APA Arbitration Clause Doesn’t Apply to Buyer/Seller Affiliate Contract

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M&A Stories

September 29, 2020

Introduction

Buyers and sellers of businesses often select arbitration as their dispute resolution procedure. Arbitration is seen as faster and less costly than going through the courts.

However, a binding arbitration clause in an acquisition document is not a guaranty that there won’t be an attempt to force the dispute into a court.

The deal

This deal here involved the sale of a Vicksburg, Mississippi auto dealership. The transaction was structured as an asset acquisition. There was an asset purchase agreement between the buyer and seller for the dealership assets (other than the land and building). There was also a purchase contract for the real estate between a buyer affiliate and a seller affiliate.

The agreements were signed but the deal did not close.

The lawsuit

The buyer and buyer affiliate sued the seller and seller affiliate in a federal Mississippi court to force the seller and its affiliate to close the deal and for damages.

The seller and its affiliate asked the court to compel the buyer group to arbitrate pursuant to the arbitration clause in the asset purchase agreement. The buyer affiliate claimed that it could not be compelled to arbitrate the real estate contract dispute, because it was not a party to the asset purchase agreement (which contained an arbitration clause) and that there was no arbitration clause in the real estate purchase contract.

The court agreed with the buyer affiliate. It compelled the buyer and sell to arbitrate the asset purchase agreement dispute, but permitted the real estate purchase contract dispute to proceed.

This case is referred to as BLW Motors, LLC v. Vicksburg Ford Lincoln Mercury, Inc, Civil Action No. 3:19-CV-577-DPJ-FKB, United States District Court, S.D. Mississippi, Northern Division, (April 1, 2020) 

Comment

So now things get more complicated, expensive and time consuming. The buyer and seller battle out the non-real estate part of the deal in arbitration while the buyer affiliate and seller affiliate battle out the real estate part of the dead in a federal court.

Acquisitions of a business often involve multiple related agreements and multiple related parties. An arbitration clause in one agreement will probably not apply to disputes between related parties in a related agreement. Therefore, make sure that all parties to all agreements agree in writing to arbitration for all disputes arising from all of the acquisition documents.

By John McCauley: I help people manage M&A risks involving privately held companies.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in arbitration, dispute resolution provision Tagged with: ,

Case Demonstrates Risk of Trying to Operate Business Before Acquisition Closing

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M&A Stories

September 25, 2020

Introduction

It is not unusual to sign a definitive acquisition agreement and defer the closing until some important third-party approvals are obtained. There is a temptation sometimes to structure the deal so that the buyer can take over the business before the required approvals and closing.

The buyer and seller in this deal structured the transaction to give the buyer access to the business before the closing occurred. In the end it did not go well for the buyer.

The deal

The seller in this deal was a Manhattan surgical center. The buyer’s owner, a surgeon who, since 1998, had acquired an ownership interest in around 20 surgical centers that he managed in California, Las Vegas, New York, and New Jersey.

The buyer and seller agreed to structure the deal as an asset acquisition that was signed effective August 4, 2015. However, the closing could not occur until the buyer received a certificate of need from a local health department, and that might not happen until June 2016.

So, the parties gave the buyer access to the surgical center pending approval of the application for a certificate of need through the device of an administrative services agreement. But, under the deal, the buyer had to come up with $6 million of financial collateral to secure the buyer’s obligation to close the deal. The collateral was required to be furnished to the seller by September 1, 2015.

The buyer could not get a bank to provide the necessary financial collateral, even after getting an extension to perform until October 1, 2015.  The buyer tried to renegotiate the deal but was unsuccessful and the parties ended up in a New York state court.

