Icome Tax Isights Structurig the Sellig Employee/ Shareholder Trasitio Period Paymets after a Closely Held Compay Acquisitio Robert F. Reilly, CPA Corporate acquirers ofte acquire closely held target compaies. I such acquisitios, it is commo for the corporate acquirer to wat to retai the services of the target compay sellig employee/shareholders. This discussio summarizes the may reasos why corporate acquirers would wat to retai the sellig employee/shareholders services durig some post-acquisitio trasitio period. However, both the structurig ad the characterizatio of such trasitio period paymets have icome tax cosequeces both (1) to the corporate acquirer ad (2) to the sellig employee/shareholders. This discussio explais those icome tax cosequeces to both trasactio participats. Itroductio I the acquisitio of a closely held services compay, it is commo for the compay acquirer to request that ay idividual employee/shareholder sellers agree to cotiue to work for the acquired compay durig a specified trasitio period. This type of employee/seller trasitio period employmet is commo i the acquisitio of both: 1. professioal services practices (such as accoutig firms ad medical practices) ad 2. other services-related compaies (such as costructio compaies ad architectural ad egieerig firms). The term of the post-trasactio seller employmet is typically a matter of egotiatio betwee the compay acquirer ad the compay sellers. Post-trasactio seller employmet trasitio periods of oe to two years are commo. However, loger post-trasactio seller employmet trasitio periods are ot ucommo. I such services-related compaies (ad particularly i closely held compaies), the employee/ shareholder sellers ofte have direct cotact with the compay s cliets or customers. For example, i the case of a costructio compay, the cliets may have a direct ad persoal relatioship with the idividual compay ower/cotractor. Although o loger a stockholder i the acquired compay, that idividual cotractor may cotiue workig for the costructio compay for a time period util all cliets become comfortable with the ew ower. I additio, the illustrative costructio compay seller may have persoal relatioships with all of the compay s costructio idustry specialty subcotractors. Agai, the sellig shareholder may cotiue workig for the acquired compay for a time period i order to successfully trasitio all of the subcotractor relatioships to the ew ower. Fially, the illustrative costructio compay seller may have persoal relatioships with all of the compay s employees ad tradespeople. The sellig shareholder may cotiue workig for the acquired compay for a time period i order to esure the smooth trasitio of these employee ad tradespeople relatioships to the ew ower. www.willamette.com INSIGHTS WINTER 2016 87
Of course, the employee/shareholder sellers would expect to be fairly compesated for their professioal services durig the trasitio period employmet. Ad, the acquirer compay will wat to fairly compesate the sellig employee/shareholders i order to esure a efficiet owership trasitio ad a successful compay acquisitio. Alterative Trasitio Period Paymet Trasactio Structures The followig two questios relate to such posttrasactio trasitio period paymets: 1. How much should the compay buyer pay to the employee sellers for these trasitio period services? 2. How should these trasitio period paymets be structured? Of course, the aswer to the first questio is based o the uique facts ad circumstaces of each idividual deal. The amout of such trasitio period paymets is typically based o direct egotiatios betwee the compay acquirer ad the sellig employee/shareholders. The amout of agreed-upo trasitio period paymets will deped o the followig: 1. The actual amout of services the sellers will provide to the buyer 2. The buyer s perceptio of the risk associated with trasferrig the acquired busiess operatios 3. The sellers opportuity cost (i.e., how much they could ear through alterative employmet opportuities) This buyer/seller egotiatio should be coducted ad the trasitio period paymet terms should be agreed to before the compay acquisitio is closed. The aswer to the secod questio will have direct federal icome tax cosequeces to both the compay acquirer ad to the employee/shareholder sellers. Ad, related to this trasitio period paymet structurig issue, these two trasactio parties (buyer versus sellers) have adverse icome tax cosequeces to each other. Therefore, the questio of the structure of the employee/sellers trasitio period paymets is the subject of this discussio. Basically, the two alterative paymet structures are as follows: The paymets could be cosidered to be employee compesatio for the trasitio period services provided by the former shareholders. This structure raises the questio: what is a reasoable amout of employee compesatio for the services redered? The paymets could be cosidered to be a ear-out provisio that is part of the overall compay (whether a stock deal or a asset deal) purchase price. This structure raises the questio: what is the total amout of the deal purchase price that the acquirer paid for the target compay busiess? I additio to tax cousel ad legal cousel, a valuatio aalyst is ofte ivolved i aswerig these two trasactio structure questios. This ivolvemet is because the valuatio aalyst ca assist i aswerig both questios: 1. What is the amout of reasoable compesatio to pay to the sellig shareholders? 2. What is the fair price to pay for the value of the acquired compay? Buyer Tax Cosideratios versus Seller Tax Cosideratios i Structurig the Trasitio Paymets The trasactio structurig issue is whether the trasitio period paymets to the compay sellers represet either: 1. a cotiget purchase price amout or 2. employmet compesatio for services provided by the sellers. I certai circumstaces, the total trasitio period paymets could be cosidered to iclude compoets of both: 1. a cotiget purchase price compoet ad 2. employmet compesatio for services compoet. There is a iheret coflict of ecoomic iterest betwee these two alterative trasitio period paymet structures. This is because, from a icome tax perspective, either trasitio period paymet characterizatio will beefit oly oe party (i.e., the buyer or the sellers) to the acquisitio trasactio. 88 INSIGHTS WINTER 2016 www.willamette.com
