale, generally at the long-term capital gains rate.

Below are two scenarios of a sale with identical purchase prices. The first is a sale of the assets of a C-Corporation and the second illustrating the same business being sold under a stock sale.

As illustrated in the tables above, the transaction structure created an additional tax burden to the seller of $11.2 million when contemplating an asset deal. The primary cause of this difference is the double-taxation associated with asset sales of C-Corporations. In other words, choosing an asset deal over a stock deal would yield a seller 76.7% of the proceeds than otherwise would’ve been available from a transaction[10].

S-Corporation Scenarios
We’ve taken a similar approach in our next analysis; however, this time utilizing a separate business entity structure: an S-Corporation. In particular, we have added some further detail regarding asset purchase price allocation and its implications for taxation. Beginning with cash[11], the assets of the business that are conveyed in the transaction are allocated a portion of the purchase price based on the agreed upon fair market value, with the remaining amount of the purchase price (if any) assigned to goodwill. This allocation can have substantial consequences on the taxes paid by the seller, as different asset classes will be taxed as either capital gains, ordinary income, or a combination of both. We’ve illustrated this in the table on the next page.

The difference in the proceeds in these scenarios is far less severe than our prior illustration. In general, the differences between selling assets and stock of an S-Corporation tend to be less material than the variances when selling a C-Corporation. The biggest determinants of variance would be differences in the basis of the stock and assets, how purchase price allocation may be attributed to classes of assets, and as outlined earlier, the lack of double-taxation in S-Corporations[12].

Hopefully it’s clear at this point that the lure of the headline number requires layers of additional diligence to ensure a seller is achieving the objectives they initially set out for.  A skilled banker will work with Seller’s legal counsel and accountant to negotiate the most favorable tax allocation[13].

Creating Additional Proceeds Value through Preparation, Research, and Structuring
Differentiating between asset and stock transactions and their impact on proceeds is really just the tip of the iceberg in terms of how economics can be impacted by deal structuring considerations. One such consideration is related to Section 1202 of the Internal Revenue Code, which outlines the qualifications for a Qualified Small Business Stock (“QSBS”) exclusion.

Brought back to the forefront of thought with the Tax Cuts and Jobs Act incentives for C-Corporation ownership, the exclusion is aimed at incentivizing investment in small businesses that meet certain criteria. Assuming these criteria are met (a summarized version of these are listed in the following table), in certain situations the exclusion on gains can be up to 100% of $10 million or ten times the taxpayer’s stock basis in the QSBS.

Knowledge of taxation nuances like Section 1202 can yield benefits for clients well beyond the obvious. Below we’ve outlined various scenarios where an advisor could leverage the knowledge of this exclusion to create value for a seller: both through straightforward and more creative positioning.

Scenario 1: Applying Section 1202 in a Sale Process – Reducing Seller’s Taxable Burden
The most straightforward way to achieve value with QSBS is simply to take advantage of it if you’re a seller and your business fits the criteria. To that end, in the accompanying table, we’ve included a step-by-step summary of procedures to claim the QSBS exclusion under Section 1202.

To illustrate the benefits of the qualification and claim, we’ve outlined two identical sales of businesses, with one able to claim QSBS exclusion and one not.

As you can see, in the scenarios depicted above, in a $40.0 million transaction, a seller can achieve $7.1 million more proceeds (or 24.6%) in the circumstance where they are able to apply the QSBS exclusion. This is simply a function of awareness and documentation to yield an economic benefit that may have otherwise been overlooked.

Scenario 2: Applying Section 1202 in a Sale Process – Ensuring Buyer’s Perspective is Accounted For
Again, what was outlined above is effectively blocking and tackling. It comes down to a banker (or other advisor) having sufficient knowledge to make a client aware of their eligibility and then working to ensure its properly documented. Not simple, but fairly straightforward. Where the application of this knowledge can yield incremental benefits beyond the status quo is engaging a banker who can apply structuring intelligence in negotiations to drive additional value.

Negotiating Scenario A: Preserving / Enhancing Value in Other Portions of the Transaction
Clients can capture value from applying the QSBS exclusion beyond simply reducing their tax burdens. First, imagine a scenario where an investment bank has advised a client that their S-Corporation will sell for approximately $50.0 million. The bank has also advised that buyers will likely build into their models a tax/proceeds structure that benefits from QSBS benefits upon their ultimate exit[14].

When preparing to go to market, based on the assumptions above, it is clear that the difference between a purchase price of $49.5 million and $50.5 million will have a meaningful difference in the returns of a buyer targeting QSBS benefits upon their exit. As illustrated below, the additional $1.0 million of purchase price, while beneficial to the seller, could have substantial negative consequences to the buyer, and therefore be met with disproportionate resistance.

Based on our calculations, a $1.0 million increase in purchase price that disqualifies the buyer from yielding a QSBS exemption upon their sale creates an internal rate of return (“IRR”) 4.3%[15] less and a total difference in proceeds of $23.1 million. The incentive simply isn’t there for the buyer to accelerate their purchase price past the $50.0 million ceiling.

