Our Role as a CPA in Helping Our Clients Handle Mergers and Acquisitions

I want to dedicate this article to my wife of 50 years, Christine, who is going through some medical issues. While sitting in the hospital room with her, Christine suggested “why don’t you write an article.”

I hope you find this both interesting and helpful..

I hope I am not too late in writing this article, as I suspect mergers and acquisitions have slowed due to the rise in interest rates. I have been in practice for over 50 years. As such, I have been involved in many both sales and acquisitions. In the sales of corporations (including S corporations) the seller wants to sell stock, while the buyer wants to buy assets. That puts them at cross purposes and is where we can help our clients. If the buyer purchases stock, any premium paid will be locked in the purchased stock. The only time it can be released is on the sale of the stock. The other issue with purchasing stock? The buyer is stepping into the place of the sellers, and all the liabilities - known and unknown.

If our client is the seller then we want to make sure the purchase price reflects the additional tax on the sales of assets. If your client has unused net operating loss a sale of assets can help both buyer and you client. You will need to calculate how much recapture you can offset with the NOL. The same is true for S shareholders with suspended losses. Sometimes you can have a hybrid deal where the buyer and seller agree to making an IRC Section 338(h)(10) which is a deemed sale of assets with sale of stock. I have seen less of this in recent years. Just remember, this election is a corporate-to-corporate election including S corporations. In computing your clients don’t forget to include timing items especially the reserve for bad debts that will give you additional tax basis.

Unlike the sale of stock, the sale of a partnership interest can cause a portion of ordinary income due to depreciation recapture and unrecognized income in the case of cash basis. Your client will have similar issues as the asset sells. Your role as representing the selling client is to mitigate the depreciation recapture in the purchase price allocation. The second item is to negotiate the allocation to noncompete clause in the agreement. The noncompete is tax neutral to the buyer but ordinary income to the seller. Pushing as much to goodwill will increase your client’s capital gain. Often there is a portion of the sales price held in escrow over into the next tax year. This will create an installment element from the deal, so do not forget to installment treatment in the client’s individual tax return.

The reverse is true if you client is the buyer. You want as much to assets such as accounts receivable, inventory, and fixed assets. The rest of the purchase price will default to intangibles amortized over 15 years. I have used the allocation to noncompete as a negotiation tool in the purchase price allocation as it is a 15 year intangible if noncompete or goodwill. I prefer to have our client file the IRS Form 8594 to insure the allocation of the purchase price is what was agreed to by the parties. If this is not possible, require that your client has the right of review before it is

The recent acquisitions I have been involved in require a percentage of rollover equity. I tell my selling clients to discount the value the rollover equity stated in the sales document as if it was valued at zero and only consider the cash in the deal in their decision making. If in the future their rollover equity pays out it will be a bonus. If the client is offered future stock opinions, don’t forget to consider making an 83(b) election if the per-share basis is low or zero.

The issue with rollover equity is to not inadvertently make it taxable. As a rollover equity it takes that percentage of ownership into the new entity at a carryover basis and not taxed until disposed. The rollover of a proprietorship or partnership interest is easy to accomplish tax free but is not as simple if a corporation. In a C corporation the buyer will normally take over the stock and exchange for stock of the buyer’s entity. This is considered under the reorg section of the code and is not taxable until the stock received is sold.

The sale and rollover of S stock is a little more complicated, but far from impossible to get to similar results of the sale of a partnership interest or C corporation. The issue comes up when the buyer is not a qualified S shareholder which 100% of the deals I have been involved in. To make this more relevant, I will use my most recent sale rollover of one of my S corporate clients.

My S corporate client approached me stating they had been approached by a buyer and needed my help. I first prepared what the expected gain would be and the tax results. This is the most important first step for your client. The client continues telling me that the buyer wants my client to rollover 40% of his ownership in the buyer’s new entity. I know from the buyer’s entity that the buyer is not a qualifying S shareholder.

As typical with sales I have worked one the three years, this buyer wants an asset sale.

The buyer is an investment partnership as such they want my client to convert to a LLC to get a step up in basis for any premium paid. Converting my client’s S corporation directly into the required Limited Liability Company structure would create a taxable gain on the 100% gain based on the offer price. This includes the 40% rollover that our client still owns and a less than happy client.

This is not a time to panic! There is a solution to this problem and the reason why I am writing this article. The solution is a very powerful tool to have in your tool box. I have helped clients both as buyers and sellers. The solution involves the use of an F Reorganization. The secret is to keep in corporate solution which is why the F reorganization comes into play. The steps need to be done prior to the sale.

The first step is to set up a new corporation and make an S election filing Form 2553. This will now be referred to as S Holding. After this has been accomplished the shareholders of the operating S contribute their stock in operating S to new S holding in exchange for S holding stock. S Holding will then make a QSUB election for S operating by filing Form 8869. This move prevents the S election of operating to terminate due to ownership by a nonqualified shareholder.

Now S operating is a disregarded entity under S Holding by the QSUB. Waiting about three days, the final step can be accomplished. As a disregarded entity the Regulation states in essence that a QSUB or a SMLLC are the same. S operating is then converted into a SMLLC either through merger into a new SMLLC under S Holding or by a state conversion from a corporation into a limited liability company.

The IRC Regulation 1.1361-5(b) Example 3 the conversion to the LLC uses a merger. I always like to follow the letter of the Regulation as a safe harbor. I can tell the majority of sales I have been involved with have used the state conversion route to covert the QSUB into a LLC. This is true when the FEIN preservation is of paramount importance. The risk of not using the merger step is that after the QSUB election operating S is a deemed corporation making the conversion to the LLC taxable on the deemed contribution to the LLC. I believe it is looked as a deemed liquidation & contribution to the LLC. I have been told by someone more expert than I that the IRS will not challenge the state conversion method and in the case of there is a merger S operating’s FEIN will survive the merger.

I have been involved in a number of deals where the buyer required a change in domicile, such as to Delaware. It includes addition steps by the attorneys to accomplish the change in domicile, but the tax result is the same.

Now, as a SMLLC former S operating can sell membership units to the buyer. Making the 754 election the buyer will get the required step up and you client can roll his interest into the buyer’s entity tax free. This is true because the rollover units are still in corporate solution under Rev. Rul. 99-5.

There is an optional step where retaining the FEIN is important I do this for both mergers and state conversions. I file Form 8832 with the entity unit requesting that the FEIN from S operating Inc. be transferred to former S operating LLC. I put in language that it was due to a F Reorganization and provide a copy of the merger/conversion paper from the Secretary of State.