Tax Considerations in M&A

Hello M and A Scientists. This podcast is sponsored by our business lines the M and A Science Academy, Firm Room and Deal Room. I often get asked how we make money. There it is. Check them out in the show notes. It's the best way you can support this podcast when you need to get your team up to speed on the latest and best M and A practices. Obviously this podcast is a great place to start, but when you need to step up your game while earning some credentials, the M and A Science Academy provides over 40 courses and a library of templates. Coming soon, we're offering Agile M and A Diligence and integration certifications. Visit mascience.comacademy to learn more. Firm Room is the world's most intuitive virtual data room that meets public company security standards at a fair price. We all know paying per page for a VDR is a scam. Firm Room has helped Companies save over $80 million in VDR fees. We actually did the math. Don't let your investment bank dupe you into paying per page for a VDR. That's just dumb. Visit firmroom.com pricing to see how much you'll save when you switch to Firm Room. And you could do a free trial right there on the spot and do a side by side comparison so you can see why it's a better product for a better price. Dealroom is a leading M and A lifecycle management platform. It manages your pipeline and combines diligence and integration into one process so that the integration is faster and easier. Even if an investment bank is driving the sale process. Dealroom helps you take over once the LOI is signed and drive better integration results. Learn more about Dealroom@dealroom.net see why the best in M and A are using Deal Room now on to our interview. I'm Kisam Patel and you're listening to M and A Science, where we talk with deal professionals and learn valuable lessons from their experience. This podcast focuses on stories, strategies and what actually happened during M and A Deals. Welcome to M and A Science where we curate knowledge from the best in M and A to continuously improve. If you're interested in keeping up with the latest from M and A Science, subscribe to our free newsletter@mascience.com Every week we share highlights from interviews, invitations to events, M and A role openings and other resources as we build the greatest community of forward thinking M and A practitioners. Again, that's mascience.com I'm your host Kisam Patel, CEO and Founder of M and A Science. Joining me today is Leslie Adamo Vice Chair, Tax Group at Lowenstein Sandler Lowenstein Sandler is a national law firm with more than 300 lawyers working from five offices across New York, Palo Alto, New Jersey, Utah and D.C. today we're going to talk about tax considerations and M and A. Before we kick things off, a quick little disclaimer that the information provided in this podcast is intended for a general audience and is not a substitute for the advice of competent counsel. This content reflects the personal views and opinions of the participants and no attorney client relationship is created by this podcast. Now that we got that out of the way, we have some big exciting news for our M and A Science community. I wanted to announce this with Leslie since your firm, Lowenstein Sandler is partnering up with us to host the first M&A Science fair.

We're excited to have everyone this will.

Be our first conference that we're hosting in New York City on October 5th. This will not be like any other M and A conference you've been to for three reasons. 1. It's by invitation only so we keep it 90% in house. Corporate M and A practitioners guaranteed high quality networking. You can request an invite on our website. 2. No boring panels. You don't learn anything meaningful from panels so instead we're using collaborative formats where the participants drive the topics. 3. The theme of this conference is what's your hypothesis? Bring your challenges problems and workshop them with your peers to bring back practical solutions you can apply to your practice. Visit our website Masscience.com to learn more. Leslie, how do you feel about hosting a conversation on tax strategies at the fair?

Absolutely. Let's do it.

If you like today's conversation, Leslie has a course on the M and A Science Academy portal that dives deeper into M and A tax. Let's kick things off with the introduction on your background.

Leslie I am a partner at Lowenstein Sandler and I work closely with clients and my corporate colleagues to understand my clients business objectives and help ensure that transactions are structured tax efficiently. So I provide counsel in a variety of transactional tax matters including M and A deals, partnership issues, individual tax issues arising at the federal, state and international levels. I also advise on joint ventures, fund formation and various tax issues specific to startup businesses and their founders. I do a lot of work with blockchain transactions, qualified opportunity funds, bankruptcy related issues and derivative transactions. And prior to joining this firm I was at another large law firm where I focused on tax planning matters for high net worth individuals, multinational corporations and investment funds.

Can you give me a sense of the Range of complexity when it comes to taxation in M and A.

Tax issues in M and A get very, very complex very quickly. Sometimes it's not so complex, sometimes it can be somewhat straightforward. That's usually not the case. The reason being is that the most tax optimized structure for the buyer is not always the best structure for the seller and vice versa. So the buyer, the seller and an M and A deal are often at odds in determining how they'd like to have the transaction structured and what would be best for each of them. Many of the complexities are informed by the different different tax structures of the buyer and sellers. Are they C, corporations, S corporations, llc, individuals? And then whether the consideration in the deal is going to be all cash, cash and equity. Is there going to be an earn out some cash or equity paid later? Is everything going to be paid up front? Also, it's not only US Federal income taxes. You also have to think about state and local taxes. And if there's any foreign jurisdictions or individuals involved, you also have to think about cross border taxes. So it can get very complex very quickly. And it's not necessarily the size of the deal that determines the complexity. My most complex deal was a $750,000 tax free reorganization. It's not size dependent, it's more dependent on these other factors.

That's interesting. I wouldn't think so. We have the structure of the entities, the structure of the terms of the deal, the type of payments, cash, equity, et cetera, and then a good old government entities and both federal, state and local level and, and probably some other little things that could come up. Let's talk about from the beginning. If we're walking through an M and A deal, how early and everybody. I know, I know your answer is going to be already, but if you give me the details of like how early should you start thinking about tax from the buy side and also from the sell side?

