Posts made in June 2018

Ignoring tax issues before the deal is struck is a big mistake

The Denver Post | BUSINESS

POSTED;  June 24, 2018, at 6:00 am

 

Many business owners put tax issues on the “back burner” when selling their companies. Ignoring tax considerations, until after the deal is struck, is a big mistake and can put you in an adverse negotiating position, even if the letter of intent (LOI) or term sheet (TS) is “nonbinding.”

Sellers should not agree on any aspects of a deal until they meet with a competent tax adviser who can explain how much they will wind up with on an “after-tax” basis. Seven major tax questions should be considered before finalizing a deal.

  1. What type of entity do you use to conduct your business?
    Is your business is a sole proprietorship, partnership, limited liability company (“LLC”) or S corporation? These corporate structures are considered “pass-through” entities and will provide you with the most flexibility in negotiating the sale of your business. Your flexibility may be limited, however, if you conduct your business through a C corporation. The possibility of “double taxation” may arise at the corporate and shareholder levels.
  2. Is a tax-free/deferred deal possible?
    Most sales of businesses are completed in the form of taxable transactions. However, it may be possible to complete a transaction on a “tax-free/deferred” basis, if you exchange S corporation or C corporation stock for the corporate stock of the buyer. This assumes that the complicated tax-free reorganization provisions of the Internal Revenue Code are met.
  3. Are you selling assets or stock?
    It is important to know whether your deal is or can be structured as an asset or stock sale prior to agreeing to the price, terms and conditions of the transaction. In general, buyers prefer purchasing assets because (i) they can obtain a “step-up” in the basis of the assets resulting in enhanced future tax deductions, and (ii) there is little or no risk that they will assume any unknown seller liabilities. Sellers, on the other hand, wish to sell stock to obtain long-term capital gain tax treatment on the sale.

A seller holding stock in a C corporation (or an S corporation subject to the 10-year, built-in gains tax rules) may be forced to sell stock because an asset sale would be subjected to a double tax at the corporate and shareholder levels. In addition, the seller is often required to give extensive representations and warranties to the buyer and to indemnify the buyer for liabilities that are not expressly assumed.

  1. How will you allocate the purchase price?
    When selling business assets, it is critical that sellers and buyers reach agreement on the allocation of the total purchase price to the specific assets acquired. Both buyer and seller file an IRS Form 8594 to memorialize their agreed allocation.

When considering the purchase price allocation, you need to determine if you operate your business on a cash or accrual basis; then separate the assets into their various asset classes, such as: cash, accounts receivable, inventory, equipment, real property, intellectual property and other intangibles.

  1. Can earn-outs/contingency payments work for you?
    When a buyer and seller cannot agree on a specific purchase price, the seller and buyer may agree to an “earn-out” sale structure, and/or contingent payments. The buyer pays the seller an amount upfront and additional earn-outs or contingent payments if certain milestones are met in later years.
  2. What state and local tax issues are you facing?
    In addition to federal income tax, a significant state and local income tax burden may be imposed on the seller as a result of the transaction. When an asset sale is involved, taxes may be owed in those states where the company has sales, assets, or payroll, and where it has apportioned income in the past. Many states do not provide for any long-term capital gain tax rates, so a sale that qualifies for long-term capital gain taxation for federal purposes may be subject to ordinary income state rates.

Stock sales are generally taxed in the seller’s state of residency even if the company conducts business in other states.

Also, state sales and use taxes must be considered in any transaction. Stock transactions are usually not subject to sales, use or transfer taxes, but some states impose a stamp tax on the transfer of stock. Asset sales, on the other hand, need to be carefully analyzed to determine whether sales or use tax might apply.

  1. Should presale estate planning be considered?
    If one of your goals is to move a portion of the value of the business to future generations or charities, estate planning should be done at an early stage, when your company values are low (at least six months in advance of verbal negotiations and/or receipt of a TS or LOI). It may be much more difficult and expensive to simply sell the company and then attempt to move after-
    tax proceeds from the sale to the children, grandchildren or charities at a later date.