The lawsuit

There was a liquidated damages provision in the acquisition documents in the amount of $6.5 million.  The seller asked the court for summary judgment in the amount of the liquidated damages and the court granted the seller’s request. The buyer appealed and the intermediate appellate court affirmed the trial court’s decision noting an earlier court’s observation that a: “liquidated damages provision negotiated at arm’s length is entitled to deference where parties to agreement are sophisticated businesspeople represented by experienced counsel”

This case is referred to as Center for Specialty Care, Inc. v. CSC Acquisition I, LLC v. Fontanella, 653849/16, Appellate Division of the Supreme Court of New York, First Department, (Decided June 25, 2020) https://scholar.google.com/scholar_case?case=11080597099317843710&q=%22asset+purchase+agreement%22&hl=en&as_sdt=2006&as_ylo=2020 

Comment

Buyers want to take over the seller’s business as soon as possible. Long governmental approval processes appear to be mere formalities that should not slow up the takeover. Thus, buyers and seller often work out complex legal arrangements that give the buyer the keys to the business before the closing.  But such arrangements add additional risks to both a buyer and a seller.

By John McCauley: I help people manage M&A risks involving privately held companies.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in certificate of need, deferred closing, governmental approval, liquidated damages provision Tagged with: ,

Tax Structure for Selling S Corp Stock While Keeping Company Real Estate

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M&A Tax Structures for Closely Held Businesses

September 8, 2020

Introduction

The buyer of a closely held business has strong reasons to purchase the target’s assets instead of stock. That way the buyer can pick and choose what assets to purchase and what liabilities to assume. Although successor liability may stick the buyer with some of the seller’s liabilities anyway.

But an asset acquisition won’t always work. A stock acquisition may be the only route to get some assets, such as valuable intellectual property licenses that can’t be transferred in an asset deal.

But what about a target’s highly appreciated real estate that the buyer does not want? That could present a problem to the target’s owner, even if his company is an S corporation, because getting the highly appreciated real estate out to the target owner could result in a large federal and often state income tax on the gain.

One taxpayer came up with a tax structure that solved this tax problem.

The proposed deal

The structure of the deal contemplated several steps. First, the target owner would form a holding company by transferring the S corporation target stock to the holding company in exchange for the holding company stock. The holding company would then make a QSub election for the target company.

This would then be followed by the target company’s distribution of the real estate to the holding company. Afterwards, the holding company would sell the target company stock to the buyer.

When the dust clears, the target owner would have cash from the buyer and stock in the holding company which would hold the real estate. The buyer would own the target stock with all of its assets except for the real estate.

The private letter ruling

The target asked the Internal Revenue Service to rule in advance that the only tax from the proposed transaction would on the gain from the sale of the non-real estate assets to the buyer. The Service agreed.

The IRS ruled that the target owner’s formation of the holding company by exchanging the owner’s target stock for holding company stock was not taxable because it was an “F” reorganization under Internal Revenue Code Section 368(a)(1)(F). Furthermore, the distribution of the real estate from the target company to the holding company was not taxable because the target company was a disregarded entity and so for tax purposes the real estate was already considered owned by the holding company. Finally, the Service ruled that the sale of the target stock to the buyer was treated for tax purposes as a sale of assets by the holding company because the target company was a disregard entity.

See Private Letter Ruling 201115016, Release Date: 4/15/2011  https://www.irs.gov/pub/irs-wd/1115016.pdf

Comment 

In addition, since the buyer was buying assets for tax purposes it gets a step up in basis.

A private letter ruling can only be relied upon by this taxpayer. Another taxpayer can’t justify doing the same transaction with this private letter ruling. But this ruling is a good indication of how an IRS auditor would treat a similar transaction.

By John McCauley: I help people with M&A tax issues involving privately held companies.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in F reorganization, S corporation, stock sale, unwanted assets Tagged with:

PLR Probably Closing Condition for Target S Corporation’s 2-Class Stock Issue

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M&A Tax Stories

September 2, 2020

Introduction

A buyer of an S corporation wants to make sure that the target is in fact an S corporation. Finding out after closing risks potentially significant federal and state corporate income taxes.

The deal

In this deal the target during due diligence discovered that the corporation had two classes of stock. An S corporation can only have one class of stock.

One target class of stock was voting stock and the other nonvoting stock. That difference did not cause any S corporation qualification issues.

The problem was caused when the corporation later changed the capital structure by creating different distribution and liquidation rights for the two classes of stock. Different distribution and liquidation rights and violates the one class of stock requirement.

