Merger-and-acquisition deal activity in the fourth quarter of 2012 was very strong, with business owners and their CFOs looking to sell their companies in advance of potential tax-rate increases on capital gains. Congratulations to those business owners who exited businesses successfully during 2012.
But the bad news is the new tax rates may still affect the sellers of small businesses if part of the transaction structure was in the form of earn-outs or sellers’ notes. (Earn-outs occur when a buyer agrees to pay a portion of the future cash flow to the seller as part of the purchase price. Sellers’ notes are a form of debt financing in which the seller agrees to get part of the purchase price in a series of installment payments.)
How much did income taxes go up on capital gains? The answer: a 5% to 8.8% rate increase, depending on the type of capital-gains income and the taxpayers’ level of income. The two basic components of the tax-rate increase include:
1. The basic federal capital-gains tax rate for 2013 and later years increased from 15% to 20% for certain high-income taxpayers.
2. The new Net Investment Income Tax (NIIT) of 3.8% applies to certain high-income taxpayers and types of income. This tax-rate increase was part of the Affordable Care Act.
The NIIT applies a 3.8% tax rate to certain “investment income” which includes interest, dividends, capital gains, rental income, royalty income, and “passive” business income. The tax applies to individuals, estates, and trusts only if they have net investment income and modified adjusted gross income in excess of $250,000 filing as married (or $200,000 if single).
But the NIIT can also have a significant impact on M&A tax structuring. Here are a number of ways to curb the impact of the tax changes.
Electing Out of the Installment Method
Taxpayers can choose the installment sales method of reporting taxable gains from the sale of a business when payments are deferred into future years. The installment method allows taxpayers to pay the capital-gains tax when the cash is received in the future. Postrecession deal structures have often included seller financing or earn-outs in order to bridge the value gap between buyers and sellers.
Capital gains will potentially be subject to the NIIT if received in 2013 or later years. Individuals who sold their businesses in 2012 and have deferred purchase-price payments need to decide if they want to elect out of the installment method to report all of the proceeds of the transaction in 2012 in order to avoid the NIIT.
The best situations to elect out of the installment method are when the seller financing or earn-outs are payable over a short period of time and the risk of nonpayment is low. Earn-outs can be a problem because they are tough to value and if the actual payments are less than estimated, a capital loss will be incurred, which is limited in use as an offset to capital gains in future years.
If a seller is going to elect out of the installment method, he should extend the 2012 tax return to get as much clarity as possible on the status of the deferred payments amounts and timing.
Stock versus Assets
The NIIT applies to a gain from the sale of corporate stock, including businesses filing as a “C Corporation” (corporate-level taxpayer) and an “S Corporation” (income passes through to shareholders). Gain from the sale of a C Corporation stock will be subject to the NIIT.
Unlike a C Corporation, shareholders of an S Corporation can make a special tax election (Internal Revenue Code Section 338(h)(10)) to treat the sale of an S Corporation stock as a sale of assets. Capital gains from the sale of active business assets, such as those tangible or intangible assets used in daily operations and as opposed to investmentlike assets, are exempt from the NIIT. The taxpayer must also be considered as active or materially participating in the business for the year of sale in order for the NIIT not to apply.
The Internal Revenue Service issued proposed regulations in December that allow S Corporations and partnerships to use a “deemed asset sale method” to calculate how much of the sale gain (if any) is subject to the NIIT. The regulations allow shareholders of S Corporations and the principals of partnerships to have similar results for NIIT purposes, regardless of the form (asset versus stock sale) of the transaction.
Conversion of C Corporation to S Corporation
C Corporations may want to consider converting into S Corporations before they’re sold to position themselves to avoid the NIIT. The sale of C Corporation stock is subject to the NIIT. Alternatively, if the transaction is structured as the sale of corporate assets, the taxable gain realized by a C Corporation is subject to corporate-level income tax at the 35% tax rate.