Conclusion: Before deciding to sell your business, work with a qualified tax adviser who can help you understand the tax complexities of various sales structures. Above all, do not enter into any substantive negotiations with a buyer until you have identified the transaction structure that best minimizes your tax burden.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com

 

Half of all business sales fall apart during due diligence.

The Denver Post | BUSINESS

Here’s how to avoid it.

By Gary Miller | Gem Strategy Management

POSTED:  June 3, 2018 at 6:00 am

When a seller tries to hide facts, or doesn’t disclose them to buyers and they are uncovered during due diligence, say goodbye to the deal. According to Forbes, “approximately half of all deals fall apart during the formal due diligence stage, and one of the most common reasons this happens is due to the buyers uncovering  issues which the sellers didn’t disclose earlier.” These situations are never pretty. Accusations are made, lawsuits follow, buyers lose their investments, sellers forfeit any earn-outs and face “financial claw backs” and businesses deteriorates rapidly. Nobody wins. These situations are all too common and in most cases should never happen.

Think about it. You spend years building a successful business. You decide to sell, spend time trying to find a qualified buyer to sign an LOI (letter of intent to purchase your company) and begin negotiations, only to have your potential deal fall apart because of undisclosed items arising during the due diligence process. So what can you do about it? Below are four “musts” for successful deal making.

First, don’t rush to go to market. Rushing to market can be caused by age, illness, burnout, divorce, legal problems, partner squabbles and myriad other reasons. But, in spite of these reasons, rushing to market could significantly impact your ability to get an optimal deal for your company. Going to market unprepared is a recipe for disaster. Since most business owners will only sell a company once in their lives, it’s a good idea to engage a professional M&A adviser to help prepare for the transaction process in general and the due diligence process in particular.

Second, prepare for the buyers’ due diligence process. Prepare for intense buyer scrutiny.  Far too often business owners simply do not do their homework prior to the process and pay the price in the end when their deal falls apart. If a seller is not prepared in advance, due diligence can drag on for weeks; and, often, if it does, buyers get cold feet and move on to other, more attractive opportunities. Have an adviser create a typical due diligence check list and put you through the rigor of answering questions that could arise.

Third, disclose, disclose, disclose. Throughout the discussions, negotiations and the due diligence review between a buyer and seller, credibility is being tested. In your discussions with the buyer, explain your challenges before they find them; understanding them will allow the buyer to get comfortable with your business. Disclosing the challenges actually builds trust and credibility. As long as the parties deal honestly with each other, trust builds. But, if either side tries to hide material information that surfaces during due diligence, trust will be shattered. The cardinal rule of deal making, during the due diligence process, is disclose all material information.

For example, in a transaction involving a moving and storage company, a large percentage of the company’s revenue came from a single government contract. The buyer wanted to read the master contract between the company and the government agency to be sure it was transferrable as the seller had represented. However, the seller knew it was not really transferable and would have to be reviewed by the government agency because of change of ownership. He figured he could convince the buyer to buy the company’s stock instead of the company’s assets after the buyer was emotionally invested in getting the deal done. Wrong strategy. The buyer agreed to complete all other components of due diligence and would review the contract afterwards. Sure enough, the buyer discovered that the contract was not transferable and could only continue with an entirely different deal structure complicated by tax issues and potential liabilities. The buyer felt mislead and the deal disintegrated.

Remember, the goal is to sell the business. Disclosing the good and the bad about the business, warts and all, is just prudent deal making.

Fourth, think like a buyer. Look at your business as if you were a buyer. Ask yourself, what would I need to know about this company if I were buying it?  What are its strengths and weaknesses?

A great exercise for sellers is to put together a list of everything that worries them about their own business – those that keep them up at night. Then, detail potential solutions to each problem that can mitigate a buyer’s concern. For example, if the business has some old equipment, the seller can be proactive and have a spreadsheet ready that details replacement costs and financing options along with the potential improved efficiencies that will contribute to the bottom line.

Despite the dismal statistics of failed deals, transparency between the parties is the key to success. When a buyer wants to buy and a seller wants to sell, and the parties like and trust each other, they will find a way to get the deal done.

Gary Miller is CEO of GEM Strategy Management Inc., based in Greenwood Village, which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. gemstrategymanagement.com | 970.390.4441