The private letter ruling

The target immediately changed the capital structure to one class of stock, each share with the same distribution and liquidation rights. Then, the target asked the IRS to issue a private letter ruling waiving the inadvertent creation of the two classes of stock in order to save the S election.

The IRS issued a private letter ruling concluding that the creation of two classes of stock was inadvertent and waiving the violation of the 2 class of stock requirement.

Private Letter Ruling 201935010 Release Date: 8/30/2019   https://www.irs.gov/pub/irs-wd/201935010.pdf

Comment 

The private letter ruling process can kill a deal. That is because it can take up to 6 months to get a ruling.

Best for the target to do due diligence on itself before putting the company up for sale. However, the target must keep in mind that there will be significant professional fees and an IRS user fee to fix a problem like this. I believe the IRS user fee is currently $30,000.

By John McCauley: I help people with M&A tax issues involving privately held companies.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in One class of stock, S corporation Tagged with:

Business Asset Sale Not a C Reorg Because No Seller Continuity of Interest in Buyer

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M&A Tax Stories

August 31, 2020

Introduction

A company and its owners may avoid federal corporate income taxation on its gain from the sale of the assets of the business if the seller receives buyer voting stock from the buyer and liquidates. This tax structure is called a C reorganization. Internal Revenue Code, Sections 368(a)(1)(C) and 368(A)(2)(G). If all the rules are followed then the owner won’t recognize income tax until he or she sells the buyer stock.

The deal

The company in this deal sold its assets in 1926 at a gain to the buyer in exchange for cash and short-term notes (all payable within 3 ½ months). The then C reorganization provision permitted the selling company to receive stock (no voting stock requirement) or securities.

The selling company did not recognize the gain on its tax return, treating the transaction as a C reorganization. The IRS disagreed and assessed tax, claiming that the short-term notes were not securities within the meaning of the C reorganization provision.

The lawsuit

The dispute ended un in the Board of Tax Appeals. The company lost there and also in its appeal to the federal 5th circuit Court of Appeals. The company took the case to the U.S. Supreme Court. The high court also ruled for the IRS. It did not rule on whether the short-term notes were “securities” within the meaning of the then C reorganization provision.

Instead, the high court held that the transaction failed as a C reorganization because the selling company did not end up with a proprietary interest in the buyer. The court held that a tax favored C reorganization (an asset sale for buyer stock or securities) expands “the meaning of a reorganization from a traditional ‘merger’ or ‘consolidation” so as to include some things which partake of the nature of a merger or consolidation but are beyond the ordinary and commonly accepted meaning of those words — so as to embrace circumstances difficult to delimit but which in strictness cannot be designated as either merger or consolidation.”

However, the high court said that receiving short-term buyer notes did not come withing this expanded definition of reorganization, merger and consolidation: “But the mere purchase for money of the assets of … (this seller) … by … (this buyer) … is beyond the evident purpose of the provision, and has no real semblance to a merger or consolidation. Certainly, we think that to be within the exemption … (the seller) … must acquire an interest in the affairs of … (the buyer) … more definite than that incident to ownership of … (the buyer’s) … short-term purchase-money notes.”

This case is referred to as Pinellas Ice & Cold Storage Co. v. Commissioner, 287 US 462 – Supreme Court 1933  https://scholar.google.com/scholar_case?case=14650039434741271904&q=Pinellas+Ice+%26+Cold+Storage+Co.+v.+Commissioner&hl=en&as_sdt=2006

Comment 

So, what does this 1933 Supreme Court decision tells us today?  It tells us that a seller’s asset sale may not qualify as a C reorganization even if the seller receives some buyer voting stock. The amount of stock must be enough to give the seller an interest in the affairs of the buyer. Later courts would give businesses more guidance on what interest in the buyer is required.

By John McCauley: I help people with M&A tax issues involving privately held companies.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291

 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in C Reorganization, tax deferred reorganization Tagged with:

Seller Retention of Receivables in Asset Sale Blows C Reorganization

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M&A Tax Stories

August 26, 2020

Introduction

Taxes can be a major transaction cost when selling a business, especially federal income taxes. One exit plan structure for an owner of a company operating as a corporation is a C Reorganization. See Internal Revenue Code Sections 368(a)(1)(C) and 368(a)(2)(G).