From the busiess sellers perspective, if the employee/sellers are idividuals ad the trasitio period paymet is characterized as compesatio (icludig a paymet for trasitio services ad for ay coveat ot to compete), the the paymet will be subject to federal icome tax at a icome tax rate of up to 39.6 percet. I additio, these trasitio period compesatio paymets will be subject to the employee portio of FICA ad to a state icome tax. O the other had, ay trasitio period paymet that is characterized as deferred purchase price (for either the compay stock or the compay assets) will geerally be more attractive to the sellers for icome tax purposes. This is because trasitio period paymets characterized as deferred frachise price will: 1. be subject to the lower capital gais tax rate ad 2. ot be subject to payroll tax withholdig. Therefore, the compay sellers would geerally prefer the capital gais tax treatmet o ay trasitio period paymets. From the busiess buyer s perspective, it may be advatageous to characterize the trasitio period paymets as employee compesatio for services. This is because the paymet of employee compesatio will usually geerate a curret icome tax deductio for the acquired compay. Noetheless, if characterized as employee compesatio, the trasitio period paymets may also be subject to the Iteral Reveue Code Sectio 280G deductio limitatio o golde parachute paymets. Ad, such trasitio period paymets would have to comply with Sectio 409A (i.e., icome iclusio for oqualified retiremet plas), requirig the cosideratio of ay collateral provisios. Factors to Cosider i the Structurig of the Trasitio Paymets Several factors should be cosidered by the trasactio participats whe characterizig whether the trasitio period paymets are cotiget purchase price ear-out paymets or employee compesatio for services paymets. These factors iclude, but are ot limited to, the followig cosideratios: The trasitio services coditios. Geerally, if the trasitio period paymets are coditioed o the future services that are actually provided by the employee/sellers, the this factor may idicate that the paymets should be characterized as employee compesatio (cosider, for example, the judicial decisio i Duberstei, 363 U.S. 278 (1960)). The proportioality of the trasitio paymets. The trasactio parties should cosider whether the trasitio period paymets are proportioal to the sellers prior owership of the compay stock. That is, if there is proportioality if all of the sellers receive the trasitio period paymets based o the services provided but oly some of the sellig employee/ shareholders the this factor may idicate that the trasitio paymets should be characterized as a retur o capital ad as a deferred purchase price. The egotiatios betwee the trasactio parties. The actual egotiatios betwee the trasactio parties play a importat role i the characterizatio of the trasitio period paymets. To the extet that the parties disagree o the purchase/sale price ad the trasitio period paymets are later proposed as a meas of resolvig that sale price disagreemet, this factor may idicate that the trasitio period paymets should be characterized as a deferred purchase price. Target compay price valuatio. If the amout of the trasitio period paymets represet a compoet of the total reasoable value for the acquired compay, this factor idicates that the trasitio period paymets should be characterized as deferred purchase price. The amout of employee/seller reasoable compesatio. If the idividual sellig shareholders are already beig paid a reasoable level of employee compesatio for their post-trasactio services, the this reasoable compesatio factor may idicate that ay additioal trasitio period paymets should be characterized as deferred purchase price. Whe the post-trasactio services are tied to the trasitio period paymets, the the paymets may be cosidered as compesatio for services uder Regulatios Sectio 1.61-2. www.willamette.com INSIGHTS WINTER 2016 89
However, if oe or more of the above-metioed structurig factors are preset, the the parties should cosider whether: 1. there is ay compesatory itet to the trasitio paymets or 2. the trasitio paymets represet oe compoet of the itrisic value of the acquired compay stock or assets. From a icome tax perspective, some of the judicial ad admiistrative guidace related to these trasitio period paymet characterizatio questios icludes the followig: Arrowsmith (344 U.S. 6 (1952)). I the Arrowsmith judicial decisio, two taxpayers liquidated a corporatio that they had co-owed. The two taxpayers divided the corporate liquidatio proceeds equally, reportig the profits from the distributios as capital gais. I a subsequet tax year, a judgmet was redered agaist the liquidated corporatio. The two taxpayers paid the judgmet, ad they the reported the judgmet paymet as a ordiary busiess loss deductio. I this judicial decisio, the court held that those judgmet paymets ad the resultig tax deductio were capital i ature. The court reached this coclusio because the claim o which the judgmet was redered related to the origial corporate liquidatio. The court cocluded that the basis of the taxatio treatmet related to