Yeah. So no matter what on both sides, it's best to have tax involved when you're negotiating the term sheet or the letter of intent stage. So before you're actually doing the definitive documents, you definitely want some tax input prior to the term sheet or the letter of intent getting signed. Lots of times a seller will benefit from having a tax advisor look at their structure when they're considering whether they might want to put themselves up for sale or they're considering a financing transaction so that a tax advisor can look at the structure, their short term and long term goals like growth or monetization strategies before discussions happen regarding those transactions. And because setting yourself up for success before you decide to put yourself up for sale can save you a lot of money in the sale process or financing process.

I'm going to pause on that one because on the buy side, I'm a deal happy person. Would jump on getting an LOI signed and then give you a call. But what you're referencing is bring in the tax expert before signing an loi. How often does that happen? I'm curious, because you work as external counsel, do you often see sophisticated buyers that are doing that or do you run across a lot of situations where people are, hey, here's a signed loi?

I'd say the buyer often will have the upper hand at the LOI stage, from what I see a lot in my practice, because a lot of times they're a bigger company and they already have a kind of a playbook. They know what they'd like to do, they'd like to go buy some assets usually. And they also know they'd like to have some contingent consideration and consideration that's contingent on not only revenue, but maybe also certain key employees staying on, et cetera. Right. Like a lot of times, the buyer setting of those terms that could have some negative tax consequences for the seller later on down. What I see happen more often is not so much that the buyer has an issue because of what's in the loi, but the seller does. Sellers are not often as big as the buyers that they're being sold to. And sometimes they don't have tax advisors lined up at the term sheet stage. Some of the terms in the term sheet could be really down, disadvantageous for the seller and hard to go back and renegotiate on. So at the very least, we would love to have a seller reserve for restructuring in light of taxes in the term sheet. They have no tax advisor, so they have another bite at the apple. Like something like the transaction will be structured to be tax optimal for the seller or something like that, or tax optimized. But it's best if a seller really has a tax advisor involved on the seller side.

How early is ideal for thinking through or bringing in a tax expert on the seller side?

I'd love to see it before they start negotiating a term sheet. A lot of times a seller needs to do some restructuring to get themselves into the best structure for a sale process. And it's great if you could start thinking about what needs to happen ahead of time. And it's great if a seller knows whether it's going to be best for them. To sell their assets or their stock and knows whether if they're going to sell their assets, for example, there'll be a big tax drag so they can start negotiating for a gross up on on the purchase price to compensate them for the tax drag if the buyer's going to insist on an optimal structure for the buyer. But if you don't start negotiating for something like tax gross up at the term sheet stage, it's very hard to get it in later as a seller.

Both scenarios earlier the better before loi.

Yes, definitely. Earlier is better.

You had a good point too on the buy side that a lot of times you can see companies that are pretty mature because they've done multiple acquisitions and they're got a strategy in place or a sense of direction where to go. But for that first time buyer, I think it might be a new concept because even you mentioned it. I didn't think about having somebody involved before an LOI and would even think that's a little awkward because you're so focused on getting the deal terms locked down and getting the seller to say yes, totally.

But tax is one of those areas where tax cash savings are real. When you're a buyer, you want to really think about what's my monetization strategy going to be later on and what's the best way for me to own this business. For a buyer, it's usually best if the buyer can get a basis step up in the asset that it's buying. So a basis step up can provide a tax shield for the buyer in the form of depreciation or amortization deductions. A buyer oftentimes is already thinking about that, that they'd like to get that basis step up. And so when they're doing their modeling, determining what purchase price they should offer, the buyer should be thinking about taxes. What will the tax drag be on this investment or what will the tax shield be that I can get from the basis step up? The buyer also needs to think about post acquisition structuring. If the buyers has to date only invested in flow through businesses or only bought asset, buying stock of a C corp might be not advantageous for them, right? Like they might not be able to incorporate a business that's in a C corp form well into their structure if it's all through pass throughs. Otherwise where if you have a corporate buyer, maybe buying a C Corp isn't so bad for their overall structure. There are definitely tax issues that buyers should be mindful of when structuring a transaction and thinking about the optimal Structure and tax efficiencies. I think buyers also have to be very mindful obviously of not acquiring any tax liabilities associated with the business for the period prior to their ownership of the company. So a buyer's also thinking about do I want to ask for a tax indemnity? What will that look like? Do I want to have any special covenants regarding taxes and cleanup matters? Tax diligence is really important, right? If there are major issues identified in tax diligence, sometimes the buyer is going to want a special indemnity put aside to make sure there's enough cash to cover the tax liabilities or certain remediation measures or special escrow or maybe go out and get tax insurance for certain known tax risks. There are a number of ways to deal with those issues, but that's something Bayer is always thinking about.

This is good stuff. We got structure of the deal. Want to be more asset forward and think about also the post close structure and what that's going to make an impact on the tax structure overall and then the tax liabilities which we're going to talk more about. What are other tax considerations for buyers?

Let's say they see a C corporation target that has a lot of net operating losses, they might think about how to price the use of those into the deal. Will they get the benefit of that tax asset post closing? That's something a buyer might be thinking about. Also buyer's often thinking about key employees. Is there a key employee or a seller that they want to keep on post closing? So will there either be a rollover so some equity compensation in the deal and how to provide that type of equity compensation or incentive equity in a way that's tax efficient for both the buyer and the key employee or the rollover. So seller. So those are also issues that buyers are often thinking about.

