Tax Tips for Searchers Asset vs Stock Deals F Reorgs and QSBS

All right, let's get started. If you're in this room, it means you decided to come learn about tax after lunch, so I hope you have a lot of coffee. Find the biggest cup you can. The good news is that in the world of tax and accounting, nine out of 10 professionals are about as dry as some of the food out there, but we've got two of the best, or at least two of the most entertaining. Will and Laura are here to talk about tax. You're getting a perspective from both the lawyer and the accountant side. They have different roles when you're going out to buy a small business, and hopefully they'll walk you through what that means.

I'm Laura Gieseke. I'm the tax attorney at SMB Law Group. I started with the firm about 10 or 11 months ago.

I'm Will Hodges, I'm a principal at Hancock Askew and I lead our tax advisory practice. We do a lot of deals and a lot of tax consequences of those deals, and we also do the returns and all that fun stuff afterward.

We're going to start with the very basics: stock versus asset acquisition. This is often the first tax impact question you'll have when looking at different acquisitions. Most of the time as a buyer, you're going to want to buy the assets. When I say you get a full step up in the assets, what that means is you get to book on your books the full fair market value of each of the assets you bought and depreciate or amortize those over time. From a tax perspective that's generally your best result. However, it's going to generate ordinary income to your seller. A lot of times the seller is going to have a visceral reaction to that because there's a gap between capital gain and ordinary rates on those assets. It's not always the case, especially if you're buying something that's mostly goodwill, but generally that's going to be the case.

The biggest hurdle you'll come across with an asset acquisition is that every single asset has to be legally transferred. Sometimes you'll end up in a situation where you've got certain contracts (government contracts are particularly bad about this) where you really need to buy the stock in order to make the business make sense to purchase.

Sellers love stock deals because we're minimizing the amount of ordinary income sellers are going to recognize. Everybody wants capital gains. Everybody believes that when they sell a business they're going to recognize capital gains. Some of the hardest conversations I have with sellers in the middle of doing deals are when we haven't explained on the front end what their tax bill is going to look like. It tears everything apart down the way.

If they're selling a C Corp or an S corp, less so, but if they're selling out of a partnership taxed as a partnership, they're going to have some ordinary gain because of depreciation recapture. That's often a surprise to people. Having this conversation on the front end can be really key.

It's not always the tax situation. There are definitely situations where a stock deal is needed because you have some type of contract that needs to be transferred over, and it's just a whole lot easier if you're buying the business or buying the stock outright and keeping that entity in place. There are tax strategies we can talk about if you really need to buy the stock. There are some tax strategies we can implement to get you a step up in basis depending on the structure of the transaction. There are also due diligence things you need to think about that are a little more intense when you're buying stock.

Someone asked about F reorganizations. We're going to talk about those. That's something specific to buying an S corporation. We were talking outside, and I said, look, we may be nerds, but you need us.

Choosing your entity: a lot of times, this is the first thing people ask us. Should I be a corporation, LLC, or partnership? Most of the time, forming an LLC is going to make the most sense, particularly if you're self-funded. If you're bringing in investors, you're generally going to want to be in an entity that's flow-through taxed as a partnership. S corporations can make sense in limited situations. They generally don't make sense when you're bringing in other investors.

Back in 2018 when we had tax reform, Congress was trying to equalize the rates, and we did a lot of choice of entity analysis at that point. Private equity firms were looking at their various investments, and what we figured out was that if we're going out and reinvesting earnings back into the business, it makes a whole lot more sense to operate as a C corporation because there's less tax leakage. If I have a 21% rate as opposed to a maximum 36% rate on the flow-through side, I can deploy a lot more capital annually if I'm paying less in taxes.

