Tax Rates are Rising! This article highlights the imminent changes to the tax laws in 2011 (e.g., the sunset of the Bush era tax cuts) and changes that will arise in later tax years (e.g., tax provisions contained in certain parts of the recently enacted health care legislation) that may affect a decision to sell your business this year. When business owners contemplate the sale of their business, typical initial questions include where to start, what types of activities are required, and how to negotiate the sale process. In addition to exploring various tax issues that will drive some business owners to sell their businesses in 2010 as opposed to selling in later years, this article outlines many of the steps a business owner should consider to prepare his or her business for sale. These steps include the sale process, the evaluation of a purchase offer, the importance of a confidentiality agreement, the role of a letter of intent, structuring a transaction, and the sale documents that “close” a transaction. Because every transaction is different, the general principles provided in this article must be adapted for your particular business and industry.
LOW TAX RATES – ALMOST A THING OF THE PAST
Capital Gains Rates. In 2010, long-term capital gains are generally taxed at a 15 percent rate. This 15 percent rate is set to expire on December 31, 2010 and, after that, long-term capital gains will revert to a rate of 20 percent. If a seller closes a transaction in 2011 instead of 2010, the seller will generally pay at least 33 percent more in capital gains taxes due to this tax increase. Some people even believe that Congress may seek to impose a retroactive tax increase in an effort to capture sales in 2010. While no one can predict the future, business owners who are debating whether to sell the stock, limited liability company membership interests, or partnership interests of their business may conclude it is better to consummate a sale sooner rather than later.
Ordinary Rates. In an asset sale transaction (as distinguished from a sale of stock), the gains from the sale may, at least in part, be taxed at ordinary income tax rates. Ordinary income is currently taxed at a maximum rate of 35 percent. However, on December 31, 2010, this rate will also expire and rise to a maximum rate of 39.6 percent.
S Corp. Issues. In addition to the items mentioned above, business owners holding assets in an S-corporation have another potential tax advantage if they sell their business assets in 2010. Generally, owners of an S-corporation, who previously converted their S-corporation from a C-corporation, have to hold the assets of that business for a 10-year period in order to avoid a tax on any built-in gain in the assets of the business that existed at the time of conversion. (Essentially, if the owner of an S-corporation sells the assets of their business before the end of the 10-year holding period, their ability to take advantage of a single level tax at the shareholder level (as opposed to a tax at the corporate level and the shareholder level – the so-called double tax) is hampered.) In 2010, the 10-year holding period is shortened to a 7-year holding period, but the asset sale must be closed by December 31, 2010 in order to take advantage of this shortened holding period.
Future Taxes. Other new taxes come into effect over the next several years as a part of the recently enacted health care legislation. The newly enacted Medicare tax on unearned income (which is effective January 1, 2013), imposes a 3.8 percent tax on the lesser of (i) net investment income or (ii) the excess of modified adjusted gross income over $250,000 (for joint filers). This new tax may pick up all or part of the proceeds of a stock or asset transaction (depending on an individual’s tax situation) and increases the effective tax rate by 3.8 percent (on top of the higher effective tax rates that will take effect on January 1, 2011). The exact application of this new tax will be dependent on the form a transaction takes, the type of business entity, and the taxpayer’s other sources of income in the tax year in which the sale occurs. Although this new Medicare tax does not take effect until 2013, the upcoming increase in taxes and new regulations imposed by the recently enacted health care legislation (e.g., penalties for not providing minimum health coverage, excise taxes on high-cost, employer sponsored health care plans, and new reporting requirements) provide additional reasons for considering closing a sale transaction by December 31, 2010 – not only will taxes increase in 2011, but taxes will go up even further in the following years.
PREPARING YOUR BUSINESS FOR SALE
Pre-Sale Diligence. When preparing a business for the sales process, it is important to involve accounting, tax, and legal professionals early in the process. Under certain circumstances, it may also be advisable to engage the services of an investment banker or business broker. Early involvement of these professionals can save a business owner time and money by pointing him or her in the right direction with respect to what issues are most and least important from a buyer’s point of view. Additionally, professionals can help manage expectations (e.g., what is the market like for a sale and what purchase price and net after-tax proceeds can I expect for my business?).