This is good. We got some pretty key areas I want to take apart the tax liability. One, we see companies buy startups pretty often and there's all this obligations you have especially as more companies are becoming distributed and now you have employees in multiple states which you register in those multiple states of which you're essentially signing up to pay stuff estate taxes. And then that's this overhead that tends to be usually either catch up game or and I don't know, maybe I'm curious where your lens is on it. But there's. I can easily see there being some inherent dues there. What do you typically see around those situations? Because that's the first thing I think of which is startups don't really take care of that stuff till they get to a certain size. So if you're a larger company buying a startup, you probably can look under the rug and identify some stuff pretty quickly right there.

Yeah. For our startup clients, so SaaS businesses or as a service business. A lot of times the big tax issue that comes up when the buyer's doing diligence on the target company is that they have not complied with all their sales tax obligations in the various states. Oftentimes buyer identifies that as a key issue and asks for some sort of escrow or purchase price deduct or remediation measures as like post closing or do voluntary disclosure in certain states or something like that. And there's negotiation around those issues. As seller, after you do your deal, especially if you're not rolling, you want to be able to walk away somewhat. You don't want to be worrying about tax liabilities trailing you forever. And so there's a lot of negotiation around what that indemnification will look like, how long it will last for, like what's the end date for the indemnification. And sometimes also there's negotiations around which states will the company go become in compliance with. Is it all 50 states that go to usually not Usually there's some identified key these states and sometimes the issue honestly is that the law is still evolving and there's not really a right answer. It's a gray area whether compliance is necessary in a state. And then the buyer and the seller are negotiating about whether there should be compliance in that state and what they will do with respect to that specific state. But we do see a lot of sales tax negotiations and compliance issues come up in M and A deals for our startup clients. State and local issues have become been more widespread in the past couple of years because of COVID and all the remote working. Remote workers also cause nexus for companies in these variety in various states. Right. So all of a sudden a company that might have had employees only in one or two states might now have employees in 25 states and have tax obligations in each of those states or tax reporting obligations. And so we're seeing issues around state, state and local compliance because of remote workers also becoming a big hot ticket item. So when we're preparing a company for sale, we're often telling the client these are going to become issues because the buyer's going to ask in diligence about your sales tax compliance and your state income tax compliance more generally because of remote workers. What have you done so far? Let's start thinking about how we're going to respond to those questions. Should we on our own right now engage a nexus study to be done so we can get in front of it? Is as buyers going to come with their accounting firm to due diligence? Should we, a seller, do our own diligence basically on ourselves to figure out where our weaknesses are?

The way you speak through it as a buyer, should I be looking at that specifically where their employee base is and then already getting a pretty early sense of the lift on the tax liability and the example of having in two states versus 25.

Yeah, buyers should definitely be doing diligence on that item. It is very commonly one of the items that buyers are doing diligence on. Not only are they looking usually at where the workers are located because remember there's going to be some post transaction integration into the buyer structure so they need to know this anyways. But oftentimes they're also looking at are the employees correctly characterized as employees versus independent contractors or vice versa. Which is another kind of related hot ticket item on diligence that often comes up is classification or misclassification, I'd say of employees.

Yep. And then in terms of the way to minimize the risk around this, either put an indemnity or hold some funds in escrows, typically the main practices.

So what you will always see in M and A deals are tax representations. Just like all the other representations you have in a deal, the company's also repping that it paid its taxes and filed its tax returns correctly, that it withheld all the payroll taxes it needed to withhold. Which goes to this misclassification issue. The second seller can schedule against those reps. If they have knowledge that they can't make any of the reps that they're being asked to make, they'll schedule against them. Buyers usually also will ask for a pre closing tax indemnity, which is an indemnity against all pre closing taxes of the target. There's lots of negotiation around what that will look like. Sometimes it's very fulsome and it covers like all tax liabilities known or unknown and it doesn't ever expire. So if tax issue ever comes up for the pre closing tax period, this indemnity lives on forever. Sometimes you'll see a deal have no tax indemnity and just have rep and warranty insurance and rep and warranty insurance will just cover breaches of the reps and sometimes also a pre closing tax indemnity if there is one. The issue is that rep and warranty insurance Very rarely will cover any known tax risks. So if any taxes were identified on the diligence schedule or were otherwise identified in due diligence that the buyer didn't like a diligence report, the rep and warranty insurance policy usually excludes all of those tax items. So the buyer will either have no indemnification for those items if they don't have otherwise an indemnification against the sellers or if the sellers have negotiated so that they only are on the hook for whatever rep and warranty insurance doesn't cover is that sellers need to know it doesn't cover any of the tax items that have been identified. So they're pretty much on the hook for all the tax items. You can also get special tax insurance which is a special product to cover known tax risks. I don't see that as often in M and A deals, but that's also a possibility as buyer. And then sometimes you see deals structured as like public style deals. Just there's no surviving reps or tax indemnity. That just means it's like walk away. I see that less often because most of my practice is not public deals or public style deals.

But that's what I'd negotiate as a seller is an as is sale.

Yes. I think most of my sellers would love to negotiate a walkway deal.

Not happening.

Not often.

