After you’ve sold your company, you’ll face the reality of having to pay capital gains tax on the proceeds, but there are ways to minimize these taxes. These methods can be discussed during the M&A process between the buyer and seller. In fact, the structure of the deal itself may be critical to help the sell-side business owner reduce their tax exposure. Ms. Meghan Jodz, Sr. Tax Manager at Grant Thornton, LLP, talks with Deal Talk’s Jeff Allen about a “Tax Shield” and how both buyers and sellers of businesses can work together to take advantage of improved tax efficiencies to minimize the amounts they have to pay the IRS.
Buyers these days are extremely sophisticated whether you're looking at private equity or corporate strategic buyers. They are looking for tax shield, they know what it is, and they're willing to pay for it.
- Meghan Jodz
Jeff: Let's talk a little bit first of all about how complex in fact the subject matter can in fact be and really those areas that business owners need to consider that the IRS is going to be looking at when they sell their companies - where the money is coming from that you're going to end up actually owing to the IRS.
Meghan: Sure Jeff, thank you. I don't think it's any mystery that taxes are incredibly complicated and a headache especially when it comes to business taxes. If you're thinking about selling, obviously you're going to have a huge gain hopefully that's showing up on your tax return. The IRS is going to be keyed in that something significant happened there. Given that taxes could be 25 percent, sometimes more than 40 percent, total tax liability is part of an economic outlay of the overall deal. It's extremely important to structure effectively for tax whether you're either the buyer or the seller.
If you're thinking about selling, obviously you're going to have a huge gain hopefully that's showing up on your tax return. The IRS is going to be keyed in that something significant happened there.
Jeff: In your position Meghan, I know that you probably consult with a number of business owners who have so many different questions, and the questions are different from business to business. And yet there may be some common concerns that all business owners may share. When you visit with a client or maybe you visit with that client's accountant, what are maybe some of the most common questions that typically come up, or things that you might have to remind them about? We don't need to go into a number of these but just maybe two or three common issues that are real concerns that you think business owners really need to be cognizant of in their tax preparation strategies?
Meghan: Sure. One of the things that come to mind is choice of legal entity. You might already have an ongoing business that's already in some type of legal entity and you really haven't thought about it from a tax perspective. But there are so many different types of legal entities and they're each taxed in a different way. And that becomes incredibly important especially when you're selling a business and it's important to the buyer who's buying that same business. Another important aspect is capital gains versus ordinary income. I mentioned the 25 percent rate. If it's a capital gains generally going to be taxed at 23.8 percent which includes the new Medicare tax. And that's just federal, that's not even including state. Ordinary income, if this pushes you into the top bracket you're starting out with 39.6 percent at the federal level, adding state taxes to it. So it's extremely important to understand whether you're going to have ordinary income or capital gains on any given transaction.
You might already have an ongoing business that's already in some type of legal entity and you really haven't thought about it from a tax perspective. But there are so many different types of legal entities and they're each taxed in a different way.
Jeff: Meghan, I've heard about the tax shield. I'm not even sure where I heard about the tax shield. I read a lot lately and I do understand though that this is something that can potentially benefit both buyers and sellers of businesses. What I was kind of hoping is you'd be able to talk to us a little bit about what it is and how it works.
Meghan: Right, thanks Jeff. Tax shield is something that's extremely important to buyers, and therefore it's important to you as a seller which we'll explain why later. Tax shield can come in many different forms but the primary form we're going to focus on today is tax basis. If you have tax basis in an asset, whether it be fixed assets, or goodwill, or intangibles you can depreciate or amortize that tax basis over time and save on cash taxes going forward. In addition you have a basis that you may have upon exit to the next owner, so it's something you can also offer down the line to the next person.
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Jeff: Meghan, to give us kind of a sense of how important the tax shield could be in a transaction, and again to both buyer and seller I know that you’ve probably had a chance to work very closely with a number of businesses who've been able to put this to use and investors have been able to put this to use. How much money are we talking about here? What kind of savings are we potentially talking about?
Meghan: Typically on most deals I've worked on a dollar of goodwill tends to be worth about 20 cents to the buyer, and that's on a net present value tax affected basis. For example the goodwill can be amortized over 15 years assuming a 40 percent tax rate and a 10 percent discount rate comes out to roughly 20 cents of tax benefit. That's something that you can offer to the buyer in addition to the economics they're already expecting out of the deal. And so the point there is let's not give that away for free. If they're getting 20 cents then why can't we share and have 10 cents of that benefit.
