Seller Retention of Receivables in Asset Sale Blows C Reorganization

Share

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

Share

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

Share

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

Share

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

Share

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 

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

Typo Forces Stock Seller of Business to Sue Buyer for Pre-Closing Tax Refund

Share

July 10, 2020

Introduction

There are lots of words in acquisition documents. A stock purchase agreement in a relatively simple transaction may contain 20,000 words. And there are many different references throughout the agreement to buyer and seller; and sometimes seller is mistakenly used when buyer was intended or vice versa.

The deal

This case involved the stock acquisition of a business. Part of the deal was that the selling shareholder was to get pre-closing tax refunds.

The lawsuit

The buyer and seller had a falling out after the closing and their dispute ended up in a Delaware federal district court. In that lawsuit the selling shareholder sued to recover the target’s pre-closing tax refunds.

The stock purchase agreement said that any “tax refunds received by … (the target) … and any amounts credited against Taxes to which … (the target) … and the Purchaser become entitled, that relate to Tax periods or … (part) … of Tax periods ending on or before the Closing Date shall be for the account of the … (selling shareholder) …”  Unfortunately for the selling shareholder the language went on to say that the target “shall pay to the Purchaser any refund… fifteen (15) days after receipt by … (the target) … or the Purchaser.”

This made no sense that the seller was entitled to the pre-closing refund but that the tax refund was to be paid to the buyer. However, that is what the agreement said and so the buyer asked the court to throw out the seller’s claim for the pre-closing tax refund in a motion for summary judgment.

The court refused to throw seller’s claim out of court clearly thinking this language in bold was a mistake: “As a matter of contract interpretation, I think … (the seller) … is correct. The plain language of Section 4.1(d) provides that the Company is to pay to the Purchaser … any pre-closing tax refunds or credits the Company receives. On the record before me, however, and drawing all reasonable inferences in Seller’s favor at this stage, I think there is a genuine dispute of material fact as to whether Section 4.1(d)’s statement that the Purchaser is to receive pre-closing tax refunds is in fact the result of a mutual or unilateral mistake and thus fails to comport with the parties’ intent at the time they entered into the purchase agreement. Indeed, based on the presentation of evidence so far, it seems to make little sense to me that the Purchaser would receive pre-closing tax refunds or credits. But that is an issue for trial.”

This case is referred to as Heritage Handoff Holdings, LLC v. Fontanella, Civil Action No. 16-691-RGA, United States District Court, D. Delaware, (July 25, 2018)

Comment

As a lawyer I always am nervous about billing a client for proofing long documents before closing. But mistakes like this are all too common.

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 allocation of preclosing taxes refunds and credits, stock purchase agreement, typo or scriverner's error Tagged with: ,

$3.5 Million Buyer Refund – No Transfer of Seller Unemployment Comp Experience

Share

July 10, 2020

Introduction

One tax expense to project when buying the assets of a business is unemployment compensation tax. Especially if the buyer is going to hire the seller’s employees. A potential risk for the buyer is inheriting a seller’s high unemployment experience resulting from high seller employee turnover.

The deal

The buyer and seller were both in the business of providing companies human resource services. They were professional employer organizations (PEOs), which is an outsourcing firm that provides services to small and medium sized businesses.

The buyer paid the Texas company $5.3 million for its assets, primarily the seller’s client accounts.  The purchase price was payable $2.5 million at the closing and about $2.8 million in the form of two promissory notes payable in equal amounts to two officers to the seller’s officers (and presumably owners of the seller). Each note was secured by the assets sold to the buyer. The acquisition agreements obligated one of the seller officers to help the buyer in transitioning seller’s clients to the buyer.

The lawsuit

After the closing, the buyer received written notice from the Texas Workforce Commission that it considered the buyer to be a successor employing unit to the seller. Consequently, Texas retroactively changed the buyer’s tax rate to reflect the transfer of the seller’s compensation experience, resulting in an increase of unemployment taxes of approximately $3.5 million.

The buyer paid the tax and sued Texas for a refund in a Texas state trial court and lost. On appeal the Texas intermediate appeals court reversed the trial court decision ordering that Texas refund the taxes to the buyer.