Let me back up and give you guys a foundation. If I'm in a disregarded entity, a solely owned LLC, or a partnership, all the items of income of that entity are going to be allocated to me on my personal return. In a partnership, I'm going to get a K-1. With an LLC, it's all coming to my own 1040. That means no matter what I do with the cash that business generates, I'm going to pay income tax on the entirety of the income that business earned during the year, whether I redeploy the cash in the business or take it out. That can create some pain for people who are trying to reinvest all of their profits and build their businesses, because you're paying income tax and not taking any cash out. In a C corporation, you pay a corporate tax of 21%, but you don't pay any tax personally until you take a dividend from that entity.

Check-the-box regulations: there's a difference between the legal classification of an entity and the tax classification of an entity. For example, if I've got an LLC, it's going to be disregarded as separate from its sole owner. The IRS doesn't even see it. It doesn't file its own return. Same thing if you've got a C corporation that owns a bunch of LLCs. The IRS is going to treat it all as owned by that single C corporation. I can change that classification with a check-the-box election. These come in really handy when we're doing reorganizations.

State law entity types: C corporations, limited liability companies, and partnerships. We don't use state law partnerships a ton. Most of the time when we refer to a partnership, we're referring to an LLC that has multiple members. The default classification under the code for a multi-member LLC is as a partnership. C corporations pay tax at the entity level. Their items of income, credit, loss are computed at the entity level. That is not true of an LLC and a partnership. Some states do impose entity level taxes on LLCs.

In Texas, you still see a lot of real estate deals done in limited partnerships because for franchise tax purposes you're able to minimize tax. But like 90% of the time these days, we see LLCs taxed as partnerships. They're easier from a governance perspective.

When you're setting these entities up, you have to be cognizant of the business objectives and what you're trying to do with the cash you're generating, as well as what the tax treatment is ultimately going to be. Tax should never be the sole factor. Most tax people will tell you that tax shouldn't wag the dog. A C corporation most of the time isn't going to make sense unless you know you're going to try to take a company public, you're going to generate a ton of loss on the front end, or your business qualifies for QSBS.

An S corporation is not a legal entity type. You'll see LLCs that have elected to be treated as S corporations and C corporations that have elected to be treated as S corporations. An LLC that has elected to be treated as an S corp has technically made two elections: one to be treated as a corporation under those check-the-box regulations, and another to be treated as an S corp. They are subject to a lot of limitations in terms of who can own them. You cannot have more than 100 shareholders. They have to be a US resident, and have to be an individual. You cannot buy into an S corp with an entity. That's where we come across most of our issues in deals because people have an investment entity, they've got three or four investors, and they want their partnership to buy into their new business. If you buy into that S corp, you're going to turn it into a C corporation.

The main thing that makes S corps tough is you cannot do anything that isn't pro rata among the owners. There's no flexibility. If you're bringing in investors and somebody wants a preferred return or different economics, it's actually impossible to accomplish that. If you do it inside an S corp, you've now got a C corporation, and you may not realize you have a C corporation. Then you go to sell your business five or six years later, somebody's doing diligence and they find it. No one's happy when that happens. You can inadvertently create a second class of stock in an S corporation fairly easily. This is the situation where you really don't want to pull an agreement off of LegalZoom and hope for the best.

A colleague used to joke that there are only C corporations and C corporations that think they're S corporations, because they all ultimately end up busting their S election at some point. The IRS is pretty generous about relief if you catch it early enough, but that's just not a game any of us want to play. It's a diligence issue too. One of the big things people look at in tax due diligence is whether you have a valid S election in place, because that can create some curveballs down the road. Things as simple as a spouse in a community property state failing to sign the initial Form 2553 will cause it to fail.

Structuring your acquisitions: since you're going to come across S corporations a lot, I want to talk about F reorganizations. I really like F reorganizations for a few reasons. First, it makes it much easier for you to buy into the entity and get a step up in tax basis.

In a simple example with an S corporation owned by a single individual, the S corporation target is a flow-through entity that has elected corporate treatment. It forms a new S corp, contributes the existing S corporation to the new HoldCo S corp, and then files an election under 8832 if it's already an LLC, or converts for state law purposes to a disregarded LLC. There will be an S corp HoldCo over the target. Essentially, they'll end up holding their old target through a new S corporation. There's a filing under code section 8869 that causes the new LLC to be treated as a qualified subsidiary of the S corp. When you make that election, all of the tax attributes of that old S corp belong to the new HoldCo.