Jeff: Is the tax shield something that is currently being widely used from where you sit, just based on your experience and from what you know of the marketplace right now? Or is this kind of still a best kept secret?
Meghan: The tax shield is extremely well known by buyers. Buyers these days are extremely sophisticated whether you're looking at private equity or corporate strategic buyers. They are looking for tax shield, they know what it is, and they're willing to pay for it. Sellers are typically less aware of the tax shield which is why we're talking to you about it today, because it seems to be a buyer concept. But the point here is that why can't buyers and sellers share in that benefit and buyer can pay sellers a little bit more for that. And that's why it's important to a seller.
Jeff: From a buyer's perspective if I'm interested in a company and yet the seller doesn't appear to be aware of the tax shield, I'm interested in it. Can I ask or can I inquire of the buyer the tax shield? Is there something that we can do here that I can purchase this from you and we can continue to talk about this deal here? Because I'm interested obviously in saving as much money as I can, but as an incentive can I ask for that from the seller?
Meghan: Absolutely, and that gets into deal structure and the process from the beginning when they put their bid in. They may give you a bid for an asset sale which we'll talk about the differences later. They might give you a bid for an asset sale or a stock sale, and they may already have a tax shield baked in if it's an asset deal or deemed asset deal. Or they may frame and discussion with you early on in the process. But typically given that sellers are not very sophisticated when it comes to tax shield, typically buyers are probably going to assume that they're getting it. And so if they don't end up getting it throughout the negotiation process then they might penalize you for it. So I think it's just important to be upfront from the beginning as a seller and frame that discussion from the beginning of the process.
But typically given that sellers are not very sophisticated when it comes to tax shield, typically buyers are probably going to assume that they're getting it. And so if they don't end up getting it throughout the negotiation process then they might penalize you for it.
Jeff: Why are buyers so concerned? It seems to me that probably most of the out of pocket expenses that is most of the money that is coming out of this deal is going to be coming out of the hands of the seller in terms of the percentage taken from their gains, but why is it so important to buyers?
Meghan: Whether the buyer is a private equity firm, a hedge fund, or a strategic corporate buyer, everybody cares about getting cash tax savings. It's just overall a good thing. If it's a corporate strategic buyer they're generally going to be taking your business and blending it in with the rest of their business which hopefully both of those together are profitable enterprise. Any tax shield that they can get, it's going to save them real tax money out of pocket. It's going to make their business more able to grow, more able to make distributions, more money available to pay employees, etc. So it's just a good thing to have that cash tax savings. If you're a private equity firm you may not have that same cash tax savings immediately. But when you go and sell to the next buyer, that private equity firm also would have a base to step up that they can offer to the next buyer down the chain. So it's important to them as well.
Jeff: And so it really has kind of this interesting succession type of effect or what I mean by that is the benefit to the private equity groups really come in those transactions that are down the line in terms of the benefits that they receive really from this. Let's talk about the other side, the business sellers, the people who are listening to this program right now and really focused on what it is that you have to say, the benefit of the tax shield to them, why should they care?
Meghan: This is one of the very few situations in deals that actually can be a win-win situation. Let's just use an example and say there's goodwill in the transaction and you're able to structure effectively so that the buyer gets 100 percent tax basis in that goodwill. Generally on a net present value tax affected basis that's going to be worth 20 cents in value to the buyer. If you effectively negotiate, they're getting that benefit so hopefully they can share some of that benefit with you as a seller and pay you some more for structuring into that type of a situation. And if your company is in really high demand, this is just something, some juice to add to the deal to get the deal done, and also to make the seller hold for the step up they're giving.
Jeff: The tax shield itself in terms of what kind of companies and what kind of deals can qualify for this, how is that determined?