As a buyer, we're looking at this company that's got 25 employees spread across. We know they haven't been paying any of their sales taxes. When we get our reps and warranties, which is becoming more and more of the go to, they're very much likely going to exclude knowing that there's these liabilities still out there.

Yeah. Anything that has been identified as an issue in diligence or on the schedules is pretty much always excluded from the rep and warranty insurance. And then the question is who holds the bag? Is it sellers have agreed to indemnify for anything not covered by rep and warranty insurance or is it that sellers have not provided any indemnification? So buyer then is on the hook for those pre closing taxes.

That covers our dues to Uncle Sam. You mentioned before of the structure with leaning towards an asset sale as a buyer to get benefits of depreciation and things like that. What are the circumstances where you would favor a stock sale as a buyer?

Buyer might want to buy stock instead of assets. And I'm thinking of a C corp specifically if the company has a lot of net operating losses and there are limitations on the ability of a Buyer to use net operating losses. And we can talk about that in a minute. But that's one time a buyer might favor a stock purchase. Or same with tax credits like R and D tax credits or whatever. Another reason is because maybe buyer has looked at their model and it's just the tax shield from depreciation is not a major factor in how they're looking at the success of the deal. Maybe they're a C Corp and just buying stock another C Corp or that company, the target company will just consolidate with their structure they already have does not create a tax drag and that's an acceptable structure. Or maybe buyers a corporate a C corporation wants to do an all stock deal like a tax free transaction and doing stock for stock be totally acceptable. So there are a number of times a buyer would be totally fine buying stock and sometimes seller just if they are a C Corp Will refuse to do an asset sale because it's so tax inefficient for the sellers if the target company is a C Corp to have the deal structured as an asset sale. So it just might be the sellers are just not going to agree to do a stock sale. Guess it goes back to being an asset purchase. But yeah, that's an issue that can come up that lands you back into a stock purchase for the deal structure.

Acquiring losses. What's the limitations there? Because I like the idea of buying a bankrupt company with millions and millions of dollars of loss to carry forward.

You like that idea and so do a lot of other people. Which is why the IRS shut down the real ability to do that. They did not like the idea of taxpayers being able to traffic in net operating losses or shell companies that had a bunch of losses. So they enacted a code provision that limits the the ability of buyers of shelf loss companies to use the losses going forward. And you'll hear People talk about 382 limitations. A 382 limitation is this limitation that is imposed if net operating losses of a corporation will become limited if shareholders increase their ownership in the corporation by 50% over a three year period. So if a corporation completely changes hands or a majority of its stock is sold, the ability of the net operating losses to be used are limited. Net operating loss carryforwards generally are useful because you can use them to offset like 80% of taxable income. But if this ownership change occurs, the 382 rules provide that the loss limitation for any year after the change of ownership is an amount equal to the value of the company on the date of the change. Of ownership multiplied by the long term tax exempt rate which is very low subject to certain adjustments. What this means in layman's terms is the ability to use net operating loss carry forwards is severely limited when there's the change of ownership of a C corporation. And so it's hard to quote traffic and losses.

I don't like that law.

A lot of people do not like that law. Another question people ask all the time as well, if I buy the asset, can I get the losses too? Like as a tax asset of the C corporation? The answer is no. You can't like buy net net operating losses. But that's also a question we get a lot. What can happen though is if there's a C corporation that has a lot of losses. As I was saying before, sellers, shareholders of a C corporation usually do not want to agree to an asset sale because there's tax at the corporate level and tax again when the cash goes out to the sellers. If a company has a lot of net operating losses, the sellers might be amenable to doing an asset sale because the corporate level gain would be shielded by the net operating losses. There no tax at the corporate level and then the cash come out just subject to the one level of tax. So there is sometimes a benefit that still can be had to having losses in a C corporation in a sale transaction.

A lot of it sounds like you want to communicate that to the seller as why the structure is going to be good overall for the deal.

Yeah, it's something that often comes up. I have yet to do a deal where the losses in the C corporation have been big enough where it actually makes sense for a seller to agree to an asset sale. But theoretically it's a very nice transaction to think about.

Teach me some stuff around how I can get around this. If I can't buy companies losing money, what can I do in terms of the structure side stock versus asset. Is there any other clever structures you've seen that have created some good tax benefits?

Do you get the benefit of net operating losses?

Yeah. Or just in general. I guess the traditional is to like you mentioned earlier is that you buy an asset and just to try to depreciate as much as possible. I was just trying to think if there's any other creative structures to get benefit if there is a company losing money. But it sounds like there isn't.

I don't know what I can offer there. That's helpful when you're thinking about just general financing transactions. I think we were going to stay a little bit away from that and go to bigger M and A. But something that like VC funds or investors are often looking for when they're thinking about tax optimizing an investment would be qualified small business stock benefits. And I don't know if you want to go into that here, but that's something you often look at in financing transactions for a tax benefit for the buyer.

Yeah, why don't we come back to that one? We had post acquisition structure, there's obviously considerations. If you're running a separate entity or combined, what do you typically see there? Is it always combined into one or they're running it as a subsidiary?