Therefore, in a process designed to maximize value, how can a seller navigate the ceiling created here? The answer is to view other value streams in a transaction and ensure those are being maximized as well.

A quick caveat: The IRS does not appreciate value shifting in transactions to ensure qualifications for Section 1202 are met. This becomes a particularly sensitive topic at the Letter of Intent (“LOI”) stage when offers are formally documented. At that stage, it is not advisable to attempt to shift value to benefit the seller (or buyer). Like so many things in a M&A transaction, proper planning allows more flexibility (and likely value creation) as you move down the path of a process.

So, what other value streams are relevant? Simply stated, it would be anything economic that doesn’t directly involve the stock of the contemplated/targeted corporation. For example, many of our clients hold real estate in affiliate entities that are leased back to the operating business. Market value for leases, similar to businesses, can be captured at some point within a range depending on a number of variables. In the circumstance identified above, a seller could adjust lease rates to the higher end of market (and thus take a negative EBITDA[16] adjustment) to hopefully create additional value for themselves. Applying the same multiple to a reduced EBITDA gives additional room on the QSBS size threshold ceiling while also creating an enhanced, separate value stream through higher lease rates. Ideally, an investment bank continues to push enterprise value knowing that there’s now additional room for buyers to still qualify for advantageous tax treatment.

There are also a handful of other value streams where this same logic could apply. First and foremost would be executive compensation, if the seller of the business is also in an operating role. Following the same logic of the lease payments, market compensation is highly dependent on a variety of factors. Therefore setting compensation at the higher end of market can accomplish the same goals achieved in the real estate leasing scenario.

Overall, the story remains that through thoughtful preparation, a seller can extract additional value that otherwise may be much more difficult to obtain.

Negotiating Scenario B: Utilizing Tax Knowledge to Justify Higher Valuation
One of the many ways a banker creates value in a process is by illustrating to buyers opportunities that exist for them under various ownership scenarios and circumstances. Most logically, these tend to be operating-specific considerations such as growth opportunities, synergies, and the like. Still, an investment banker can drive additional interest for its client by enlightening buyers to structural considerations that could capture value for them. As you may suspect, this would include reduced taxable burdens.

Most buyers of businesses are sophisticated financial or strategic organizations with legions of well-compensated tax accountants and attorneys to consider the most advantageous ways to structure transactions. Still, it is incumbent upon a banker to identify where a buyer may (knowingly or unknowingly) capture value in order to transfer as much of that value to its client as possible.

Let’s take a scenario where the purchase price for an S-Corporation is $25.0 million. Assuming that purchase price was derived by the buyer using a 20.0% IRR, an advisor can calculate the anticipated proceeds from the buyer’s ultimate exit. In the instance where the buyer has not quantified the tax benefits from a QSBS exclusion in their model, by identifying this value creation mechanism we have given them reason to increase their purchase price. To achieve the same 20.0% IRR hurdle with the newly realized tax benefits, the buyer can pay the seller as much as $30.4 million.

We can assume that in most situations, a sophisticated purchaser has already accounted for any tax benefits in the value they’ve derived. Still, they may be trying to capture that additional return for themselves as opposed to shifting some of that value to the sellers. By laying out an analysis that acknowledges the tax benefits they will be achieving, and the implied rates of return it suggests, a banker hopefully creates the foundation of a compelling argument for the buyer to pay more. In the scenario where the tax treatment was known, you’ve simply brought to the front of the discussion what was already built in, but with a better argument for enhancing purchase price. In the scenario where the tax benefits were not clear to the buyer, you have now created tangible additional value for them and therefore meaningfully justified a purchase price increase. Either way, detailed knowledge of tax structuring and proceeds impact has had sizeable economic benefit for the client.

The analysis and explanation included here isn’t intended to intimidate or overwhelm an owner that is contemplating the sale of their business. On the contrary, many of these structuring considerations are routine for experienced deal professionals. The goal is really to shine a light on some of the many unknowns or uncertainties that may exist while negotiating a transaction without the appropriate professional support.

Many of our clients are founder or family-owned enterprises that may be bringing in outside capital for the first time. It is typically the largest wealth creation, or depending on your perspective, “diversification” event of their lives. Admittedly, depending on a seller’s objectives, maximizing proceeds may not be the number one objective. As previously discussed, in some instances, a quiet transaction that doesn’t disrupt the status-quo of the business could be preferred. It can be a logical tradeoff of priorities that we see from time to time, as long as the purchase price meets the client’s threshold. Still, it is remarkable how the lure of a headline number can sometimes blind an otherwise competent seller to the other factors influencing a seemingly attractive transaction. As with most things that appear too good to be true, there often is more than meets the eye in a transaction – and is therefore a situation that could benefit from the analysis of an experienced deal professional.

Lastly, we would be remiss if we didn’t acknowledge that the tax code and legal structuring in a transaction can be extremely complex and the analysis/summaries provided in this document make a number of simplifying assumptions for the purposes of more clearly articulating several nuances. This document does not constitute any recommendations or advice regarding any of the topics covered within. As the entire premise of this document suggests, engaging an experienced transaction professional for more detailed and situation-specific counsel is always advised.

