BUYING AND SELLING BUSINESSES
One of my favorite areas in law and taxation is “M&A’s” (merger and acquisitions). In plain English, I am talking about buying or selling businesses. The reason I like M&A’s is that they are challenging, yet allow me a lot of opportunities to help my client.
Business brokers and form contracts are no substitute for professional advice from your accountant and lawyer. A tax attorney can add value to the transaction that no other professional can, by identifying tax savings and drafting a contract that benefits both parties. Let’s talk about how to do this.
GET THE FACTS!
The buyer and seller sometimes make the mistake of starting to negotiate before they know all the facts, which might reveal some attractive alternatives. For example, a cash-short seller might offer a much better price to an all cash purchaser. The buyer and seller should uncover all important facts about the target business that is for sale. The buyer should inspect the business premises and assets and talk to persons doing business with the target. He should review key contracts between the target and third parties. Buyer and seller should examine each others’ financial statements and tax returns for several years. Each party’s lawyers and accountants should review all information, especially key contracts, financial statements and tax returns. This information often uncovers dangers and opportunities for each party.
Don’t agree to anything without legal advice. It’s easier to make a deal than to change it. If the deal looks good after talking with your lawyer and accountant, have your lawyer draft a proposed sales contract. Sign it to show it to the other party to show that you mean business! This offer will quickly bring out any disagreement and start the negotiations. If the other party signs you have a deal!
VALUING THE BUSINESS
A most important term in your contract, of course, is the price. To find the price of the target business, each party must decide its value. There are at least three major valuation methods for businesses not publicly traded: The first is the comparable sales method, which values a business by comparing sales of similar businesses. A second method, the asset valuation method, assumes the business’s value equals the value of its assets less its liabilities. A third method, the capitalization method, forecasts the business’s earnings and sets the price so that those earnings represent a good rate of return on that price. Appraisers often use a mixture of methods. For example, a business with profits of $100,000 would be worth $500,000 to a buyer who desires a 20% return. This value is said to be determined by a 5X earnings multiplier.
A CORPORATION SELLING STOCK VERSUS ASSETS
If the target is a corporation and the seller sells its stock, the seller’s gain, if any, will be long term capital gain, which has tax benefits. On the other hand, if the seller has a loss, it is a capital loss, fully deductible against capital gains, but the seller may deduct only $3,000 per year against ordinary income (the balance carries over to the next year).
A corporation that sells its assets must allocate the purchase price among the assets and will have taxable gain equal to the price of each asset, less its basis. Basis means cost with certain adjustments, such as a reduction for prior depreciation. If depreciation deductions have reduced the basis below the asset’s selling price, the seller has paper gain. Furthermore, f the corporation distributes the proceeds to shareholders, they will have taxable gain equal to the proceeds less their basis in the stock, so the gain will be taxed twice.
The buyer often benefits by buying assets instead of stock. For example, the buyer may begin depreciation anew, using the purchase price of each asset. In contrast, if you buy a corporation with fully depreciated assets, the price you paid for the stock does not entitle the corporation to additional depreciation.
There are nontax reasons for a buyer to buy assets, rather than stock. The buyer of assets may select only desirable assets and need not assume any of the business’s liabilities or contracts. The buyer of a corporation’s stock gets the corporation’s liabilities along with everything else.
On the other hand, there are some reasons for the buyer to buy stock. The buyer gets a corporation without the cost of incorporating. The buyer may not be able to individually obtain contracts as favorable as those of the corporation. The corporation’s existing tax situation may be desirable.
If the parties agree on an asset purchase, the tax law requires use of the residual allocation method. This method forces the buyer and seller to allocate the business’s purchase price among tangible assets according to their fair market values. A seller will want to assign less purchase price to assets with potential gain. However, the buyer will want a high purchase price on assets that qualify for depreciation, to increase the depreciation deduction. After allocating the business’s purchase price among tangible assets, buyer and seller must assign all unallocated price to goodwill and intangible assets covered by section 197 of the Internal Revenue Code.
The tax laws require the buyer to deduct certain intangible assets over a fifteen year period including goodwill, covenants not to compete, franchise rights and others. Goodwill is the tendency of customers to do business with your company rather than its competitors. The seller’s sale of goodwill results in capital gain.
HOW TO PAY
There are many ways to pay for a business purchase. The simplest and safest for the seller is cash. The buyer may borrow the money from the bank. An alternative is for the buyer to pay the price over time in installments with interest. In that case the seller can use the installment method under which the seller is taxed in proportion to payments received each year.
Another alternative is an earn-out, under which the buyer pays a down payment and bases the remainder of the price on business profits. This method is safe for the buyer, and yet it offers the seller a potentially higher purchase price if the business performs well. Tax wise, an earn-out is treated like an installment sale.
TIPS & TRAPS
My role in an acquisition is to identify possible dangers and opportunities in the deal and draft a clear, effective purchase contract. There are many more considerations here than I can cover in this article. To list a few:
When buying a corporation or LLC, real or potential liabilities to third parties, such as taxes owed are real dangers.
A seller’s agreement not to compete with the purchased business is legal only if it is reasonable in its time and geographic area. The seller is taxed when paid.
Most contracts call for warranties from both parties as to key facts. Personal warranties may be called for. Some contracts give the buyer the right to offset amounts against his payments to the seller if warranties are broken.
Notes and escrow agreements should be used to protect the seller until paid in full.
There are environmental liabilities are extremely dangerous..
An acquired corporation has limited use of prior net operating losses. A below market interest rate on an installment agreement may cause the IRS to treat the transaction as if imaginary interest is paid.. A corporation’s acquisition of another corporation may be tax free and may preserve tax benefits of the acquired corporation depending on how accomplished.
S corporations, partnerships, and limited liability companies present additional issues.
This article is far from complete. Don’t try to buy or sell a business without good legal, tax and accounting advice.