It totally depends on what the buyer's doing. Right. So post transaction integration is very much a function of who the buyer is and what the buyer is looking to do with this investment. So obviously if you have a fund that's just purchasing this company as a portfolio company and not looking to have it be part of a roll up, they might think of it more as a standalone investment. Ask the management team to roll a little bit or stay on and run the business for them. On the other side, big strategic investors, a big company that's maybe thinking they want to buy this target company and operate it as part of their overall business. They see it as adding something they don't currently have. In that circumstance. Sometimes you'll see they really just want the assets. They don't really want the people. Sometimes they want the people too. When they want the people too, there's often negotiations around who will run what level, how autonomous will the company be. And some of that can come back to taxes. When thinking about earnouts and contingent deal consideration and how that measured and paid out for the sellers, what they're thinking about is how do I get as much of that as possible paid to me as long term capital gain like the rest of my deal consideration versus as ordinary income like compensation.

When does the case shape for creating a holding company to house these multiple entities? Because I'm trying to get a sense of the plus and minus that you may have between companies and then that kind of puts you in an odd spot as well.

Yeah. So for buyer that's really dependent. I guess this goes to pre transaction structuring considerations for the buyer. The buyer really should be thinking when they're thinking about the best structure for them from a tax perspective where they want the target company sit in their overall structure and whether they do need to reorganize and whether it makes sense if they let's say they're a foreign company and they have a US subsidiary already. Should that US sub by this company or should it sit under the foreign holding company? Or if it's an asset purchase, should one of their existing businesses buy the assets or should they form a new holding company for those assets? So that's all just very dependent on buyer structure and ultimate monetization or goals.

You added the international component really made it complex.

Yes, the international component makes it very complex. I think most people know the US seeks to tax worldwide income where it can. You do want to make sure, especially if you have a foreign buyer, that you are not going to subject them to unnecessary U.S. taxes. And it's really wise for a foreign buyer in particular to get US tax advice prior to buying any US based businesses which, which most do.

Okay, a lot of stuff to think through. Structure wise, post acquisition, the case around employee, because we may buy a founder business, keep them around and put them on some kind of compensation plan where they can earn equity in the combined organization. And then we also have a lot of retention offers that would include some equity component. Are there any specific considerations around those kind of structures?

Yeah. So one issue that we see fairly commonly is you'll have key employees who are also equity holders of the target company. And oftentimes what the buyer seeks to do is subject some of their deal consideration to contingencies. Like all the other investors get all their deal consideration upfront or maybe a piece up front, a piece later. But the key employees only get their later piece if they're still employed or they've been employed for a certain period of time. They almost have to vest into it or reverse vest out of it. And, and you have to be very careful because generally deal consideration can receive long term capital gains. We can talk about seller structuring in a minute, but what you want to be careful about is that none of that seller consideration, you don't want to turn any of it into compensation income by subjecting it to contingencies like retained employment. If there are any of those types of contingencies or additional complexities that come into play play, you do need to talk to a tax advisor on the sales side to make sure that you're not really disadvantaged by agreeing to those conditions.

Because as a buyer, I'd very likely do that.

A lot of buyers try to do that. A lot of experienced buyers, they understand the tax issues that can come up for employees when some of their deal consideration is subject to contingencies. And oftentimes they're willing to work with seller counsel on trying to help Structure that that contingent consideration in a way that's tax efficient for the seller, but it can become a really major negotiating point. And this is often a point that comes up in term sheets.

Got it.

Also, if a seller is supposed to be getting and this goes to overall tax efficient structuring for sellers, if the seller is supposed to be receiving equity in the buyer or supposed to stay on and retain equity in the target company, it's very important that the seller talk to a tax advisor and make sure that is structured tax efficiently so the seller has tax deferral on the equity portion of the consideration. You don't want to be a seller who receives equity consideration or your equity in the target, but have to pay tax because you want the cash to pay the taxes on that portion.

What goes into that?

The seller has a whole host of other tax efficiency goals in mind that they're thinking about when doing an M and A transaction. Right. So usually the seller's main goal is to pay as little aggregate tax as possible on their sale proceeds. So that really means that they want to structure the transaction so there's one level of tax on the cash. They also want their deal consideration to be long term capital gains, not ordinary income. And again, they don't want to pay tax if they are getting any equity for their equity. So those are the main goals the seller has. And how to structure efficiently for all of those goals is really dependent on the seller structure. So if the seller is a C Corp, it's generally always the case that it's most tax efficient for the seller just to sell their C Corp stock, One level of tax on that sale is usually long term capital gain. If a buyer requested a seller that was a C Corp to instead sell its assets, it could be very tax inefficient for the seller shareholder because corporations have tax paid at the corporate level, the entity level, and there's tax again when the cash comes out of the business. So there's two levels of tax on that type of transaction. Which is why it's generally not the case that sellers who have C Corp will agree for the C Corp to sell its assets in the transaction. It's usually always a stock sale, S Corp or a flow through entity, although they're a type of corporation. And interesting with an S Corp. Again, if you sell the stock of an S Corp, the seller shareholders have one level of tax on that gain. Usually it's long term capital gain, just depending on the holding period in their stock. If an S Corp sells its assets, it's Usually only one level of tax because it's a flow through entity. Except there's certain states that don't follow the federal income tax rules for S Corps and they actually also impose entity level tax on that gain. Also, if an S Corp sells its asset, some of the gain might be ordinary income rather than long term capital gain. So until very recently, it was almost always the case that shareholders of an S Corp it was more tax efficient for them to sell the stock of the S Corp than its asset. Recently, in the past year and a half, two years, there's been a whole host of new rules that people call the PTE tax regime. So pass through entity tax regime where certain states have enacted rules that basically allow S Corps and tax partnerships like LLC to pay state taxes on behalf of their individual owners at the entity level. And then the equity holders get a deduction against their federal taxes for the state level state taxes paid. It's like a workaround to the salt, the lack of the SALT deduction that we currently have. So to get around not being able to deduct state taxes against federal taxes generally, these PTE regimes were enacted. And so now whenever we have a seller that is an S Corp or a tax partnership, you actually need to do modeling based on all of the states that are implicated in the transaction to determine whether the offset from the PTET regimes is greater than the savings by doing an equity sale. And so now where it used to almost always be the case that for an S Corp target, an equity sale was the best, sometimes we're actually seeing asset sales be more tax efficient, which is just a very big change from what we used to see. And that again could change if the SALT deduction cap is lifted. Llc, which are generally tax partnerships. I'm going to use the term LLC interchangeably with partnership to mean the same thing. Generally the sale of equity or assets from any is subject to one level of tax. So whether you structure as an entity an equity sale or an asset sale, there won't be two levels of tax. And likewise, when a partner of a partnership or a member of LLC sells its equity, certain of the long term capital gains is recharacterized as ordinary income in something called the hot asset rules. So generally inventory items and depreciation recapture are recharacterized as ordinary income. If an LLC or partnership sells its assets, they're also some ordinary income. But now again, because the PTET regime, if an LLC sells its assets, there could be the benefit of these, the ability to deduct state taxes against federal taxes on the gain, which could be a big tax savings. So again, there's a need now to model out what is better when you're a seller and you hold equity in an llc, whether you should be selling the assets or the equity would be more tax efficient and the buyer can receive basis step up in an LLC transaction whether equity or assets are sold. So there's a lot more flexibility and structuring.

