Tax Strategies For Selling Your Company
By David Boatwright and Agnes Gesiko
Latham & Watkins LLP

The tax consequences of an asset sale by an entity can be very different than the
consequences of a sale of the outstanding equity interests in the entity, and the use of buyer
equity interests as acquisition currency may produce very different tax consequences than the use
of cash or other property. This article explores certain of those differences and sets forth related
strategies for maximizing the seller’s after-tax cash flow from a sale transaction.

Taxes on the Sale of a Business


The tax law presumes that gain or loss results upon the sale or exchange of property.
This gain or loss must be reported on a tax return, unless a specific exception set forth in the
Internal Revenue Code (the “Code”) or the Treasury Department’s income tax regulations
provide otherwise.


When a transaction is taxable under applicable principles of income tax law, the seller’s
taxable gain is determined by the following formula: the “amount realized” over the “adjusted
tax basis” of the assets sold equals “taxable gain.” If the adjusted tax basis exceeds the amount
realized, the seller has a “tax loss.” The amount realized is the amount paid by the buyer,
including any debt assumed by the buyer. The adjusted tax basis of each asset sold is generally
the amount originally paid for the asset, plus amounts expended to improve the asset (which
were not deducted when paid), less depreciation or amortization deductions (if any) previously
allowable with respect to the asset. Taxable gain is generally decreased, and a tax loss is
generally increased, by transactional costs and expenses paid by the seller.

Ordinary vs. Capital Gains and Losses


The character of a taxable gain or loss can be vital in determining the amount of tax due
upon the sale of corporate assets. Gain can be classified as ordinary income or capital gain. Gain
upon the sale of assets that are characterized by the Code as “capital” is capital gain. The sale of
a capital asset held for more than one year creates long-term capital gain and is, for sellers other
than so-called “C corporations” (i.e., corporations for which an election to be subject to
subchapter S of the Code has not been made), taxed at a much lower tax rate. Currently, this rate
is less than half of that applicable to ordinary income. If a taxable gain occurs from a capital
asset held for less then one year, it is a short-term capital gain, which is generally taxed like
ordinary income.


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C corporations are subject to identical federal income tax rates on their ordinary and
capital gain income, so the character of a C corporation’s gain is often irrelevant. However, the
capital losses of C corporations still may only be offset against capital gains, and such losses are
also subject to far more restrictive carry-back and carry-forward provisions than are ordinary
losses. So, if a C corporation has excess capital losses during a taxable year (or capital losses
which have been carried forward from an earlier year), the corporation may prefer capital gains
over ordinary income, because the excess capital losses may be used to offset the capital gains
(but could not be used to offset ordinary income).


It is usually very important (and, in most instances, required) for the seller and buyer to
agree upon an allocation of the sales price among the assets being sold, as such will determine
the character of the gain recognized by the seller and also will determine the amount of sales, use
and other transfer tax liabilities arising from the sale (which are usually imposed on the seller by
law, but may be passed on to the buyer via contract). Although tax authorities are generally free
to challenge such an allocation, they usually will respect an allocation agreed upon by the seller
and buyer and negotiated at arm’s- length. For sellers that are not C corporations, how the sales
price is allocated can save or cost substantial amounts of tax.

Tax Consequences Arising From Sale of Assets



In an asset sale, the buyer agrees to purchase all or a select group of assets from the
seller, usually subject to either all or certain liabilities. If both the acquirer and the selling entity
are corporations and the sales price consists or includes stock of the buyer, the transaction may
constitute a “tax-free reorganization.” Otherwise, the selling entity will typically recognize
taxable gain or tax loss with respect to the sale of each asset equal to the difference between the
amount realized for each asset sold and its adjusted tax basis.



A selling entity that is a C corporation, will pay federal and state income taxes on the net
taxable gain from the asset sale. If the corporation then wants to distribute the proceeds to its
shareholders, each shareholder will then be taxed on the amount distributed to him or her. If the
distribution is a dividend, the amounts distributed to the shareholders will be taxable as such
(subject, in the case of C corporation shareholders, to a special exclusion known as the
“dividends received deduction”). If the distribution is in liquidation of the distributing
corporation, each shareholder will recognize taxable gain equal to the difference between the
amount distributed to it over its adjusted tax basis in his or her stock in the distributing
corporation. To avoid this “double- tax problem,” and also to minimize or avoid sales, use and
other transfer taxes, a C corporation should avoid asset sales. Instead, the owners should seek to
sell their stock.