A distribution of sales proceeds to the shareholders is subject to the NIIT (double layer of tax imposed on the gain). C Corporations that converted to S Corporations cannot avoid a corporate-level tax on the sale of assets if the sale occurs within five years of the conversion date (known as the “built-in gains tax” or BIG). Note the proposed regulation noted above creates a hypothetical sale of assets, thereby obviating the need for a 338 election (the ability to treat a stock acquisition as an asset acquisition for federal-tax purposes) or an actual asset-sale transaction for an S Corporation or partnership.
The decision to convert is complex because the S Corporation operating income would be subject to higher individual tax rates of 39.6% compared with the corporate tax rate of 35% (assuming both are in the highest bracket). But such operating income would be subject to only one level of tax (assuming the sale does not create BIG income).
ESOPs for Tax Savings
Employee stock ownerships (ESOPs) have long been touted for their tax-savings benefits, their creation of a market for privately held stock, their ability to create perpetuity for the business, and as a tool for motivating employees. An ESOP can be used to purchase stock in a tax-free transaction if it owns at least 30% of the stock. Now that capital-gains rates and the NIIT increase the capital-gains tax burden (by 5% to 8.8%), business owners may have even more interest in using an ESOP for liquidity.
In addition, as a shareholder of an S Corporation, the ESOP does not pay income tax on the taxable income of the company.
Using Stock As Deal Currency
We have seen a renewed interest in using stock as part of the consideration in a transaction. If sellers receive at least 40% of the purchase price in stock, the transaction can be structured as a tax-free reorganization (really a tax deferral, since the tax basis of the stock given up carries over to the stock received).
The higher capital-gains tax rates create an incentive for sellers to reevaluate this structuring option. Buyers may be reluctant to structure the deal as a tax-free reorganization because they do not get to step up the tax basis of the assets purchased (or adjust capital-gains tax based on current price versus the original price), there’s increased structuring complexity, and if they view their stock as undervalued.
Like Kind Exchange
The sale of assets that have been depreciated can create both ordinary income (to the extent the portion of gain relates to depreciation previously claimed) and capital-gains income (value in excess of original cost basis). The 2013 tax-rate increases on ordinary income (4.6% for individuals owning pass-through entities for tax reporting) and capital gains (the increase of 5% to 8.8%) provide an incentive to explore deferred-gain tax strategies for high-income individuals.
One technique is the “like kind exchange,” in which certain qualified business assets can be structured as like kind exchange for similar assets. A like kind exchange enables two parties to exchange tangible assets without recognizing taxable income. While this technique has often been used for real property, it also applies to both tangible and intangible assets.
Tangible assets used in a business qualify if the exchanged property is in the same asset class (asset classes are narrowly based upon the descriptions of the asset and its industry use). Intangible assets such as licenses, patents, and trademarks also qualify, but goodwill does not.
Business owners are now struggling with the decision to sell their companies because they now need a higher sales price to net them the same after-tax proceeds as a 2012 transaction would have provided.
How much higher does the business value have to be to net the same after-tax proceeds in 2013 as from a 2012 transaction? Assuming no state corporate income tax and tax basis in the stock, the sales price needs to be at least 9.7% higher in 2013 to net the same after-tax proceeds in the 8.8% tax-increase scenario (capital-gains rate increase and net investment tax combined). In the 5% capital-gains tax-rate increase scenario, the sale price needs to be at least 5.3% higher.
From an earnings-growth perspective, assuming the same facts as above and an average transaction multiple of six times earnings before interest, taxes, depreciation, and amortization (EBITDA), the EBITDA needs to increase by 6.3% in the 5% tax rate increase scenario to net the same after-tax proceeds. In the 8.8% tax-rate-increase scenario, EBITDA needs to grow by 9.5% to net the same after-tax proceeds. In today’s economy, this may take two to three years for the business to grow into the same after-tax net-proceeds value.
Thus, the tax-structuring strategies discussed in this article should provide some relief from the recent tax-rate increases so that business owners can meet their after-tax proceeds objective. But business owners should be careful not to let taxes alone dictate their M&A liquidity strategy, since other factors such as the competitive landscape, industry consolidation, business profitability and growth, personal goals, and M&A market trends should be considered.
George D. Shaw is the partner in charge of transaction advisory services at DiCicco, Gulman & Co., a Woburn, Massachusetts-based CPA and business advisory firm.