This does a couple of things. First, you've got a disregarded LLC. When you buy a disregarded LLC, you are treated as buying assets even if you buy the equity for legal purposes. So you can buy all the membership interest in an LLC. If it's disregarded, it's a tax asset acquisition. Great answer for us. The best part is you're no longer beholden to the seller's S corp treatment. You get a fresh start, blank slate. You aren't dependent on that.

If you make a 338(h)(10) election, which a lot of people like to talk about when buying an S corp because it's a way to buy the S corp and treat it like an asset acquisition, if it turns out later that the S corp election of the seller was bad, you no longer get asset treatment. Your 338(h)(10) is dead. So I prefer doing the F reorg.

Let me lay this out. You go to buy a company, and there are contracts in most cases that you really need to have for the business. If you structure as an asset deal, which is the default in our world, you technically have to go get every single one of those contracts assigned. You might have 100 contracts with different consent provisions. It can be prohibitive. The seller may say they can't do an asset deal, you have to do a stock deal. The first question is: can you do a stock deal using an entity that has multiple classes of stock, which is the default that we all do? That's not allowed with an S corp. The only way to buy into an S corporation directly as a searcher is if you buy as an individual. Most of the time people don't want to do that. An F reorganization essentially allows us to reorganize that S corporation into an LLC that's treated as an asset acquisition only for tax. It's an equity acquisition for every other purpose, so all those contracts that you need to transfer transfer like in a stock deal.

Is this like a caterpillar going into a cocoon? Yes, that's exactly right. The benefit of the EIN not changing is one. So if you've got payroll and things at this entity that you want to continue, you don't have to change any of that. That can be useful for things like 401k plans and health insurance.

The other nice thing about doing an F reorganization is if you're doing a partial rollover. So when you buy in, you can buy 80% of that entity or more, the percentage doesn't matter. The sellers are treated as contributing 20% of the assets to the new company and you're treated as purchasing 80% of the assets to form a new partnership. So it's a way to facilitate rollover equity while getting true rollover. If you make a 338(h)(10) election, it's 100% taxable, even if they only sell 80%.

In terms of payroll, you'd still need to diligence that. There are states like California especially where they will take the position that if you've bought all of the assets, you have successor liability on sales tax. If you're buying all of the assets of a company, I would still make sure from a state and local tax perspective you've done your diligence. Successor liability is always the fun one when you're doing due diligence, because everybody wants to know what they could possibly be stepping into. That's where we can start talking about reps and warranty insurance, but that's probably beyond the scope of this presentation.

When we set up this LLC as a partnership between the buyers and the old S corporation, the buyers truly are only going to get depreciation off the 80% they bought. You only get a step up to the tune of what you bought in cash. The 20% is a deferred gain that's going to stay with the seller and either unwind through special allocations over time or stay around until we dispose of the business. This is a great result for them because they don't have to recognize the gain in the assets they're deemed to have contributed. If you're doing a rollover, this is a convenient way to do it out of an S corporation. It is going to generate more tax in most cases than them selling the S corp across the top. But my response is usually, who are you going to sell it to? Everybody you try to sell it to is going to have the exact same issue I do.

One caveat: even SBA lenders are very inexperienced with this, especially with a partial chain of ownership. There's a seller education and lender education process. I suggest having those conversations very early. Partial rollovers are relatively new in the search fund space, so it's a lot of conversations that need to be had early on to mitigate any potential issues down the road.

Question about QSBS: going from an S corporation to a C corporation for purposes of QSBS is one of the more complicated reorganizations. I would actually empty the S corp and then do a new C corp because of potential issues. We can talk about that later. I've never heard of doing that post-close. Most of the time when we do these pre-restructuring transactions, we're trying to do specific things to get into a place we need to be before the transaction.