the origi of the claim (i.e., the liquidatio). Likewise, if the paymet of a trasitio paymet represets othig more tha the itrisic value of the compay stock (or assets) that the idividual sellers owed before the trasactio, the Arrowsmith suggests that the trasitio paymets represet a paymet for the acquired compay shares (or assets). Lae Processig Trust, 25 F.3d 662 (8th Cir. 1994). I the Lae Processig Trust judicial decisio, a employee-owed compay sold all of its assets, The, the compay sale proceeds were distributed to the employee-owers. I this case, both the right to the distributio ad the amout of the distributio were cotiget upo the employee/shareholders beig employed by the compay at the time of the trasactio, their job classificatio, their legth of employmet, ad so forth. The court rejected the compay s claim that the distributio paymets were ot employee compesatio. Rather, the court held that the distributio paymets were based o factors traditioally used to determie employee compesatio, specifically, the value of services performed by the employee, the legth of the employee s employmet, ad the employee s prior wages. Therefore, the court cocluded that the sale proceed paymets were more closely aliged to employmet services tha to stock owership. R.J. Reyolds Tobacco Co. (149 F.Supp. 889 (Ct. Cl. 1957)). I this case, a employer compay claimed that paymets made to certai ower-employees, uder a profit distributio pla ad proportioate to their shareholdigs, were deductible compesatio expese rather tha stock divideds. The court held that the paymets were ot compesatio paymets, but were istead o accout of the employees stock owership. The court reached this coclusio for the followig reasos: 1. The paymets were i proportio to each employee s stock owership. 2. The paymets were i additio to each employee s existig reasoable compesatio arragemets. 3. I prior icome tax, accoutig, ad litigatio matters, the employer compay had treated the paymets as divideds rather tha as compesatio. Reveue Rulig 2007-49. I Reveue Rulig 2007-49, three sets of guidace were issued o the followig situatios: 1. No trasfer for Sectio 83 purposes had occurred whe ew services-based restrictios imposed o vested stock caused those same stock shares to become uvested. 90 INSIGHTS WINTER 2016 www.willamette.com
2. A trasfer for Sectio 83 purposes did occur whe a employee-shareholder exchaged substatially vested stock for uvested stock i a Sectio 368(a) reorgaizatio. 3. A trasfer for Sectio 83 purposes also occurred whe a employeeshareholder exchaged substatially vested stock for uvested stock i a taxable stock acquisitio trasactio. I situatio (1), Reveue Rulig 2007-49 suggests that a employee shareholder ca subject its existig stock to services-related coditios ad retai capital gais tax treatmet. I situatios (2) ad (3), the employee shareholder will maitai basis i the property ad ca make a Sectio 83(b) electio at the trasfer i order to have ay subsequet gai taxed at the capital gais tax rate. While ot directly o poit with respect to the trasitio period paymet issue, this rulig suggests that, at the very least: 1. the itrisic value of the stock is capital i ature ad 2. ay icrease i that stock value may (or may ot) require a Sectio 83(b) electio i order to subject ay additioal upside to capital gais tax treatmet. Summary ad Coclusio Closely held compay acquirers ofte ask the sellig employee/shareholders to cotiue to provide services to the compay for a trasitio period after the compay sale is completed. These compay acquirers wat to esure that there is a efficiet trasitio of the sellers relatioships with customers/cliets, suppliers ad subcotractors, ad employees. The structurig (or the characterizatio) of these trasitio period paymets ca have a direct icome tax cosequece to both: 1. the compay buyer ad 2. the sellig employee/shareholders. Such trasitio period paymets may be categorized as compesatio expese for services provided by the sellig shareholders. These paymets would qualify as curret period tax deductios for the acquired compay, but they would represet ordiary icome to the sellig employee/shareholders. Alteratively, these trasitio period paymets may be categorized as cotiget purchase price ear-out paymets. These paymets would represet capital gais to the sellig employee/shareholders, but they would oly adjust the buyer s tax basis i the acquired compay stock or assets. I other words, the acquired compay would ot receive a icome tax deductio for these paymets. This discussio summarized the trasitio period paymet icome tax cosideratios to both the compay buyer ad the compay sellers. This discussio listed may of the factors that the trasactio parties should cosider whe characterizig these paymets. Ad, this discussio preseted some relevat judicial ad admiistrative tax guidace with regard to the characterizatio of such paymets as compesatio expese versus a purchase price earout. The trasactio participats should cosider this trasitio period paymet characterizatio issue whe egotiatig ad structurig the compay sale trasactio. Both trasactio parties may cosult their tax ad legal advisers. Ad, both trasactio parties may cosult a valuatio aalyst i order to assess: 1. the reasoableess of the post-trasactio employee/sellers compesatio ad 2. the reasoableess of the total amout of the trasactio purchase price. Robert Reilly is a maagig director of the firm ad is residet i our Chicago practice office. Robert ca be reached at (773) 399-4318 or at rfreilly@willamette.com. Such trasitio period paymets... would qualify as curret period tax deductios for the acquired compay, but they would represet ordiary icome to the sellig employee/ shareholders. www.willamette.com INSIGHTS WINTER 2016 91