About Matrix Capital Markets Group, Inc.
Founded in 1988, Matrix Capital Markets Group, Inc. is an independent, advisory focused, privately-held investment bank headquartered in Richmond, VA, with additional offices in Baltimore, MD and New York, NY. Matrix provides merger & acquisition and financial advisory services for privately-held, private-equity owned, not-for-profit and publicly traded companies. Matrix’s advisory services include company sales, recapitalizations, capital raises of debt & equity, corporate carve outs, special situations, management buyouts, corporate valuations and fairness opinions.

Our industry focused, dedicated sector advisory groups serve clients in the automotive aftermarket, downstream energy & convenience retail, healthcare and outdoor recreation & marine markets. Our broad sector advisory groups serve clients in a wide range of industries including business services, consumer, diversified industrials, restaurants and transportation & logistics. For additional information or to contact our team members, please visit www.matrixcmg.com.

The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. While Matrix believes 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 presentation 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.


[1] Strategic buyers are operating companies that are in/around the same business as the selling company. They can be direct competitors or entities that service the same marketplace, but do not compete with the target company.

[2] Market discovery is a term analogous to running a full sale process with the assistance of an investment bank (and other advisors). The scale and duration of the process varies meaningfully based on the goals of the client.

[3] We refer to a “stock” sale/transaction throughout this document due to that being the common terminology among deal professionals. That said, the more appropriate terminology would likely be “equity” sale/transaction given that not all entities’ ownership is held in stock.

[4] It is important to clarify that “stock” sales reference both public and private entities. Oftentimes, when individuals view the term stock, they connect it to the public markets, when in fact, it applies to private businesses as well.

[5] The scenario identified above does not contemplate a 338(h)10 election. A Section 338(h)(10) election is a tax structuring strategy that allows a buyer and seller to treat a stock purchase as an asset sale for federal income tax purposes.

[6] Built-in gains are attributable to S-Corporations that recently (within five years of a transaction) have converted from C-Corporations. In these instances, the S-Corporation’s built-in gains tax applies to appreciated assets received on the date of the S-Corporation conversion and are thereafter transferred or sold in the subsequent five-year period.

[7] We have elected to focus on S-Corporations for the basis of this analysis and have used that structure as a stand-in for all pass-through entity corporate structures. Needless to say, there are several distinctions between S-Corporations and Limited Liability Companies (LLCs); however, the structuring and tax dynamics largely mirror one another. Therefore, we’ve elected to streamline our analysis by limiting the text to just identifying S-Corporations.

[8] In many states, owners of S-Corporations elect to pay certain state and local taxes at the entity level to receive tax credits on their personal returns.

[9] Taxes will differ when proceeds are distributed out of a corporation that will continue to exist versus one that is making a liquidating distribution. In the latter scenario, the owner can deduct their basis in the stock when calculating the gain.

[10] This commentary elects not to acknowledge the buyer’s interests in the structuring dynamic. Buyers benefit from tax shields created from the step-up in the basis of assets and therefore are rarely indifferent when it comes to the economic implications of the asset-versus-stock structure. Said differently, both buyer and seller have vested economic interests in structuring dialogues.

[11] Cash generally exists on the asset allocation table; however, most business sales are structured as cash-free and debt-free transactions. An example of cash that may be applicable here could be funds left in the company for administrative/business convenience (such as cash remaining in a cash register). Typically, buyers will gross up the purchase price to compensate the sellers for these amounts.

[12] Similar to the caveat shared earlier in the document, the scenario identified above does not contemplate a 338(h)10 election.

[13] Similar to what was described above regarding the common divergence of interests of buyer and seller in deal structure, the same dynamic applies when allocating value to asset classifications in an asset transaction. There are competing interests between buyer and seller because of favorable or unfavorable tax treatments depending on various classifications. That said, these are not always zero-sum situations, and mutually beneficial allocations can be achieved, provided there is sufficient insight and advice available to all parties.

[14] The desirability of QSBS for institutional investors is predicated on a number of qualifications, including the tax status of the LPs (or equivalents) in the investor group. To the extent LPs are subject to United States taxes (e.g., high-net-worth individuals and family offices), the benefits of QSBS are enhanced, although this is not a universal truth. In general, most financial sponsors or family offices looking to benefit from QSBS exemptions acquire the assets of a company during a transaction rather than invest directly into the entity (due to the original issuance limitations). The nuances that create suitability of QSBS for sponsors are highly detailed and require case-by-case analysis.

[15] While 4.3% is the total difference in IRR, a portion of this is attributable to the change in tax benefits, while a portion is simply a function of paying slightly more cash at closing. Of the total, 3.9% of the difference in IRR is attributable solely to the change in tax treatment. The remaining difference (0.4%) results from the increased purchase price in Scenario B.

[16] EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation and Amortization. It is used by financial professionals as a proxy for cash flow of the core operations of the business, putting aside items like capitalization and non-cash items.