But there is a potential problem with a stock acquisition for the buyer. If the buyer buys
the corporation’s assets, virtually the entire purchase price can be deducted over time through
depreciation and amortization deductions. If, on the other hand, the outstanding stock of the
corporation (a non-depreciable or amortizable asset) is bought, the buyer will be limited to
deducting depreciation and amortization based on the adjusted tax basis in the corporation’s
assets immediately prior to the acquisition (in other words, any premium paid over book value


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cannot be deducted for income tax purposes). The foregone deductions essentially mean that the
government will fund less of the buyer’s purchase price through future tax savings, which often
means that the buyer will want to pay less for the stock of the corporation than it would want to
pay for the corporation’s assets.


Where the seller is an “S corporation” (which is taxed similarly to a partnership in that it
generally doesn’t pay income taxes), or is a subsidiary of another corporation, the buyer and
seller may jointly elect to treat a purchase and sale of stock as an asset purchase and sale for
income tax purposes. The benefit of this is that the buyer will obtain an increase in the adjusted
tax basis of the assets of the corporation and may be willing to pay an increased price due to the
increased tax savings available to the buyer in the future. Also, the making of this election is not
taken into account for sales, use and other transfer tax purposes, so those taxes may be largely
avoided.

Tax Consequences Arising From Sale of Equity Interests



In a sale of equity interests, the buyer agrees to purchase all or a portion of the
outstanding equity interests in an entity from one or more of its owners. If both the acquirer and
the entity to be sold are corporations, and the sales price is or includes the buyer’s stock, the
transaction may be a tax-free reorganization (discussed below). Otherwise, each seller will
recognize taxable gain or tax loss equal to the difference between the amount realized by it from
the buyer and its adjusted tax basis in the interests sold. If gain is recognized, some or all of the
gain may often be deferred through the use of seller financing, which can increase the seller’s
after-tax yield because the seller is investing pre-tax instead of after-tax money at the interest
rate provided in financing documents, but there can be a toll charge for this deferral in certain
larger transactions.



Tax-Free Corporate “Reorganizations”



The Code sets forth a number of tax-free transaction structures known as
“reorganizations” that are available where both the seller and the buyer are corporations (either
C or S corporations) To qualify as a reorganization, a transaction must meet certain
requirements, which vary greatly depending on the form of the transaction. If all applicable
requirements for a reorganization are met, shareholders of the acquired corporation are not taxed
on the portion of the sales price that consists of shares of the acquiring corporation. Of course,
the threshold issue for the sellers will be whether they are willing to take stock of the buyer and,
if so, how long they would be willing or required to keep it. If certain or all of the sellers are
concerned about taking stock in the buyer due to investment or market risk, consider (i) requiring
that the stock be freely tradable upon receipt, so that concerned sellers may sell all or a portion of
the shares received by them immediately in open market transactions, (ii) negotiating price
protection from the buyer, so that, if the buyer’s stock value goes down below a stated threshold
over a stated period of time, the sellers would get additional consideration, and/or (iii) seeking an
investment hedge arrangement from an investment bank. All of these arrangements may be
structured in a manner that does not result in the transaction itself not qualifying as a tax-free
reorganization.



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A. Straight Merger



A straight merger is simply a merger of one corporation into another corporation pursuant
to applicable state law. This is a relatively flexible form of reorganization because (i)
shareholders of the entity being acquired may receive all stock or a combination of stock and
other consideration (such as cash), (ii) shareholders receiving both stock and non-stock
consideration are not taxable on the stock consideration, (iii) shareholders do not have to be
treated equally (meaning some shareholders may receive cash, some all stock, and others a
combination of cash and stock), and (iv) certain restrictive provisions applicable to the other
forms of reorganizations do not apply to straight mergers.


As a general rule, in a straight merger, some or all of the shareholders of the corporation
being acquired may receive as much as approximately 60 percent of the sales price in cash or
other non-stock consideration without being taxed on the stock portion of the consideration.



A potential non-tax problem with this form of reorganization is that the acquirer directly
assumes the liabilities of the acquired corporation in the merger, which can pose a risk to the
acquirer’s other existing businesses and assets. This can be solved, however, by simply merging
the corporation to be acquired into a wholly owned limited liability company subsidiary of the
acquiring corporation (which is still treated as a straight merger for income tax purposes).


In any event, a straight merger will result in sales, use and perhaps other transfer taxes,
which could be avoided using certain other reorganization formats (which are discussed below).

B. Stock for Stock


A stock-for-stock reorganization involves the acquisition of at least 80 percent of the
stock of the corporation to be acquired solely in exchange for voting stock of the acquiring
corporation. The acquiring corporation cannot pay a single cent of non-stock consideration.
Though less flexible than the straight merger, in this type of reorganization, sales, use and
transfer taxes are generally avoided and the acquirer also avoids the problem of assuming the
liabilities of the acquired corporation. This is so because those liabilities remain encapsulated in
the acquired corporation (which becomes a subsidiary of the acquired corporation). This same
result may be accomplished, however, through use of a subsidiary merger format (discussed
below), which is generally more flexible and therefore preferred to stock-for-stock
reorganizations.