One of the first and most important steps a business owner must take is to organize the minute books and corporate/partnership records of his or her company and make sure that these records are accurate and current. These are among the initial items a potential buyer will request. While organization is a simple task, many privately held businesses are not well-organized from a corporate records standpoint. Poorly kept corporate records create a bad first impression and may adversely affect the business valuation. Also, it is important to put together a due diligence “book” that contains a business owner’s vendor and customer contracts, employment records, business licenses, financial and tax records, and other important items particular to a business owner’s industry. Because this type of information typically is critical to your business, it is important that your attorneys draft and obtain from third parties appropriate confidentiality agreements before providing any information to such parties. Additionally, depending on the identity of the recipient (e.g., is your potential suitor a competitor or is it a financial buyer), care should be given as to what information should be initially disclosed versus being disclosed later in the process. A business owner may also want to convert these and other due diligence documents into a digital format (e.g., transferring the documents onto a CD or another format) as this step will ease the dissemination of materials to potential purchasers.
Another seemingly easy, but often overlooked, item to address is to make sure your business entity is in “good standing” in the jurisdiction where it was formed and in all jurisdictions where it is required to be qualified. If your business entity is not in good standing, take immediate action to cure missing filings or payments to return your business to good standing. Again, if your business is not in good standing when a prospective buyer checks, it creates a negative impression that will adversely affect the potential buyer’s view of you and your business.
Determining Pre-Sale Goals. Another item to consider in connection with the sales process is the list of goals you hope to accomplish. To quote an apt old expression, “If you do not know where you are going, you will surely get there.” One can accomplish many goals with a sale of a business—retirement planning, estate planning, and business succession planning to name a few—and it is wise to outline these goals in advance of the sales process.
Of course, one of the most important goals is obtaining the desired sales price for your business, but it is not always that simple. Your tax professional can help you take into account net after-tax dollars and potential increases in tax rates that may affect the timing of when you want to sell your business in order to minimize the government’s share of your sale profit. Additionally, the structure of the transaction—e.g., asset sale, merger, or stock sale—has both tax and legal consequences and should be examined and discussed early in the process in order to help manage expectations and increase the likelihood of achieving your goals.
Your professionals can also help you with pre-transaction financial and estate planning. Planning vehicles, ranging from simple gifts to family members to Grantor Retained Annuity Trusts (GRATs), can be utilized to sharply reduce the government’s share of your sale proceeds and to plan for your family’s future.
Because your business is unique, many of the issues you will encounter during your preparation for sale and the sale process will also be unique. Your professionals will help to guide you through the process, including communicating to potential purchasers the unique aspects of your business. No two sales or purchases are alike. Your professionals can help you analyze these and other issues in greater detail and blend them with your business and financial situation, which will ultimately determine how you should proceed.
INITIATING THE SALE PROCESS – THE LOI
When a business has located a potential buyer and is presented with a purchase offer (sometimes referred to as a letter of intent or “LOI”), many issues arise from that offer, including (i) the necessity of entering into a confidentiality agreement, (ii) the evaluation of the purchase offer, and (iii) the navigation of the due diligence process.
When presented with an offer for the purchase of your company, it is critical to consider both the overall financial terms, as well as the other terms of the offer (e.g., indemnification obligations, financing contingencies, conditions to closing, and non-competition issues). These other “non-financial” terms, if not properly drafted, can severely reduce what might otherwise appear to be an acceptable financial arrangement. An offer to purchase your business should be in writing. There are many benefits to having an LOI. First, an LOI memorializes what the potential buyer has told you and/or what you have discussed. By memorializing these initial discussions, it can help minimize misunderstandings (as we have all experienced, people sometimes hear things differently from how the speaker intended to convey them). Second, an LOI should outline many aspects of the transaction, such as details about the financial aspects of the offer (e.g., an all cash offer, partial payment with a note or stock, an “earn-out,” etc.). It is also important to consider which aspects of an LOI are “binding” and which are “non-binding.” An LOI often outlines the indemnity terms a buyer will require from the seller, the representations and warranties concerning the business to be sold that the seller will give to the buyer, financing contingencies, and other terms of the transaction. Memorializing an offer into an LOI also helps a business owner compare one offer to purchase against another. For example, one offer may provide more money overall with an earn-out contingency payment, while another offer may provide less money overall, but because the up-front cash is more certain (e.g., initial cash payment), the second offer may actually be more favorable. Finally, an added benefit of an LOI is that it may also create momentum if a prospective buyer is waffling on a potential transaction.
Many buyers find it strategically useful to address certain negotiations up-front in an LOI as opposed to waiting to negotiate them later (and potentially come to an impasse) in the documentation stage. A well drafted, detailed LOI can save a great deal of time, transaction expense, and exasperation at the “definitive agreement” stage. On the other hand, an ambiguous LOI may lead to litigation and can make it difficult to sell your business to a different buyer (e.g., Was that previous LOI non-binding? Did it terminate completely?). It is important for the seller to find out early in the transaction whether the potential buyer and seller have an understanding about the essential aspects of the transaction.