Under a C reorganization structure, the company may escape federal corporate income taxation of the transaction and the owner may defer all federal income taxation on the gain from the transaction. A C reorganization is accomplished in two steps.

First, the company exchanges “substantially all” its assets for buyer stock. After the closing the owner liquidates the company and ends up with the buyer stock. The buyer will defer gain until he or she sells the buyer stock.

The deal

The company in this deal sold its assets to the buyer in exchange for buyer stock. However, the company’s receivables were not part of the deal.

The company claimed on its return that it was entitled to defer gain under the then applicable C reorganization provisions. A critical requirement for C reorganization treatment was that the company sold “substantially all” of its assets to the buyer in exchange for buyer stock.

The lawsuit

The IRS determined that the owner could not defer the gain as a C reorganization because the company did not sell substantially all of its assets to the buyer. Specifically, the company did not sell the receivables which represented 32% of the net book value of the company’s assets.

The company disagreed with the IRS and challenged the Service position in the U.S. Board of Tax Appeals, the predecessor to the Tax Court. The Board of Tax Appeals held that selling 68% of the net book value of the company’s assets was not “substantially all” of its assets: “We have repeatedly held… that 68 per cent stock ownership or control did not constitute ‘substantially all.’ … If a transaction of the sort here involved can be said to be within the provisions of the statute, then there is no limit to the proportion of assets that may be retained by a corporation …”

This case is referred to as Arctic Ice Machine Co. v. Commissioner, 23 B.T.A. 1223 (1931)  https://cite.case.law/bta/23/1223/

Comment

So, what is substantially all of a company’s assets? To play it safe, sell 90% of the fair market of the company’s net assets and 70% of the fair market value of the company’s gross assets. See Revenue Procedure 77-37, 1977-2 C.B. 568.

By John McCauley: I help people with M&A tax issues involving privately held companies.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in C Reorganization, substantially all assets, tax deferred reorganization Tagged with: , , ,

Business Seller Fights Through a Jury Trial and an Appeal to Enforce Oral Side Deal

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August 12, 2020

Introduction

Sometimes the parties to an M&A transaction want to leave certain agreed terms out the written agreements to avoid adverse tax consequences. These additional terms are made in the form of a handshake: an oral side contract.

However, an oral side deal has risks.

The deal

The business owner in this deal owned and operated a Hawaii business that operated through three companies. One sold and rented traffic safety devices. Another manufactured and installed signs, and a third company sold screen-printing supplies and equipment. The owner agreed to sell the assets of his business to a private equity buyer in the summer of 2007 for cash in the amount of $23 million.

The buyer’s anticipated lenders did not like the all-cash proposal. They were concerned that the business owner might not remain involved in the businesses unless he had a financial stake in the acquiring company.

This led to a restructured transaction where the owner’s manufacturing company would receive buyer stock along with cash. And the stock would be cashed out in 3 years at a pre-determined price.

But there was a problem. A mandatory redemption of the buyer stock caused a tax problem for the manufacturing company. Specifically, it would result in taxation of the gain in 2007, the year of the sale of the business. That did not work for the owner. He wanted to defer the tax until the buyer stock was sold back to the buyer in 2010.

This problem led to an impasse. An attorney suggested that they remove the repurchase obligation from the written documents and leave it to a gentlemen’s understanding or an oral contract.  The buyer agreed and promised to purchase the stock. The problem was solved, and the deal closed in the summer of 2007.

The lawsuit

Following the acquisition, the business did not perform as expected. The 2008 recession was partly to blame, as were mismanagement and misguided strategy. In 2010 the buyer told the owner that the buyer could not afford to buy the stock.

The owner sued the buyer in a California state court. He won and the buyer appealed to an intermediate appellate court. The Court of Appeals affirmed the judgment of the trial court.

