Borrow 4 Tricks from the Accountants to Negotiate a Better Deal Price

Remember back in middle school, when it was so much fun to memorize the rules just well enough to beat the system? You may have forgotten how much fun it was, but the accountants haven’t.

Most dealmakers have at least a couple of tax professionals on the payroll so they can focus on the more important things. But consider this: the top federal corporate tax rate is 35%, and the top individual rate is 39.6%. When is the last time you had that kind of negotiating room over the purchase price?

I’m going to share a few of the accountant’s secrets that may make a difference at some point if you keep these things in the back of your mind, and at the very least will broaden your perspective. Most of these are only useful in certain situations, but make sure to at least check out #4.

Trick #1: Indefinitely defer the seller’s taxes by investing the proceeds in another small business.

This one is probably most applicable to venture capital, or possibly lower middle market investment bankers – skip to trick #2 if you don’t fall in this category.

IRC Section 1045 lets you defer all taxes on the sale of the business if you re-invest the proceeds in another small business. How to do it, from the seller’s perspective:

1) Convert your business to a C corporation, making sure to obtain your stock through money, services, or property other than stock. (Just try not to do this immediately before the sale – this is something you have to plan for, or the IRS won’t allow it.)

2) Hold the stock of the business you are going to sell for six months and one day.

3) Make sure total business assets never exceed $50 million.

4) Re-invest ALL the proceeds from the sale into another small business corporation within 60 days of the sale (or you will be taxed on the portion you didn’t re-invest).

It’s as if you multiplied the sale price by 1.396.

Trick #2: Scrap the earnout provision or shorten the earnout term.

Because this trick is only relevant to individual taxation, it will only work if the business is being sold by an individual or if the business structure means that the individuals are taxed, rather than the company – an LLC for example.

Earnout provisions can be a great compromise, but do have their disadvantages. They can restrict the buyer’s actions during the earnout period since the seller will likely insist on retaining a substantial interest or management position during the earnout period so they can achieve the agreed-upon target. The earnout provision may also be one of the most contentious parts of the deal, simultaneously reducing risk but increasing uncertainty. There is an inherent conflict in making the price contingent on the seller achieving a performance target while making that achievement dependent on the buyer’s actions. If for whatever reason you want to eliminate or shorten the earnout, use your knowledge of a couple simple facts as a bargaining chip:

• Even if the sale qualifies for treatment as a long-term capital gain (top tax rate of 20%), the earnout payments will be treated as imputed interest and taxed partially as ordinary income (top tax rate of 39.6%).
• The portion of the earnout payments taxed at the higher ordinary income rate will increase with each passing year. For this reason, this tax consideration could be particularly useful as a bargaining chip to shorten the earnout period.

Trick #3: Appeal to the children.

The only amount that you can give anyone without having to pay taxes on it is a pitiful $14k. You get a little more cushion ($5.25M) if you die first and leave it to your heirs as an estate, but if you want to leave your kids more than that amount (as many successful business owners might), you are going to have to fork over as much as a whopping 40% of the excess to Uncle Sam. How to avoid it:

1. Put a trust in place for the owner’s beneficiaries (an irrevocable trust, like a GRAT). Do this as early as you can; putting the trust in place the day before the sale is a great way to get on the IRS’ radar. Hopefully the owner has a trust in place already.

2. Move the equity of the business (or a portion of it) into the trust.

3. Then sell the business.

This can be an excellent move if you’re on the sellside. On the buyside, mentioning this maneuver may also be one way to build some goodwill.

Trick #4: Play the name game.

This one is the most complex, so read carefully. The trick allows a C corporation to avoid extra taxes, so it’s only relevant to sales of companies with that business structure.

When the company being sold is structured as a C corporation, the assets are taxed to the seller first at the corporate level (up to 35%) and then at the individual level (up to 39.6% of the remainder). In addition, the buyer loses out because his basis in the assets doesn’t get a step-up. (Translation: when the buyer gets rid of the assets later, he doesn’t get to deduct as much.) To avoid both problems, instead of just paying the seller for the stock:

1. Specifically identify part of the purchase price as rental agreements, interest, services (e.g., consulting fees), and intangibles assets (e.g. a noncompetition agreement, IP licenses, and personal goodwill) rather than as stock.

2. The result: The buyer gets a deduction for all his payments, but the seller loses out by paying ordinary income tax (39.6%) instead of capital gains (20%). So why would the seller agree to this? Because the extra 19.6% the seller pays is less than the 35% corporate rate that the buyer would have had to pay. The two parties can then decide how they want to split that 15.4% savings.

(Side note about that personal goodwill – make sure you get an intangibles valuation professional to do a valuation, and make sure you consult your lawyer to make sure you can establish the existence of the personal goodwill based on the relevant case law.)

None of these considerations will swing the negotiation drastically one way or the other, but they are a way to gain an extra edge. Make sure you quantify everything; e.g., “Twenty percent of personal tax savings under our proposal with a purchase price of $50 million is ten million dollars in your pocket!” For most people, the tax considerations (especially the personal taxes of the other party) are an afterthought, if they are a thought at all. This is just one way to bring another variable into the equation.

Note: This post should not be construed as tax advice specific to your situation. I am not a tax professional, and the advice above is not comprehensive; rules typically have exceptions, exceptions to the exceptions, and usually exceptions to those exceptions, too. Consult with your accountant or attorney on all tax matters.