This information is an asset and needs to be protected. Insisting upon a well-crafted confidentially agreement before sharing any sensitive information will help protect this information in case the transaction is not ultimately consummated. Your legal professionals can help you evaluate and/or draft a confidentiality agreement tailored to your particular transaction.
THE DUE DILIGENCE PROCESS
Once a buyer and seller have executed an LOI and confidentiality agreement, the due diligence process will begin. A buyer will want to see your minute book, vendor and customer contracts, employment records, business licenses, financial and tax records, and other important items particular to your business, and may present you with a due diligence list requesting other items. You may want to consider discussing these requests with your legal professional as you may not want to turn over certain items until the transaction has progressed to a certain point (e.g., information can be released in stages as the transaction progresses in a manner satisfactory to you). Your legal professional can discuss the pros and cons of disclosure with you and ways to protect the business if the transaction does not close or the potential buyer misuses the confidential information.
During the due diligence process, other items relating to the sale process are often proceeding on a “parallel basis.” The buyer and seller often begin honing the details of the structure of a transaction and preparing the sale documents.
STRUCTURING AND DOCUMENTING THE TRANSACTION
Stock Purchase, Asset Purchase or Merger. The sale of a business often takes one of three basic forms—a merger, “stock” purchase, or asset purchase. The structure of a transaction may result in very different tax effects on both the buyer and the seller (and these tax consequences may be different depending on whether your business is a C corporation, S corporation, partnership, limited liability company, or other form of entity). It is important to consult your tax and legal advisors early in the sale process to address these issues. Sellers will generally prefer a stock sale or merger over an asset sale for several reasons, including the ability to transfer the liabilities of a business and to potentially take advantage of the lower tax rates on capital gains that may result from a stock transaction, as opposed to an asset transaction. Furthermore, a stock transaction is sometimes administratively easier than an asset transaction in that many contracts of a business may contain prohibitions or restrictions on assignment to a buyer in an asset transaction. In a stock transaction, because the contracts stay with the business, permission to assign a contract usually is not required. On the other hand, permission may need to be obtained to transfer a contract in an asset transaction when that contract is “transferred” to the buyer. Additionally, in a stock transaction, it may not be necessary to apply for new licenses upon the sale of a business, while it is more likely to be necessary to obtain new licenses in an asset transaction. The operative documents in a stock transaction will be outlined in a stock purchase agreement and typically include disclosure schedules; these will detail specific issues affecting your business. By disclosing these items, you may be able to avoid liability to the buyer for problems that may occur in the business following the sale. Your advisors will explain these issues in greater detail. Additionally, employment agreements, non-competition agreements, and consulting agreements are common for a stock purchase transaction.
Tax-Free Reorganizations. If both the buyer and seller are corporations, the parties may consider engaging in a tax-free reorganization if part of the purchase price is stock of the buyer. These types of transactions are governed strictly by statutes and regulations. Your legal and tax counsel can explain whether this is an option for your transaction and whether the net after-tax economic results are better for you.
Liability Assumption in an Asset Sale. Buyers will generally prefer an asset transaction for several reasons, including the potential stepped-up cost basis in the purchased assets, the ability to “cherry pick” the assets to be purchased, and the ability to avoid assuming all or some of the liabilities of the business being sold. The operative documents in an asset sale will be outlined in the asset purchase agreement, but usually include an asset purchase agreement, a bill of sale, disclosure schedules, and may include consulting and/or employment agreements for the selling owners of the business.
Indemnification. One of the most important issues for a seller to negotiate in a transaction, whether stock or asset sale, is the indemnification provision. An indemnity provision is an agreement where the seller agrees to protect (or “indemnify”) the buyer from certain liabilities, events, or occurrences. Generally, a seller of a business is asked to indemnify a buyer for breaches of warranties or representations in the purchase agreement, certain pre-closing liabilities of the business, and other aspects of the business that may be unique to the transaction. As important as the language of the indemnity is the “cap” set forth in the indemnity provision (i.e., the limit on the amount the seller could have to reimburse the buyer). This amount can range from a percentage of the purchase price to an unlimited amount. Without a “cap,” one could sell his or her business and actually owe the buyer more than the purchase price if representations or warranties are breached (i.e., you could end up paying someone to purchase your business!). Your legal counsel should help you negotiate this part of the transaction and the language in the ultimate purchase agreement, but many people elect to negotiate these terms up front in the LOI so no surprises arise later in the process.
This article presents a broad overview of upcoming tax law changes and the process of selling a business. Each business is different and, as a result, the issues faced will be unique to that business. We have highlighted issues generally applicable to the sale of a business and areas of concern raised by potential sellers and buyers. Please call us with any questions.