The buyer argued that the owner could not introduce evidence of the gentleman’s agreement because of the parol evidence rule and a boilerplate integration clause (also called an “entire agreement” clause or a “merger” clause). The Court of Appeals disagreed saying that the integration clause did not exclude additional terms that are not inconsistent with the written documents. And the handshake deal or gentleman’s oral agreement was supplemental and consistent with the written documents.

This case is referred to as Kanno v. Marwit Capital Partners II, LP, No. G052348, Court of Appeals of California, Fourth District, Division Three, (December 22, 2017).

Comment

Obviously, the IRS would have taxed the gain in 2007 had they known about the side deal. The M&A tax risk here is that the IRS could come after the owner for tax fraud even now because there is no 3 year or 6 year period of limitation for tax fraud.

Thus, the potential risk in doing an oral agreement was not only the legal fees and cost of enforcing the oral agreement, but the potential for tax, interest and hefty fraud penalties accruing from the 2007 taxable year.

By John McCauley: I help manage the tax risks associated with buying or selling a business.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in 351 M&A transactions, boot, handshake redemption obligation, integration clause, nonqualified preferred stock, parol evidence rule Tagged with: ,

Stock Seller Sues Buyers for Failure to Close S Corp Books to Obtain Q1 Taxable Loss

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July 27, 2020

Introduction

One tax issue when selling the stock of your S corporation business midyear is dividing up the year’s income and expenses. That is because an S corporation passes its income, and expenses through to the owners of the business who report them on their personal income tax returns.

This can be done in two ways. One way is to allocate the year’s income and expense to the seller and the buyer based upon their ownership interest in the company for the year. For example, if a sole shareholder sells all his stock to a buyer at the end of March then the seller will report 25% of the company’s income, expense and credits for the year on the seller’s personal tax return.

Alternatively, the buyer and the seller could consent to close the books at the end of March by making an Internal Revenue Code Section 1377 election. In that case the seller will report Q1 income and expense on seller’s personal return and the buyer would report all in Q2, Q3 and Q4 income and expense on the buyer’s personal tax return.

The deal

This deal involved a Chicago based business specializing in the air and ocean freight forwarding industry. The seller owned 25% of the company’s stock and he sold his stock on March 31, 2009 to the other shareholders.

The lawsuit

The company had a $125K first quarter loss for 2009. After the closing, the seller asked the buyers to consent to make a section 1377 election so that the seller could report an approximate $31K loss for the company on his 2009 personal tax return. The buyers refused.

The company did better the rest of the year generated profit for the year.  The company allocated to seller $143K of 2009 company income. Thus, instead of having a $31K loss from the company the seller reported $143K in income from the company for the year. This resulted in federal and state taxes of about $85K.

The seller sued the buyers in a Chicago federal district court for breach of the stock purchase agreement. The seller argued that the buyers had a duty under the stock purchase agreement to consent to the section 1377 election under a “boiler plate” “Further Assurances” provision that required the parties to “execute and deliver all such other instruments and take all such other actions as each other may reasonably request from time to time in order to effectuate the purposes of this Agreement.”

The buyers asked the court to dismiss the lawsuit claiming that there was nothing in the stock purchase agreement to require the buyers to consent to making a section 1377 election. The court disagreed: “Although the Agreement did not expressly require the … (buyers) … to sign a Section 1377 Election request, the “Further Assurances” provision could plausibly be construed to require the … (buyers) … to accommodate the request because it would appear reasonable for a business owner terminating his interest in a company to stop paying taxes on income earned by the company after the termination date.[3] Given that … (the seller’s) … request could be construed as reasonable, the … (buyers’) … alleged conduct would be a violation of the “Further Assurances” provision and constitute a breach of the Agreement. Accordingly, … (the seller) … has plead all the necessary elements of a breach of contract dispute, so the … (buyers’) … motion to dismiss for failure to state a claim upon which relief can be granted is denied.

This case is referred to as Manfre v. May, No. 1:18-cv-2184, United States District Court, N.D. Illinois, Eastern Division, (March 12, 2019)

Comment

The seller could have saved himself a lot of grief by expressly requiring the buyers to consent to making the section 1377 election in the stock purchase agreement. Don’t rely on boilerplate to bail you out.

