Sellers: Chose Carefully to Maximize After-Tax Cash Flows

Deal structure is important in any effort to maximize after-tax cash flow on behalf of a seller. Reducing the number of levels of federal income tax imposed on profits the seller derives from the transaction is key and is tied to both the structure of the company--whether it is organized as a Subchapter

Regarding the organization of the business, it is critical to explore who must pay tax on profits derived from the sale--the company itself or just its owners. Though exceptions abound, if a business is set up as a Subchapter C corporation for federal income tax purposes, for example, it generally must pay tax on its profits before they are distributed to shareholders, who then typically must pay tax themselves upon receipt of any profits. This constitutes two levels of taxation.

Conversely, Subchapter S corporations generally do not pay tax on profits. Instead, the profits are taxed on a flow--through basis only to shareholders, a practice that represents only one level of tax.

Structures for Taxable Transactions

Often, sellers are so narrowly focused on the purchase price they do not step back and consider the importance of the overall deal structure. However, properly structuring a transaction is as critical to a seller's efforts to reap maximum value as is negotiating valuation. Therefore, the goal is to structure a transaction in such a way that the seller faces as few levels of tax on profits as possible. In order to determine the most beneficial structure, a seller must consider three key questions when exploring any potential deal:

1. Does the transaction involve a single or double level of tax?

2. Will I receive capital gains treatment on this transaction?

3. When will I receive cash from this sale--immediately, or is it deferred?

Some typical transactions and brief discussion of tax considerations follow:

* Stock Sale. From a tax-planning perspective, selling stock, rather than assets, affords the seller the greatest financial advantage. A stock sale is subject to a single level of tax at the current federal rate of 15 percent on long-term capital gains, assuming the seller has held the stock for more than 12 months prior to the transaction.

To mitigate risk and preserve value, the value of this stock can be locked in, using devices such as puts, options and collars, for example. An additional benefit of a stock sale is that the seller does not retain any liabilities.

* Asset Sale. In the case of an asset sale by a Subchapter C corporation (and in some cases a Subchapter S corporation), the deal generally faces two levels of taxation. The corporation is taxed at its federal rate, which may be as high as 35 percent, and the shareholders also are taxed at a federal rate of 15 percent on qualified dividends. Therefore, asset sales are taxed at a combined federal rate of 50 percent while stock sales may be taxed at a federal rate as low as 15 percent.

However, there are some instances when a seller might choose an asset sale over a stock sale, for example to placate a potential buyer unwilling to assume the liability that accompanies the purchase of stock. Because the seller is paid for the assets of the business and retains specified liabilities, an asset deal may translate into a greater risk and increased tax liability for the seller.

Careful negotiation of a significantly higher sales price will be necessary for the seller to recoup the costs associated with both greater tax responsibilities and a higher degree of risk.

* Deal Structures for Non-Taxable Transactions. In the case of non-taxable transactions, the seller generally receives stock rather than cash for a sale. Typically, restrictions are placed on the stock that limit when and how much stock the recipient can sell. While this type of deal does confer long-term capital gains tax advantages upon the seller, the inability to sell the stock at will prevents truly maximizing value because that stock may decline in value before the seller is allowed to sell it.

Communication Is Key

The success of any acquisition requires both buyer and seller to be on the same page and share an understanding of the specifics of the transaction well before the deal is consummated. The structure and terms of an acquisition have significant tax and economic consequences.

Thus, it is important that both parties resolve these fundamental issues early in the process, and agree on what, precisely, is for sale--assets or stock--and work together with their advisors to balance their competing interests.

Michael F. Corrente, JD, LL.M, a principal in the tax group of Tofias PC (mcorrente@tofias.com.), offers public and private companies extensive experience and insight in areas of tax consulting. These include accounting for income taxes, effective tax rate planning, acquisition/disposition structuring, subchapter C, S corporation and partnership tax planning.