The issue under Texas law was whether there was “substantially common management or control or substantially common ownership of the entities.” Texas focused on the seller’s post-closing obligation to help the seller clients transition to the buyer. Texas argued that these transitional services showed that the seller was providing post-closing management of its former employees.

This was enough for the trial court to impose seller’s experience rating on the buyer but not for the appellate court: “There is no evidence that Seller continued to provide PEO services to the client accounts following the Buyer’s acquisition of the accounts.”

This case is referred to as G&A Outsourcing IV, LLC v. Texas Workforce Commission, No. 03-16-00752-CV, Court of Appeals of Texas, Third District, Austin, (Filed August 17, 2017)

Comment

One takeaway from this case is that an M&A unemployment tax risk might exist in acquiring a PEO, where the seller employees are staffed out to the seller’s clients. Those employees might be likely to jump ship to a permanent position resulting in high seller employee turnover.

The buyer would also have inherited the seller’s unemployment compensation rating under Texas law if the seller controlled “through security or lease arrangements the assets necessary to conduct the business” after the closing. The seller’s sold assets were secured by the promissory notes. But the saving grace for the buyer in the eyes of the Texas appeals court was that the secured party was not the seller but the seller officers/apparent owners.

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 seller's unemployment experience rating, successor liability Tagged with: ,

Seller $309 Million Stock Gain May Be Nonbusiness Income and Escape CA Franchise Tax

Share

July 8, 2020

Introduction

One tax risk of a multistate corporate business selling the stock of a subsidiary is exposing the gain to many states with different rules and tax rates.

The deal

The seller here provides credit and debit card processing, electronic banking services, check risk management, check cashing, and merchant card processing services to financial institutions and merchants. It purchased 29 percent of a target’s stock in 2004.

The acquisition gave the seller needed expertise and services at lower cost. The deal was structured so that the seller had some management control over target. The seller was hopeful that the seller could favorably shape the target’s marketing strategy. Also, the target’s modest size reduced the risk that the target would filch the seller’s customers.

The arrangement between the seller and target did not go as planned. By 2006, the seller was not meeting the minimum purchase requirement in the acquisition agreements, and the target board was discussing the applicable penalty payment. Additionally, the seller and the target had trouble agreeing on a business model or a “go to market” strategy in terms of approaching customers with a price and who would do what and where. After the target made a pitch directly to one of the seller’s customers, the seller explored acquiring all the target to obtain managerial and operational control and have an effective going-to-market strategy. Ultimately, the seller decided to sell its target stock.

It did so in 2007. In its 2007 California tax return, the seller, a Florida corporation, reported $309 million in capital gains from the sale of the Covansys stock as nonbusiness income. Meaning that the seller was reporting that the gain was all taxable by Florida. Florida’s top franchise tax rate was between 5 and 6%.

The lawsuit

The California Franchise Tax board challenged the seller’s position saying that the $309 million gain should be apportioned among the states under a property, sales, and payroll basis. California’s top franchise tax rate was close to 9%.

The seller paid the California tax and sued the Franchise Tax Board for a refund in the Sacramento Superior Court. The court agreed with the Franchise Tax Board that the $309 million gain was partially taxable by California as apportionable business income because the seller’s management and acquisition of the target stock constituted an integral part of the taxpayer’s regular trade or business operations.

The seller appealed and the California Court of Appeals reversed the trial court’s decision. In an unpublished opinion it held that in determining whether the gain was apportionable business income, the relevant inquiry was whether the target stock was integral to the seller’s business when it was sold, not whether the stock had been integral to the company’s business at any point in time. It directed the trial court to decide the issue on that basis.

This case is referred to as Fidelity National Info. Services, Inc. v. Franchise Tax Board, No. C081522, Court of Appeals of California, Third District, Sacramento, (Filed July 27, 2017)

Comment

State franchise tax can be a big deal when projecting after tax proceeds from a deal. And how the tax gain pie is to be split is not always clear. Therefore, it is important to be prepared for the possibility of state taxing agencies fighting with you if the stakes are high enough.