The QSBS structuring is a different question. The F reorg has to happen pre-acquisition. As searchers, all you're really trying to do is issue spot. One of the things you should add to your question list for the first call with a seller or broker is: is the target company an S corp? That's what sends you down this rabbit hole. I've seen SIMs where the S corp wasn't disclosed or it was buried in a footnote, and the buyer didn't understand it was an S corporation until we saw the tax returns. It's not something a broker will necessarily think to tell you. The issue you may have is that you discover this two weeks before close, and the seller is using his or her divorce lawyer to do the deal. You say something like "F reorg" to that divorce lawyer, and that's a problem.

If you're doing an asset deal, you don't need to worry about this. This is when you need to buy the stock but you're dealing with an S corporation. Why would you ever not do assets? The reason you'd choose a stock deal for non-tax reasons: you've got something you can't transfer in an asset deal because you need consent that you can't get, or you have hundreds of contracts each with consent provisions. It's almost always some sort of government contract or customer contract.

With vehicle fleets, you can transfer those individually. It's less fun, but it depends on how much pain you can tolerate on the transfers.

We did an F reorg recently that confused the buyer's bank to the point where we had multiple hour-long phone calls explaining that yes, you do get to keep your EIN, and here's the regulation that shows it. There's an education process on both ends, pre and post. Sometimes even large banks that should know better will surprise you, because you'll get one person who's never seen it before and they draw a line in the sand.

There's a deal going on now where there are four owners of an S corporation. Two are not exiting, one is partially exiting, one is fully exiting. When you do the F reorganization, the S corp HoldCo is the seller because of the way S corps work. When they sell that business, the cash comes into the HoldCo. As we talked about earlier, you cannot have disproportionate distributions out of an S corporation. So now I've got four people who are going to be allocated income in proportion to their interest, but two are not getting any cash and one is only partially getting cash. They're not happy because they're getting hit with income on their personal tax returns and not getting cash to pay their taxes. It's a really difficult problem to solve. If you have investors and you want different economics, stay away from this.

From the seller's perspective, asset transfer versus equity transfer: a seller is going to want to do a stock transaction because the amount of gain and the taxes they pay will be lower. We see situations where we'll do a calculation on the gross-up for how much they need to be paid in an asset transaction. Then it becomes a negotiation point of whether the buyer wants to pay an additional amount, because when the buyers are buying more of these ordinary income assets, they're going to get a depreciation deduction. Right now we're dealing with bonus depreciation rules, looking at 80 to 100% of writing assets off as soon as we get them. When people start running cash flow analysis, they can get a benefit for going ahead and paying additional money on the front end to the seller to effectuate that type of transaction. If you do an F reorganization, it's going to be taxed like an asset deal, so that calculation comes into play.

Bringing in investors and what effect that has on your structure: investors are generally going to want some kind of preference. You can't do that in an S corp, so that puts us in partnership world. We can specially allocate items of income, gain, loss, and deduction to properly reflect the economic relationship of the parties. I'm the one who drafts that and Will is the one who executes it on the tax returns. There are also securities considerations that I'm sure have been touched on in other panels. You can't just go advertise that you're raising money. There's not really a tax effect there, but I want everybody to be aware. Operational considerations: how much you give to someone, what their preference is, how much voting rights they have, what they have the ability to prevent you from doing or force you to do, whether they can force you to sell. All of those things are completely negotiable in a partnership. S corporations are severely limiting by comparison.

When we're talking about allocations for preferred interests, we have a waterfall. Let me explain what waterfall means. A waterfall basically describes how we're going to distribute cash. If we've got a big pile of cash, we've got tiers of waterfall to work through. Technically it says: if I liquidate this entity tomorrow, who gets what? You're going to see preferred return in the first tier, return of capital to the LPs in the second tier, or vice versa. The way that's written is extremely important, not only from a pure economics perspective because you can change how your investors receive their return, whether they're compounding on a preferred that's accruing or not, but also from a tax allocation perspective. Most of the headaches I have working in partnership tax is when an agreement is written and we have a situation where the entity is operating in a loss but I have to make an income allocation to the preferred investors because of the way the waterfall goes. You don't need to know anything other than: please don't draft this waterfall yourself. Give it to an attorney. People hate to get allocated income and not have any cash to pay the tax. It's shocking that upsets people.