Meghan: I mentioned earlier that there are so many different types of legal entities and they're all taxed differently, and this is where it becomes extremely important in a sale context. The least efficient for allowing for a step-up or a tax shield would be stand alone C Corporation. It's just going to be too expensive, too cost prohibitive for the seller to give that tax shield to the buyer. There are some situations where it might make sense in a consolidated C-Corp group that might be doing a carve out or selling off a piece if they can take that money and reinvest it in another business sign - that might be effective. But general C-Corps are the least beneficial type of entity from this perspective. Moving on to S-Corps, you've probably heard of a section 338(h)(10) election which is extremely common. And that works, although when there's a seller roll-over that's really not tax efficient. The best type of legal entity is a limited liability company. That can be taxed three different ways actually upon election. You can either be a C-Corp, an S-Corp, or a partnership if you have the limited liability company designation. And a limited liability company that is taxed as a flow-through entity is an extremely effective vehicle for giving the tax shield to the buyer and getting paid for it hopefully, as is a partnership structure.
The least efficient for allowing for a step-up or a tax shield would be stand alone C Corporation. It's just going to be too expensive, too cost prohibitive for the seller to give that tax shield to the buyer.
Jeff: And we're going to maybe talk a little bit more about that in greater detail right now. You're listening to Deal Talk, my name is Jeff Allen. I'm joined today by Ms. Meghan Jodz, senior tax manager at Grant Thornton LLP. We're talking about a very complicated subject here. We're talking about taxes and the way that business owners can prepare in their deal discussions with buyers of their companies down the line and things that they can do perhaps to save themselves and the buyers money. And of course we're talking today if you're just listening in about a tax shield, and a tax shield can benefit both the buyer and the seller. We've got more details to share from Ms. Jodz when Deal Talk returns in just a moment.
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We appreciate our guest for joining us today too. Ms. Meghan Jodz, senior tax manager at Grant Thornton LLP. We're talking about the complicated subject of taxes with respect to deals and transactions involving those business owners who are just getting started in the process of selling their business to investors and how the tax shield can benefit both the buyer and the seller of a business. Meghan, it seems to me that I read somewhere that with the tax shield that a business owner can actually get paid for implementing the tax shield for this transaction. They're selling their businesses to a buyer, and they can get paid for it. Obviously it's protecting both sides but talk to us a little bit about this feature.
Meghan: Thanks Jeff, yes, you absolutely can get paid for part of it and this falls under the heading of effective negotiation. Really the process starts from the very beginning before you even send out the first presentation slide deck. What you need to do is really talk closely with the investment bank and the lawyers about this concept ahead of time and begin to frame a discussion around how much is this tax shield that you can offer the buyers. And this is where you really need to do your homework early to quantify how much this is worth to the buyers and know that in the beginning. One idea I have for drawing out a higher bid for this tax shield would be ask for bids for your company for either a stock deal or an asset deal. And that can be complicated what that means from a tax perspective. But suffice to say there are two different prices: typically for a stock deal where you're not going to get a tax deal, and an asset deal where the buyer is going to get a tax shield. You could start the process asking for those two different bid prices in order to draw out the higher price for the tax shield deal.
I would really encourage people to get away from the concept of gross up which is very common in a lot of the deal documents. What the gross up is it nearly makes you whole for the difference in tax you pay as a seller on a stock deal or an asset deal. In most of the deals I've worked on that difference is not that much although you're giving the buyer a huge benefit and you're not sharing in any of that benefit. The other reason to get away from the concept of a gross up is that it just sets you up for disputes between buyer and seller post-closing, sort of nickel and diming how much that gross up is. And the third thing is you're really not being grossed up because an asset sale is going to be more complex from a tax perspective and require more calculations and more forms to be filed. So you're really not being made whole by the gross up. I would just encourage you to talk to your invest bankers, talk to your lawyers very early about this concept so that they can help you negotiate a higher price for the tax shield.
Jeff: When you talk about starting early in the process how early are we talking about? If someone has in mind to sell their business within two years is that an early enough point in time to start the discussion on this?
Meghan: Absolutely, the earlier the better. Because going back to the discussion about the structure, if you're two years ahead of a sale and you're not in the right structure right now it may be possible to move into that right type of legal entity or type of structure to at least give at least some of this tax shield away effectively, at least the amount that's grown over the next two years or even more than that. Early planning is very important in any tax area but especially when you're getting ready for sale. And the other piece is having these calculations ready when you start talking to the investment bankers, is key as well.