Leslie, my notebook is one big blur right now. Who's got the leverage in negotiating this between buyer and seller?

So much of it's just dependent on who needs to get the deal done. It really depends on the deal. I'd say there are certain fundamentals. If there's a C Corp target, it's usually the case that the shareholders just can't do the deal if it's structured as an asset purchase because it's so tax inefficient. The seller just can't have the deal structured that way. But if the target's an S corporation or an llc, there really is often some negotiation that occurs regarding optimal structure. It's usually fairly easy to find a structure that works for both parties. One of the bigger issues we see is with S Corp targets, S corps are really finicky. An S Corp can only have certain types of shareholders, specifically like U.S. individuals. So if the buyer was a corporation or a partnership fund, if it purchased the equity of an S Corp, the S Corp turns to a C Corp automatically. It's typically not the case that buyers are going to want to buy the equity of an S Corp. And if you have any rollover sellers, they're not going to want it either. But there couldn't be a real tax efficiency for a seller of an S Corp to sell the equity because again they can get all long term capital gains versus there's an asset sale, portions, ordinary income. And so sometimes there's negotiations around like a gross up and whether the buyer will gross up the seller for any tax leakage for not getting their optimal structure. And this can come into play with any number of transaction structures. But sellers will sometimes, depending on leverage, ask for gross ups to do the transaction in a way that's tax advantageous for the buyer. So the buyer wants a structure that's just not best for the seller. If the seller has some leverage, they can say gross me up for the taxes that I will owe that are additional because of the structure you want. And the little tricky part there is because that roast up is actually additional deal consideration. What you really need is a gross up on the Gross up because it's tax. So it's an iterative calculation. So what you think might be in a million dollar difference in taxes can be like a $2 million gross up. And so that could become a pretty big negotiating point in some transactions.

That's my new vocab word of the day. Gross up.

Oh yeah, this is a gross up on the gross up.

Oh, I like that. Do tell. Is that a thing?

Yes. To calculate the gross up, you need to take into account that taxes are going to have to be paid on the gross up. So it's in an iterative calculation.

Oh my God. I'm not going to complain about my hourly bill from you next time.

I'm worth every penny.

Case in point, at this point, how much of this is spelled out in the loi?

So it's a really great question. This is why I like to get involved very early in. Lois, I'll just say this firstly really depends on who's negotiating what the positions of the parties are, what the structures are and what the big deal points are. Let's just take an easy example. There's going to be some contingent consideration in the form of equity. Sometimes we'll just put in a sentence that says this will be structured in a manner that's tax efficient for the sellers so that the equity is received on a tax deferred basis. And we'll just put in a sentence rather than figuring out exactly what the deal structure is going to be. Sometimes we'll figure out the whole deal structure because it's that important or it's that tricky, there's that many nuances. Or we know it's going to be because buyer isn't going to like what we need from a seller's perspective. Sometimes if we represent an S corporation target, we'll put in language that says, hey, if you want full basis, step up on the assets and you're going to want an asset purchase. We're going to want to receive a gross up for the additional tax we'll have to pay because we didn't structure the transaction as a stock sale. And that'll be a sentence in there. But that's enough because if it's a really material point for the seller, you need to get it in there because you can't bring it up later or it's hard to bring up later and win the point. So. So those are material issues you want to get in at the term sheet stage. I've had a client before where they've come to the firm after they've Signed an loi and the term sheet has said even though they're a C corp that they're selling the assets of the corp. And although Lois are often non binding, if the seller is already pregnant with the dealer, they're already going to do it. You can't walk back from that after you agreed to it. It's really hard to renegotiate and still get the deal done. You want to start talking about these issues early.