On QSBS: section 1202 is a permanent exclusion on capital gain up to 100% of the gain on the sale of qualified small business stock, up to $10 million or 10 times the adjusted basis of your initial investment, whichever is greater. There are a few quirks. It only works for certain types of businesses. It has to be an original issuance of stock. You cannot go buy a C corporation and have that stock count as QSBS. It has to be a new C corporation where you received the stock in the original issuance. There are some asset requirements; it has to be below a certain size. You have to hold stock as QSBS for five years. If you run an LLC for 10 years and contribute that to a new corporation, your holding period will tag for purposes of whether the sale of that interest is capital gain later. That's not true for QSBS. The QSBS clock starts when the C corp stock is issued. That surprises people sometimes.

Why doesn't everybody do this? You have to sell the stock. You cannot sell the assets out of QSBS. As you're looking for businesses, you're looking to buy assets for the most part. The same is generally true when you go to sell. The business has to be carefully managed to make sure you actually fit the requirements for the entirety of your holding period, so there's tax and investor tolerance issues. However, in terms of investors, you can have a partnership invest in your corporation and each of the partners will be entitled to the exclusion.

I frequently have people tell me they want to issue equity in their new entity to compensate a CEO, an employee, or maybe somebody from the seller side. If you are taxed as a partnership, you just need to know enough to know it's an issue. If you have somebody who has an ownership interest in your entity and you are taxed as a partnership, they cannot be a W-2 employee of that entity. Easy to fix, but you have to know about it on the front end. We set up a whole payroll structure underneath the partnership to employ everybody, so your equity issuance and your W-2 payroll entity are not the same for tax purposes. You can really cause problems with things like health insurance plans and retirement plans.

You're bound by your form. The IRS isn't. So if the guy is telling you that you can deduct your brand new G-Wagon, no. You are bound by the structure you choose. The IRS isn't. If they decide that in reality something looks like it happened a different way and generated a different tax consequence, they will recharacterize the transaction and send you a notice of deficiency. It's a substance over form rule. If you hear something online or on TikTok and it sounds too cute by half, our rule of thumb is if we can think up an answer to the problem within 10 minutes, it's not going to work.

Question: when you're buying a business that needs real estate, how do you recommend structuring? Are they buying it together as one business or separating?

It's not uncommon to see people put real estate in a separate LLC. We see that a decent amount. If you've got just one piece of real estate that the business owns and is using, you won't necessarily segregate it. But if it's a real estate investment, you usually will see it segregated. Another plug: do not ever, ever put real estate in an S corp. It's impossible to get it out without it being taxable. Even if you plan on holding it forever and passing it down, your children get a step up on your death in the basis of their S corp stock, not in the building itself.

Question about OpCo/PropCo: it's hard to answer in a hypothetical. It's so situational. Get it separated on the front end. If you're dealing with advisors and you know that's what you want to do, communicate that as soon as possible. We can structure into most of the things people want to do, with some constraints, but if we don't have the time to think through it, it's going to be a lot more difficult.

Question about phantom income: phantom income means you have been allocated income without cash to pay the tax. Most of the time, your investors will probably ask for a tax distribution provision that says to the extent you allocate income to me, you are going to pay me cash. Usually it's based on the highest marginal tax rate of the parties. That generally counts against what they get in the waterfall.

Pass-through entity versus non-pass-through entity: when we say pass-through entity, we're referring to entities whose income, gain, loss, and deduction are all allocated eventually to your personal tax return, whether on a K-1 or directly on a Schedule C on your 1040. The only entity that is a taxing entity for federal purposes is a C corporation. You will have some states with entity-level taxes on pass-throughs (Texas has a franchise tax, for example).