Jeff: You had mentioned, Meghan, the business seller to ask for stock and asset purchase bid prices from each buyer in order to draw out the extra consideration. This may not be a question necessarily for you to answer but it's possible that I may have determined that one or the other is the best choice for me to make in terms of how I want to offer my company. Maybe it's strictly an asset-based sale that I'm looking for and I just want to get rid of everything, lock, stock, and barrel. Should I still be asking for stock and asset purchase, bid prices with regard to this or do I first have to just talk to maybe my business advisor to find out which sale is right for me?
Meghan: Jeff that is a really good question. Generally, all sellers are going to want to sell stock in order to pay the least amount of taxes and also get rid of all potentially liabilities associated with the business. And generally buyers on the other side they're going to want to buy assets not take on those liabilities and get their tax shield. So in that sense buyers and sellers are at odds. However, there are structures where you can have your cake and eat it too, so you can legally sell stock even though it's treated as an asset sale strictly for tax purposes so you can get the best of both worlds as a seller.
Jeff: Is this where I ask you, Meghan, is that kind of a subject for a different show? Having your cake and eating it too with regard to ...
Meghan: Yeah, that could be a subject for another show.
Jeff: Okay, then we'll go ahead and we'll hold off right there because it sounds like that could actually get kind of complicated and that discussion warrants it.
Meghan: Yeah, that's extremely ...
Jeff: Okay, very good. What about management roll-overs, let's talk about that a little bit, benefits or concerns, or key points of interest there?
Meghan: Right. When you talk about roll-overs there's really two categories. There's the equity owner of the business. If that person is maintaining equity in the business going forward post-sale that's one thing. But the other thing is whether there's management that may not be an owner of the company currently but they may get ownership in the new enterprise going forward. Those I refer to as a roll-over. Those can get very complicated from a tax perspective and it's extremely important to structure those properly and I'll just give a quick example. A lot of people are familiar with the S-Corporation 338(h)(10) sale which is a stock sale that's treated as an asset sale for tax purposes.
Let's just do an example. Let's just say the founder owns 100 percent of this S-Corporation and is going to sell 80 percent and continue to own the remaining 20 percent going forward, and participate in management, and continue to grow the company so that ultimately they'll get even more for the remaining 20 percent. If you do the 338(h)(10) transaction 100 percent of the gain in the corporation will be triggered. And so that's really not effective from a tax perspective to pay tax on the 20 percent that you're not selling. That's just a simple example of where it's so important to structure properly for either management roll-overs or owner roll-overs. And the only other thing I'll say about management roll-overs is while you as an equity owner may not be directly impacted, we all know that businesses are run very well by happy management teams. And so if you're slugging your management guides with a huge amount of tax or an inefficient tax transaction they may not be too happy going forward and it may be pretty difficult to keep them engaged in the business and continue to grow it and succeed.
Jeff: Meghan, as we kind of start to run a little bit short of time here on what's left here on our program I'd like to go ahead and find out from you if there are any real key take aways, just some real quick, short elevator take aways you can leave with our audience today, those folks who are currently in discussions right now maybe with their business advisors or maybe with valuation consultants, they're thinking about selling their business. Maybe they already have a target investor in mind looking at their company. But they want to find out more about this tax shield and maybe what it can do for them. Just some important key tips, pieces of advice, those companies listening that they might be able to learn from right now.
Meghan: Thanks Jeff. Everybody knows taxes are a headache and you've probably heard enough here that your head's already aching. My key take away is really don't leave taxes until the end of the deal process. Tackle the tax situation early even one or two years before you're even planning on selling. Get some good tax advice so you make sure you're structured properly. Make sure you can frame up this discussion on the tax shield, and really get the most out of the deal from your perspective that you can.
Jeff: Meghan, if we have any business owners currently listening to this program and they'd like to find out more about it, we talked about a lot of things kind of in rough and gave some brief or basic sketches of what exactly the tax shield is. But they’d like to find out how it can actually help them in their particular situation, what can they do? Even business buyers for that matter, how can they reach you?
Meghan: Thanks, Jeff. You can reach me in Philadelphia at 215-376-6065, I'd be happy to help you.
Jeff: Thanks very much. Meghan Jodz, we appreciate your time. It's been a pleasure having you today on the program. Hopefully we can have you back on Deal Talk soon.
Meghan: Thanks a lot, Jeff.
Jeff: Ms. Meghan Jodz, Sr. Tax Manager at Grant Thornton LLP in Philadelphia, Pennsylvania. We hope you enjoyed the discussion.
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