C. Stock for Assets


A stock-for-assets reorganization involves the acquisition of “substantially all” of the
assets of the selling corporation solely in exchange for voting stock of the acquiring corporation.
As is the case with the stock-for-stock reorganization, this format requires that solely voting
stock of the acquirer be used; however, there is a special rule that permits non-stock
consideration to be used so long as the total non-stock consideration given by the acquiring
corporation (including assumption of the liabilities of the acquired corporation) does not exceed
20 percent of the total consideration given (including the liabilities assumed).


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The stock-for-assets format offers the acquirer the benefit of not having to assume the
unknown or contingent liabilities of the acquired corporation (either directly or via taking the
acquired assets subject to such liabilities, as in a merger and a stock-for-stock reorganization).
But, like the stock-for-stock format, it is only feasible when all or virtually of the deal
consideration will be stock of the acquirer. Also, it leaves the shareholders of the selling
corporation with the task of cleaning up and liquidating the selling corporation. Finally, in
contrast to the stock-for-stock format, this type of reorganization will result in sales, use and
other transfer taxes.

D. Subsidiary Mergers


Subsidiary mergers are accomplished when the acquiring corporation forms a subsidiary
corporation and either merges the corporation to be acquired into the subsidiary (known as a
“forward subsidiary merger”) or merges the subsidiary into the corporation to be acquired
(known as a “reverse subsidiary merger”). Although the merger is between a subsidiary and the
corporation to be acquired, stock of the corporation that owns the subsidiary (its “parent”) is
given as consideration to the shareholders of the corporation to be acquired.


The reverse subsidiary merger is the usual form of reorganization chosen, because (i) it
protects the acquirer from the liabilities of the acquired corporation by keeping those liabilities
separately encapsulated in the acquired corporation (which becomes a subsidiary of the
acquirer), (ii) unlike all of the other reorganization formats except the stock-for-stock format, it
avoids having to transfer legal title to assets, which results in sales, use and other transfer taxes,
(iii) it often avoids anti-assignability provisions in the contracts of the corporation to be acquired,
(iv) it permits up to 20 percent of the transaction consideration (without taking into account
liabilities of the corporation to be acquired) to be paid in non-stock consideration, which is
considerably more generous than available in the stock-for-stock and stock-for-assets formats.

The one drawback to the reverse subsidiary merger, compared to the straight merger and
the forward subsidiary merger, is that the latter two permit as much as about 60 percent of the
transaction consideration (without regard to the liabilities of the corporation to be acquired) to
be paid in non-stock consideration. This advantage is often of limited benefit when the acquirer
is a public company, since, subject to applicable securities laws and any contractual restrictions
that may be imposed by the acquiring corporation’s investment bankers, a shareholder of a
corporation acquired by a public company may usually dispose of all or a portion of its public
company shares received in the reorganization in open-market transactions at any time.

Where the consideration in the deal will include at least 40% stock consideration but
greater than 20% non-stock consideration (so the reverse subsidiary format would be taxable),
the forward merger would be the preferred subsidiary merger format. However, if any
requirement of a forward subsidiary merger is not met, the potential tax downside is quite
serious. Specifically, the transaction would be treated as a taxable asset sale by the target
corporation and then a taxable liquidating distribution from the target to the selling shareholders
(giving rise to the double-tax problem). Where there is concern about whether a requirement of
a forward subsidiary merger may be met, there are two possible ways to avoid the serious


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potential downside. The transaction could be structured as a straight merger using a wholly
owned limited liability company subsidiary of the acquiring corporation to acquire the assets of
the target (discussed above) or it could be structured as a so-called “two-step merger.” In the
two step merger, the target is first acquired via reverse subsidiary merger and, shortly thereafter,
the target is either merged into another subsidiary of its new parent or into the parent itself.
Pursuant to IRS rulings, if it turns out that any requirement of a forward subsidiary merger is not
met, the transaction will be treated as a sale of stock by the target shareholders (giving rise to
only one level of tax).

“Blown” Corporate Reorganizations


Any transaction that meets the requirements of any of the reorganization formats is non-
taxable for income tax purposes, which is usually the desired result. However, where the sellers
would have a deductible tax loss if the transaction were not characterized as a “reorganization,”
planning should be considered to intentionally fail to meet one or more requirements of each
possible reorganization format.

Conclusion


The involvement of qualified counsel throughout the process is imperative in minimizing
the tax liability that can result and in meeting both the buyer’s and the seller’s respective tax and
non-tax goals going forward.

David Boatwright is the local Chair of Latham & Watkins’ Tax Department in San Diego, and
Agnes Gesiko is an associate. For more information on this or related topics, contact David
Boatwright at (619)238-2885 or david.boatwright@lw.com.