Profits interests are a way to get employees compensatory interest in your partnership without it being taxable upfront. There's a difference between a profits interest and a capital interest in a partnership. They are both ownership interests, but a profits interest doesn't get paid in liquidation waterfall until everyone else has received their capital back. That's why they're called profits interests. You don't get anything until the value of the company has exceeded what it was on the date of issuance. It is still an ownership interest. If you've got that situation, we can structure around it. We form two entities under the partnership. We check the box on one to have it treated as a C corporation. That C corp will own 1% of a new LLC that the operating company owns 99% of. Employees will be employed by that disregarded partnership underneath the operating partnership. Your equity issuance and your W-2 payroll entity won't be the same for tax purposes. You'll have a little bit of tax leakage with the 1% going into the C corporation.

If you're going to own a business in which you're taking the cash out regularly, most of the time a pass-through entity is going to be more tax efficient because you don't have an additional layer of corporate tax. It's not always the case, which is why this is something you should work with an accountant on the front end. It's going to depend on your long-term goals. Tech startups, for example, are almost always C corporations because they generate tons of losses on the front end and their whole goal is to go public or get acquired by another C corp.

What are we using to fund the lion's share of the purchase price? Debt strips out a ton of the cash in early years because you're trying to pay it down. To the extent you've personally guaranteed debt in a partnership, that is basis to you and you can take out cash to the tune of that debt tax-deferred. It's not tax-free, because when you sell it you're going to recognize it. You cannot do that in an S corp. There are benefits if you've personally guaranteed the debt.

On the risk of relying on the seller's S corp election: it's a diligence issue. You're going to want to see a whole lot more from the seller, and you're going to ask for a ton of representations in that purchase agreement such that if they are wrong, they have to pay you. The indemnity is only as good as their ability to pay. If you can get comfortable with the S election, worst case you've bought a C corporation. If you end up being wrong, you were technically supposed to be paying corporate double tax if you made a distribution dividend.

When to call us: I like to work with people as soon as they're under LOI. I like to know what your goals are upfront, what you're trying to accomplish, what structure your seller is in, what conversations you've had, and what education we might need to do with your lender and your seller. That's where we work together. I'll structure the transaction. We can tell you what it's going to cost. Often sellers want to know their primary concern: "I really thought I was going to sell stock. What does this asset acquisition mean for me?" To the extent they have a bunch of hard assets they've been depreciating, the bill can be different. If it's a service business where 90% of the asset base is goodwill, that's capital gain anyway. There may not be any difference. We like to assess that upfront because if you can get the seller comfortable very early, the rest is just a bunch of legal forms to them.

From a CPA perspective, on the buyer side, around the LOI, completely agree. If I'm dealing with sellers, I want to talk to them even earlier because that can sidetrack a deal. The deal you mentioned is a perfect example: the sellers thought the buyer was going to buy into their S corp, and he can't, he's got four or five investors, he cannot buy in as an individual. We're sort of at an impasse.

On LOIs: be as specific as you can. If you tell a seller you're "buying their company," they're going to interpret that as a stock deal. That's the mistake I really see the most. People don't understand that the seller is interpreting what they've written in their LOI as a stock deal, and then the seller is viscerally reacting to them wanting to do an asset deal. It feels like a walk-back to the seller.

Who's your counsel? You need to know that upfront. If they've hired competent M&A counsel, that's a lot easier for us to work with than having a huge education campaign with someone who's never done a deal before. Most of the time they have their family lawyer who they've used for everything including their trust work and divorce. They give it to that attorney and the attorney has no idea what's going on. The question I would ask is: who's your counsel? Do you have an accountant working with you on this transaction? If the answer is no, that tells you everything you need to know. My own counsel has people they can recommend. Offer to help and find competent assistance. This is a proxy for how hard the deal will be. If we still don't get anywhere after offering to talk to their attorney, it's an indication the deal's going to be tough.

Thanks, everyone.