M&A Deal Structure: Tax Considerations

M&A Deal Structure Tax
November 18, 2021

Private equity has made strong moves into the architecture and engineering (AE) industry. This interest, combined with the fear of a long-term capital gains rate increase, has the merger and acquisition market hotter than ever before. But before you start counting the zeros, let’s talk about what’s on every Seller’s mind, second only to the purchase price, taxes. Conducting thorough tax due diligence early in the M&A process can help drive the structure and purchase price negotiations and identify potential deal-breakers.

How Much Is This Going to Cost Me?

In general, there are two options to consider when structuring an M&A transaction. Both types deliver their own unique tax benefits that have different appeals depending on whether you are a buyer or a seller.

Buyers typically want an asset purchase for the tax deduction of amortized goodwill. In contrast, Sellers typically desire a stock sale to preserve long-term capital gains treatment. Let me introduce you to the 338(h)(10) tax election to meet somewhere in the middle. A stock sale is treated as an asset sale solely for tax purposes through this election. However, although it’s a good start, one tax election does not magically solve all the potential tax issues that a merger or acquisition may face. An item to note, the 338(h)(10) election is only available to entities taxed as an S-Corporation.

In general, there are two main areas of tax to consider in a transaction, the Seller’s deferred tax liability related to cash basis tax reporting (a potential deal-killer), and the tax due from the actual transaction.

As a Seller, your best approach to deferred taxes is through education because there are options to consider when determining the best tax strategies for your specific situation. Tax will come due through an accounting method change, an S-election revocation, or a deemed liquidating distribution into another entity not eligible for the cash basis of reporting for tax purposes. If it sounds complex, well, that’s because it is. We strongly encourage you not to go it alone. Your CPA can help you calculate this tax well before any sale effort.

Another tax consideration is that pesky Net Investment Income Tax (NIIT) of 3.8%. Is your AE firm ownership considered an investment that, once sold, will trigger the tax? Most likely not, if you receive a W-2 from the entity and materially participate and it’s your “trade or business” source of income. In addition to other tax considerations, we cover this in our on-demand webinar, M&A Deal Structure through a Tax Lens.

Structuring M&A Deals around Tax

Proactively structuring a transaction for tax efficiency and maximum benefit is critical. Most M&A deals have at least some seller financing, even when private equity is involved. Seller financing means a note is used as one form of payment. Some deals also have an earn-out provision or paid-out performance metric as an additional purchase price. Installment sale treatment is available for both options to prevent the Seller from paying tax before cash is received.

These are just some tax considerations that should be part of your transaction planning process. Watch our on-demand webinar, M&A Deal Structure through a Tax Lens, where we compare/contrast deal structure options as they relate to tax treatment and how to maximize tax benefits.

Jen Nelson, CPA - Stambaugh Ness