Make your company more attractive to buyers with a tax election

Sellers of middle-market companies are increasingly engaging advisers to perform sell-side due diligence before they go to the market. Part of the due diligence process involves evaluating tax structuring opportunities, including tax elections that deliver a step up in the basis of the assets for the buyer.

“Sophisticated buyers have understood this for a long time. Now, sellers are starting to appreciate a buyer’s desire for this, so they want to get out in front of it,” says Dave Godenswager, senior manager, Transaction Advisory Services at BDO USA, LLP.

Smart Business spoke with Godenswager about how deal structure impacts a company’s tax expectations during a sale.

What do you mean by tax elections that step up tax basis?

There are two ways to buy a business. A stock acquisition — easier to document from a legal standpoint and an advantage for certain customer contracts — is where a new owner purchases the stock or units of the business. In an asset acquisition, the assets of the business are sold to the buyer while the selling entity remains intact. In some cases, a stock transaction can be treated as a sale of the assets for tax purposes.

If a buyer purchases assets, or has the ability to treat the transaction as if he or she purchased assets, the buyer may be able to amortize the purchase price for up to 15 years, which in turn lowers the buyer’s future tax costs. This tax shield is compelling for private equity firms in particular because they typically want to hold a company for five to 10 years and are focused on the company’s cash position.

Buyers have historically keyed in on this, and middle-market sellers can use these techniques to make their company more attractive and marketable. They also can look at this when going to market, asking, ‘Is there a possibility we can monetize this or use it as a negotiating point?’

How does a seller know whether or not this is possible for his or her company?

Generally, as a seller, before going to market you want to consider your company’s tax profile to understand potential tax exposures and opportunities. You want to be in a position to say, ‘Yes, we’ve identified this and we’re taking certain steps.’ During due diligence, advisers can help determine if there is an opportunity to implement certain pre-closing reorganizational steps. For instance, consideration may be given to a Section 338(h)(10) or 336(e) election or perhaps an F reorganization, such that the seller is able to deliver a step up in the tax basis of the assets to the buyer.

Since many middle-market organizations are taxed as flow-through entities — S Corporations, limited liability companies or partnerships — they are uniquely positioned to deliver some of these tax benefits.

How important is this in today’s market?

It’s been a seller’s market — with few high-quality companies on the market, private equity firms are chasing the same deals. While the deal space is still hot for sellers, there is uncertainty about tax reform and what a potential border adjustment tax could mean for businesses. Understanding structuring opportunities gives the seller a better chance to get a transaction closed.

What else do sellers need to know?

Sellers want to understand and express the deal structure to the buyer before signing the letter of intent. Some structures may result in incremental taxes, and therefore sellers need to be clear with buyers that they intend to be compensated for these tax costs. Often, buyers are willing to do this because the tax benefits are compelling.

It’s also important to have an adviser who understands the structuring nuances in order to calculate an accurate gross-up payment. Historically, sophisticated buyers have had that, but sellers are realizing they need to make sure they are getting adequately compensated since incremental taxes could include recognizing ordinary income, built-in gains tax for S Corporations and certain entity-level taxes. Sellers also need to be focused on potential accounting method changes and the impact of deferred revenue as a result of the transaction.

The tax opportunities may not change the legal form of the deal, but there are certain provisions that will need to be tailored in the purchase agreement. It is a nice benefit that sellers can present to buyers to become more attractive in the market.

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