By John McCauley: I help manage the tax risks associated with buying or selling a business.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in further assurance provision, S corporation, Section 1377 election Tagged with: ,

Chosen Merger Structure Accelerates over $2 million in Taxes for Seller

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July 21, 2020

Introduction

Selling a business usually generates significant tax consequences. However, a transaction can sometimes be structured to defer the payment of taxes.

The deal

The business owner held the KFC and Pizza Hut franchises in Russia through target, a New Jersey corporation. He owned 75% of the target and his partner owned the remaining 25% of the target through a British Virgin Islands company.

The business owner negotiated a sale of the target to a Dutch company that operated fast food outlets throughout Central and Eastern Europe. The purchase price was $54 million with $23 million payable in cash and the rest in buyer stock. The business owner was a party to the merger documents and was listed as the owner of all the target stock.

The deal was done by the business owner buying his partner out for $14 million 3 weeks before the closing, promising to pay the $14 million purchase price after the business owner closed with the buyer.

As agreed, the merger closed 3 weeks later. The business owner received $31 million in buyer stock and the $23 million in cash. The business owner then paid his partner $14 million for the target stock he bought 3 weeks before.

The business owner had a zero tax basis in his 75% share of the target, so he was looking at serious income taxes. His tax position was helped because the purchase price included enough buyer stock to defer part of the gain from his target stock.

The lawsuit

The business owner’s gain from the transaction that was to be recognized was only on the cash that he received from the buyer. And that was the issue.

The business owner argued that he only received $9 million in cash from the buyer; with the other $14, million going to his partner (who received no buyer stock, just cash from the deal). The IRS agreed that this would have been the case if the partner had sold his target stock directly to the buyer. But the IRS argued, the partner did not. The partner sold its stock to the business owner for $14 million in cash.

Therefore, the IRS argued, the business owner received $23 million in cash from the buyer not $9 million and therefore the additional $14 million in gain resulted in immediate federal income tax of over $2 million.

The Tax Court and the U.S. Court of Appeals both agreed with the IRS. Both courts said that the business owner chose the form or structure of the deal.

Had the owner insisted that his partner sell his partner’s target stock directly to the buyer, then the business owner would only be taxed on $9 million in cash received. But since the business owner chose to buy his partner’s stock 3 weeks before the merger and then sell it to the buyer, the business owner has to recognize gain on the $23 million cash paid by the buyer at the closing not the $9 million.

This case is referred to as Tseytin v. CIR, T.C. Memo. 2015-247, Docket No. 354-12, United States Tax Court, (Filed December 28, 2015); https://www.ustaxcourt.gov/UstcInOp2/OpinionViewer.aspx?ID=10654#xml=https://www.ustaxcourt.gov//UstcInOp2/PDFXML.aspx?DocId=10504&Index=%5c%5cnt%2d26%5cUSTCPDF%5cAOTHistoricWWW&HitCount=6&hits=a+b+55+56+1303+1304+

and  No. 16-1674, United States Court of Appeals, Third Circuit, (Opinion Filed: August 18, 2017)

Comment

We cannot tell whether the business owner tried to get his partner to sell directly to the buyer. But the lesson here is clear. The form or structure of the deal can matter for tax purposes. Therefore, get good tax advice before you talk structure with your buyer or seller.

Also, I am reminded about what my mom and dad told me: life is not fair.  Here the business owner is stuck with the form he chose even if the substance netted him $14 million less in cash.

But it does not work the other way. The IRS can get more tax out of a taxpayer by recasting the form of the transaction to conform with its substance.

By John McCauley: I help manage the tax risks associated with buying or selling a business.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

Legal Disclaimer

The blogs on this website are provided as a resource for general information for the public. The information on these web pages is not intended to serve as legal advice or as a guarantee, warranty or prediction regarding the outcome of any particular legal matter. The information on these web pages is subject to change at any time and may be incomplete and/or may contain errors. You should not rely on these pages without first consulting a qualified attorney.