I agree. I also see the dynamics of leverage and negotiation where seller has more leverage pre loi, buyer has more leverage post loi.

Fair to say, yeah, that does often happen and that's why you do again want things in the term sheet.

Would there be things you wouldn't want just because that may and I guess depending on level of sophistication and who you're buying the business from, they may not want it till you bring it up.

The buyer might not want it in there. We've seen many times where buyers really have the upper hand in the term sheet stage because they've dictated the structure and the sellers hasn't engaged counsel to help negotiate on those points. Like if buyer has said 25% of the deal consideration is completely contingent on these three guys working and they end up with disproportionately more of that contingent consideration. Whatever it is. It's really hard to later negotiate different terms. The terms that were negotiating the term sheet might end up in some of the purchase price being compensation rather than long term capital gain deal consideration. And it's really hard after you already have assigned LOI to say hold on, that's not what I saw what I thought I agreed to does zombie long term capital gains. It's like well that's not what you signed in the term sheet. You signed terms that just wouldn't result in that.

It's hard to unprregnate a deal. But. But then how do you do it if you have to, it just goes.

To who has the upper hand and at what point. If the management team decides that the structure just doesn't work for them and they're needed to operate the business going forward, buyer might be much more inclined to negotiate those points than if the sellers or most of them aren't really needed and the buyer has all the leverage.

Can you advise your client to play hardball, walk away and all dependent?

Each client decides what I can say is and I always have to remind myself this, you just need to give your client the information and some guidance. But ultimately a lot of these decisions are Business level decisions. You have to help them have enough knowledge so they know what they're signing and understand the ramifications. But ultimately a client might decide that even though it's not most tax efficient, it makes most sense to do a deal a certain way for other reasons, and that's okay too.

Can we go back to qsbs and expand on that more?

So QSBS stands for qualified small business stock. The real tax benefits of QSBS is this. If you hold QSBS stock for more than five years and then you sell that stock, you can exclude from income tax the greater of $10 million or 10 times your basis in that stock. Okay, so simple example. If you invested $2 million into a C corporation and your stock qualified as qsps stock and six years later you sold that stock, you can shield $20 million of that gain from tax. Two million times ten times your basis. That's the real benefit of QSPS is a total exclusion from tax.

The minimum was 10 million and then 10x basis.

Yeah, you get to exclude the greater of $10 million or 10 times your basis in the stock.

Bootstrap from scratch. Got it.

You're a founder. $10 million.

$10 million. But if I threw in $5 million, it could be up to $50 million.

Yes.

Okay, I got it.

Not all stock in corporations is QSBS stock or you'd hear about this a lot more. QSBS is stock in a C corporation. So it has to be a C corporation and it has to have been issued when the corporation was a qualified small business, meaning it's aggregate gross assets at all times before the stock was issued and immediately after the issuance, does not exceed $50 million. And generally aggregate gross assets for that purpose means cash and tax bases of the assets of the corporation. So if you had a C corporation, new startup started as a C corporation, and let's say it's operated for like years. So, and let's say an investor decides to put in $3 million at a $65 million post money valuation, it still could be QSPS stock because that valuation is not the valuation used when determining whether the aggregate gross assets of the company exceeds $50 million. You look at instead the cash and the tax bases of the assets. So if you're an investor, you don't just rely on the pre or post money valuation for determining whether it's still a qualified small business. You have to do a little more work to figure it out. When you have assets contributed to a corporation or if an LLC converts to a corporation, you have to use the fair market value of those assets when determining whether it's a qualified small business and whether the 50 million value has been exceeded.

The same with S Corp.

So S Corps are really funky because if you own S Corp stock and then you convert your S Corp to a C Corp, you can't get QSBs because when you originally received the stock, it was S Corp stock. So if you are a shareholder in S Corp and you want potential QSBs for your corp, we actually do a special type of reorganization to get you that stock tax efficiently. And that's a whole nother topic I'm happy to talk about. But it might be beyond the scope of this conversation. But there is a way to make that happen so long as all the other requirements are met. But it's not as simple for that S Corp founder as just converting to a C Corp. Not only does the C Corp stock have to be acquired at original issuance, which means you have to have received your USPS for an investment into the company. You can't have bought it in a secondary. It also can be disqualified if there have been any significant redemptions within the year prior or year after you purchased your SBS stock. So there's special disqualifying redemption rules you have to look at. And then the corporation during substantially all of the holding period for the relevant shareholder and their stock of the corporation has to have met the active business requirement, which means at least 80% by value of its assets needs to have been used in the act of conduct of a qualified trade or business. And the code defines by exclusion what a qualified trader business is. So basically says what is not a qualified trade or business is leasing, financing, investing or similar businesses. Businesses where the reputation or skill of the employee is the principal asset of the business, like law, health, consulting. Those can't be QSPS businesses or hotels, motels or restaurants. So there's certain types of businesses that can't be QSPS businesses, but generally tech startups are okay because those are usually software as a surface business and technology businesses. Although the area can get a little gray if you have a fintech business which straddles technology and finance. So that's the quick and dirty on QSPS stock. So this is a big deal in startup financing transactions.

Why did the tax code get so complicated?

It's a really great question. I don't know. But every year there's someone who's saying I'm going to, I'm going to make it so your Whole income tax return can be on one page. It's never going to happen.

Are there certain politicians that get paid for a tax law they put out there?