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 nonbusiness income/sale of subsidiary, state franchise/income tax, unitary business Tagged with: ,

Seller Owner Must Pay Sales Tax on Underreported Buyer Liquor Sales Made Before Closing

Share

July 8, 2020

Introduction

Selling a business with a liquor license takes time. The buyer cannot acquire the license or permit without state approval.

The buyer and seller sometime agree to a transitional arrangement where the buyer takes over the business from the seller and sells liquor to customers under the seller’s liquor license. This includes the buyer collecting sales tax, filing sales tax returns, and paying over the sales tax to the state.

But what happens when the buyer underreports the sales tax during the transitional period?

The deal

In this case the sole owner and president of a corporation operated a retail liquor business. He tried in succession to sell his business to 3 different buyers. In each case the potential buyer took over the business while the liquor permit process was pending under a management agreement. In all three cases the potential buyer collected the sales tax from customers, filed sales tax returns and paid the sales tax to the state of Ohio.

The potential buyers were responsible under the management agreements for all sales tax owed during the term of the management agreement terms. Furthermore, the seller audited the buyer’s compliance.

The lawsuit

Unfortunately, the buyers underreported sales tax and the state of Ohio went after the seller’s owner as a statutorily designated responsible party for almost $100K in sales tax. The owner unsuccessfully challenged the sales tax assessment in the Ohio Board of Tax Appeals and Ohio Court of Appeals.

This case is referred to as Painter v. Testa, No. 16 CAH 03 0016, Court of Appeals of Ohio, (January 20, 2017).

Comment

It is tempting for a seller to want to hand over the keys to a retail business to the buyer before all governmental approvals have been obtained, under some form of transitional arrangement such as a management agreement. One tax risk is doing is the risk that the seller’s owner will be exposed to underreported sales tax.

The owner would be better off waiting to turn over the business until after the license has been obtained. Alternatively, the owner should try to secure the risk with a adequate cash deposit from the buyer.

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 pre-closing management agreement, seller owner responsibility for underreported sales tax Tagged with: ,

$2.8 Million Tax Cost for Failure to Follow Planned Structure of Subsidiary Sale

Share

July 6, 2020

Introduction

The formalities of a sale of a business can have significant tax consequences to the owners. It is important that the preferred structure of the sale is implemented. And that means that the seller and the seller’s advisers, take the time necessary to carefully review the acquisition documents before signing..

The deal

This case involved the $16.5 million acquisition of the stock of a Texas manufacturer of electronics for the computer, telecom, medical, and industrial control arenas. The target was the operating company and was owned by 3 individual shareholders through a holding company. The stock of the operating company was the only asset of the holding company.

The owners had a lawyer, accountant and investment banker helping them structure a transaction which would yield the highest net after tax sales proceeds. The plan was for the owners to sell the holding company stock to the buyer. And the buyer was agreeable to purchasing the holding company stock.

However, there was a screw up and the buyer purchased the operating company stock instead of the holding company stock.

The lawsuit

The transaction was reported to the IRS as a sale of the holding company stock not the operating company subsidiary stock. The IRS audited and assessed additional tax based upon the sale of the subsidiary stock, resulting in additional taxes, interest, and penalties of about $2.8 million.

The taxpayers fought the IRS in Tax Court. It argued that the sellers and buyer both agreed to a holding company stock sale and that the incorrect paperwork was a mutual mistake. The Tax Court was not persuaded and ruled in favor of the IRS. The taxpayers appealed to the United States Court of Appeal and lost.

This case is referred to as Makric Enterprises, Inc. v. Commissioner, 2016 T.C. Memo. 44, United States Tax Court, (Filed: March 9th, 2016).  https://www.courtlistener.com/opinion/4562998/makric-enterprises-inc-v-commissioner/?q=cites%3A(2461464)  Makric Enterprises, Incorporated v. Commissioner Of Internal Revenue, No. 16-60410, United States Court of Appeals, Fifth Circuit, (Filed March 27, 2017)

Comment

Someone must quarterback a transaction and make sure that the purchase documents are in line with the desires of the business owners. In this case the quarterback would make sure that each owner, the accountant, the lawyer, and the investment banker were satisfied that the closing documents were accurate before signing them.

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 mutual mistake, structure of transaction, Taxation Tagged with: ,

Recent Comments

Categories