Demystifying tax issues in small business M&A

Welcome to the sixth installment of our Private Market Insight series, where we curate technical advice from experts across the industry to serve buyers engaged in the Small Business acquisition process. Today, we’re talking with Diana Oprescu Stoica, who is a Senior Manager at PwC, focusing on tax. She has seen hundreds of M&A transactions during her career and is here to share her knowledge about tax issues that might come up in M&A transactions.

Diana is based in San Francisco and has been doing tax for about 11 years now. She started her career in Romania and transferred to the US a few years ago, so her experience is a mix of European and US tax law in her current role. Throughout her career, she has been focused on international M&A tax, advising private equity funds and corporate clients on the tax aspects related to a deal. She engages in the deal process throughout the entire life cycle, doing the tax due diligence, structuring the transaction, and also providing input on the legal documentation. 

Tune in to the latest episode and learn more about asset vs stock purchases, things to look out for in due diligence and why the way you structure the deal might put the buyer or the seller at an advantage, from a tax liability perspective:

Start the acquisition process with taxes in mind

Especially in the beginning of a business, taxes setups are pushed down on the priority list, but tax becomes very important when working on attracting an investor or acquirer in their business. This is because, when you acquire a company, you inherit their entire tax history and become liable for the “sin of the past”. The IRS can assess tax liabilities for a company all the way back to three years from the due date of a tax return. 

As a buyer, you can become liable for tax exposures or for IRS’s tax assessments that are related to a period when you weren’t the owner of the company. That’s why it’s really important to do tax diligence with an expert and evaluate the risks, as well as put in place protections before closing on the deal (reps and warranties, for example). 

As an owner selling a business, it’s important to be prepared for the acquisition and know the tax profile, the tax function and the tax exposures that can come up during a negotiation because this can impact the purchase price a buyer will be offering. 

Tax due diligence at a glance

Like with most things part of the M&A process, this is also a “meet me in the middle” negotiation. On a deal, the interests of the buyer and the seller are divergent – both want great outcomes for themselves. So with tax indemnities, it’s no different. The buyer and the seller need to figure out what can be negotiated and what are the risks that one can assume and what needs to be properly protected. For example, a lot of companies which are in the scale-up phase are in a tax loss position. So from a federal income tax perspective, there aren’t a lot of tax risks tax exposures that can occur there. If there’s a profit being made, then there’s a different conversation. Another example is for sales tax exposure, where it might be worth getting an indemnity for a cash tax leakage down the line. 

The big tax structuring question: stock sale vs asset sale:

TL;DR – it’s a big difference from a tax perspective and it’s different from buyer to seller. If you’re doing a stock sale, the buyer inherits all the tax risks of the entity acquired. Therefore a stock sale is more favorable to the seller and less favorable to the buyer. In an asset acquisition, by contrast, the buyer only inherits the non-tax liabilities, like sales tax, for example, or other transfer/transactional taxes. Income taxes are not passed over from the seller to the buyer. The asset sale is more favorable to the buyer because it limits its tax exposures. 

Another important difference here between asset and stock sale is the actual tax implication on the transaction. From the seller’s perspective, a seller would generally prefer a stock sale because they can get capital gains treatment on the proceeds of the sale. And this is taxed at the preferential tax rate, long term. On the other hand, if you’re doing an asset sale the income from the sale of those assets is treated as ordinary, usually meaning higher rates. Individual situations apply here, so please work with your tax expert to determine the best path for you. A buyer prefers acquiring assets because it gets a “step up” on the basis of those assets, which means that they can deduct the cost that they are paying for those assets and reduce your future tax liability. 

For real estate it is also important to consider transfer taxes because whenever real estate gets transferred, it would trigger real estate transfer taxes. 

Structuring transactions

To make sure that you’re properly structuring a transaction, you first have to be clear on what type of entity you’re buying: a corporation, an LLC, a partnership or some other type of organization. It’s important to know exactly what you’re buying because, for example, LLCs and partnerships are tax transparent entities and buying an interest directly in those kinds of entities would mean that the income of the LLC / partnership would flow up to the buyer. With a corporation, a tax opaque entity, the tax liability does not flow up to the buyer. 

If you don’t want the tax revenue or losses to pass on to yourself, then you should consider blocking the income to reach your personal level. You may consider blocking the income at the corporation, and then you only pay tax on that income when the corporation passes on the income to you, as a shareholder. On the other hand, like if you’re buying a corporation, things are more simple. It’s basically sheltering the income and losses of the corporation from those of the individual. Or are you planning to grow the business and do some add-on acquisitions, for example, then you could either roll them underneath the target company that you’re acquiring now or consider having both entities underneath the same holding company. 

Another important question would be what’s the long term plan. Commercially, is it the plan to hold the entity for a while and then sell it or is the plan to grow the business and get cash repatriations from the entity? All these kinds of considerations make small tweaks to the structure in order to accommodate the commercial objectives and tax is never the driver and should never be the driver in a transaction. It should only be something that makes the commercial objective more efficient and drives value to the transaction. 

Structuring is something that is really tailored to the commercial objectives of each investor. You could be having co-investors, and those co-investors could be non-US residents, for example, and in that case you most definitely would want to block the income for them, so they aren’t considered residents for tax purposes. 

A holding company is less important if you’re buying a profitable corporation and you just want to invest in that and then hold it for a while, grow it, and then sell it. Adding two layers of corporation could mean double taxation because you’re adding in another layer of tax. When you distribute dividends from a corporation then the second corporation on top would be paying tax on that income. 

Most common tax red flags

For some of the smaller companies you would tend to see issues like potential expense deductions risk, for tax purposes, when the owner isn’t actually allowed to deduct the expenses that aren’t necessary and ordinary in the course of the business. There could be other issues when it comes to contractors and how you’re rewarding the founders, the shareholders.

And then as the company grows and starts to expand its footprint, people can lose track of where their tax footprint is. Then you need to look at where the company has assets, employees and revenue to assess whether that company can be taxed in that jurisdiction or not. 

Bonus: International remote workers

If the target company is working with many international contractors that could trigger international tax exposures across multiple jurisdictions. With people on 1099s, not only you need to verify if that person is truly an  independent contractor, but also where they contract from.  If there are issues there, you could be liable for employment tax, payroll, tax issues in that jurisdiction. And then even if that person is a contractor, you could be exposed to tax in that jurisdiction. With employees it is even trickier, since having one or two employees in a foreign jurisdiction, then it’s probably time to set up an entity there and pay  local tax, even if the exposure itself would not be high. It’s also important to consider tax early on in the process and think about it, even if it’s just to conclude that it’s not really material enough in the context of the deal that you’re considering, but it really plays a lot only to, to consider tax and how, how tax can impact the, the investment you’re you’re planning.

Be sure to check out the full episode for more details on each of the topics we discussed with Diana. Our goal is to ensure that entrepreneurs have access to the services and knowledge they need as they evaluate SMBs as part of their acquisition process. Tune in to our next episode on our Twitter Spaces every month, ask questions and let us know what topic and/or guest you would like us to bring to the next conversations.

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