Posted in boot, cash, form over substance, merger, substance over form, tax deferred reorganization Tagged with: ,

Buyer of Target Can Sue Sellers for $9 Million of Pre and Post Sales Tax Liabilities

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July 15, 2020

Introduction

It can be challenging for a national footprint business to navigate the 11,000 sales tax jurisdictions in the United States. Thus, buying a large business presents state and local sales tax risk.

The deal

This deal was a $110 million stock acquisition of a target with a national footprint structured as a merger. There were standard tax representations and warranties and indemnification provisions. The purchase price was secured by a $11 million escrow.

The lawsuit

KMPG performed a tax audit after the closing and discovered that there were unreported sales tax liabilities owed including for sales made in Chicago, New Jersey, New York, and Texas prior to the closing with taxes and related costs of about $5 M.

The selling shareholders promised to indemnify the buyer for the target’s pre-merger taxes. The buyer made a claim for indemnification under the escrow for these taxes based upon the KMPG audit even though the tax agencies had not yet come after the target for the taxes.

The 18 month post-closing window for buyer indemnification expired and the seller sought release of the escrow funds. The buyer refused and the dispute ended up in a New York state court in Manhattan.

The seller argued that the buyer indemnification claim was defective since the taxing authorities have yet to pursue assessment of the taxes. Therefore, the selling shareholders asked the court to rule in its favor on this claim in its motion for summary judgment and release the escrowed funds to the selling shareholders.

The court rejected this argument holding that the buyer does not have to incur the tax before making a timely indemnification claim: “Article IX does not require Damages to have been incurred prior to the Claim Expiration Date, provided that the Claim Notice is timely and contains a reasonable estimate of the Damages expected to be incurred.” Thus, the escrowed funds were not released to the sellers.

This case is referred to as SHAREHOLDER REPRESENTATIVE SERVS. LLC v. THE NASDAQ OMX GROUP, INC, Docket No. 651145/2014, Motion Seq. No. 006, Supreme Court, New York County, (July 5, 2016 and July 25, 2018); https://scholar.google.com/scholar_case?case=10543741897857324145&q=SHAREHOLDER+REPRESENTATIVE+SERVS.+LLC+v.+THE+NASDAQ+OMX+GROUP,+INC&hl=en&as_sdt=1000006&as_vis=1 and https://scholar.google.com/scholar_case?case=3431382646305476485&q=tax+OR+taxes+%22merger+agreement%22&hl=en&as_sdt=2006&as_ylo=2017

and  2019 NY Slip Op 07752, Supreme Court, Appellate Division, First Department, (October 29, 2019; https://law.justia.com/cases/new-york/appellate-division-first-department/2019/10241n-651145-14.html

Comment

The buyer also claims damages for an estimated $4 million is post-merger sales tax on the theory that target’s management lied in the  merger agreement’s tax representations and warranties when they said that the target “(a) … timely filed when due . . . all federal income Tax Returns, and all other material Tax Returns that they were required to file under applicable laws and regulations. . . .”; and (b) to … (the target’s) … knowledge, “no Taxing Authority has any reasonable basis to assess any additional Taxes against any of the Target Companies for any period up to and including the Closing Date. . . .”

The buyer had some hurdles in pursuing the claim for post-merger taxes. First the indemnification for unpaid taxes only applied to pre-merger taxes. Second, the buyer did not make a timely indemnification claim for the post-merger taxes based upon the breach of the tax representations and warranties.

The saving grace for the buyer was the fraud carveout, which permitted the buyer to sue for making a false tax representation and warranty outside the indemnification provision. This worked because a fraud claim was not an indemnification claim which required the claim to be made by the 18 month anniversary of the closing.

By John McCauley: I help manage the tax risks associated with buying or selling a business.

Email:             jmccauley@mk-law.com

Profile:            http://www.martindale.com/John-B-McCauley/176725-lawyer.htm

Telephone:      714 273-6291 

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Posted in fraud carveout, post-closing sales tax, pre-closing sales tax, sales tax risk Tagged with: ,

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