I don't know. It is very complicated and there are a lot of things you have to think about at every turn. But you're well advised, you can save a lot of money.

I agree. Agree. I'm always looking at the broader infrastructure and figure out where you can apply some lean agile models, I guess here. Leslie, how many people do you see relocate prior to their exit or tax savings, specifically to Texas and Florida?

We have a lot of clients who have relocated to Texas and Florida in the past couple years. Certain states have provisions that fall back on the savings one could have by moving to a different state. And some of it's dependent on if they're moving after they've gotten their original closing consideration before a contingent payout has been made.

Okay, so that's a big problem. Personal consideration, I say more often than.

People moving before an M and A event, we're just seeing people wanting to move for just general tax savings on their everyday income. We're seeing a lot of that. Like people are just sick of not getting the benefit of the SALT deduction. And we're seeing a lot of people just move saying that's the reason they're moving. Not necessarily because they had a big deal coming to fruition, although we've seen that as well. And in that circumstance, I have a colleague who advises on all the ways to make sure that you are actually giving up state tax residency because these states are aggressive.

Yeah. How far ahead do I need to do that? This is all top of mind while I'm taking this call from Miami today.

You have to really move to get any benefits from actually moving. But yeah, you usually have to do it before oftentimes and it's really state specific, but usually have to do it before you have a signed deal and.

You have to establish a residency.

You have to have time to establish.

The residency, go over there, rent an apartment, then go sign the deal.

Yeah, it does. It doesn't really work that way. You're going to probably subject yourself to an audit that you're not going to win.

Okay, I appreciate that insight there. In terms of diligencing for the tax considerations as a buy side, what are the big ticket items that I, as a deal person should be asking about ahead of time just to understand what some of those things are.

Part of this, again, depends on the structure. Right. So if you're buying equity in an entity you're assuming tax liabilities. If you buy the stock of a C Corp, whatever tax issues that C Corp has travels to you as owner of the company. Now you might have indemnifications or wrap and warranty insurance to cover yourself financially, but it's still your headache. Now if you're instead just doing an asset purchase, a little bit less of your headache. What tax issues are at the target, the target company that's the seller. Because those issues should primarily stay with the selling entity and an asset purchase. Except maybe some state and local taxes. And if you're acquiring equity in an LLC or S Corp, some of those preexisting taxes will naturally flow through somewhat to the prior owners, but still have your headache. Cause you own the company. So you always want if it makes sense given the deal to do fulsome diligence. That's always my recommendation is fulsome tax diligence. You have an accounting firm come in and actually diligence the company, look at all its tax returns and make sure it's been doing everything correctly. And so we always do recommend fulsome tax diligence.

Bring in the experts.

Bring in the experts. Get it done. Yeah. And as like law firms don't do the tax diligence. Usually it's an accounting firm. And then the accounting firm typically will put together a due diligence report like a tax due diligence report. And then the lawyers will look at that to figure out what are the big ticket issues that need to be negotiated on the tax side. And we'll decide what needs to make into the purchase agreement as far as obligations of buyer and seller with respect to taxes and any cleanup that needs to be done or indemnity that asks the needs to be asked for any.

Big do's and don'ts. Lessons learned from experience do get a.

Tax advisor involved early on. It saves you a lot of money later on. The juice is worth the squeeze. I'd always say get a tax advisor all just to make sure you are structuring the transaction tax efficiently. And then as a buyer do your diligence on the target company. That'd be my big buyer advice. And then another just piece of advice I guess for sellers. If there's a target company and some of the sellers are going to be rolling and have equity in the buyer going forward or equity in the target going forward and some are selling, their interests are not always going to be aligned. So sometimes depending on how the deal negotiations are proceeding, those rollover shareholders or equity holders might need special counsel like sometimes we counsel management teams of private equity portfolio companies and represent the management team specifically in negotiating their rollover and their incentive equity that they're to receive for go forward services once the company's been purchased by the private equity fund.

I like to think of the broader stakeholders what's the most creative strategy you ever seen to avoid paying taxes? You know, sub entities in Bermuda?

What's the most creative the IRS has done a pretty good job shutting down anything that would be a tax shelter. So I haven't seen anything crazy as far as structuring. I'd just say I've seen smart structuring people, people who can structure smartly do well. That again goes to typically just structuring as a seller to get most of your gain as long term capital gain if you need to structuring into the PTE deductions that we now have available and also really importantly structuring your go forward incentive equity tax efficiently. So I wouldn't say there's any real tips for sheltering the gain, but I'd say you can structure efficiently and then.

We set up trust in Wyoming.

I would say this. If you're a founder of a startup or you are a shareholder of a earlier stage company, you should start thinking about overall tax structuring for you and your family. Thinking smartly about how to use trusts and grants and eventual estate planning pay off. That goes again to why sellers in particular should get tax involved really early is because you do need to start thinking about some of those tax efficient structurings earlier on rather than at the time you're trying to sign an loi because some of it is it's a little too late to get into some of the tax efficient structures once you've signed an LOI and have a real valuation on the table.

This has been great. Leslie. Thank you so much for joining us. Those of you still tuned in, till next time, here's to the deal. Thank you for taking the time to explore the world of M and A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M and a function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email kisan kison a science.com or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit Masscience.com for a lot more content and resources. That's where you can also subscribe to our newsletter. Again, that's mascience.com here's to the deal. Views and opinions expressed on M and A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.