The Taxation of SMB Acquisitions in Plain English - Experimental Excerpt
March 27, 2024
by a professional from Harvard University in Lynbrook, NY 11563, USA
Hey folks, I'm experimenting with writing some basic tax background for SMB buyers. I have both some tax and transactional experience so hoping I can translate tax jargon into plain English. Putting up the first bit here to see if there's interest. Note, excerpt continues in comments since I ran into the word limit.
Feedback on substance, style, or items I should cover welcome. Not legal advice obviously b/c if it were, I'd charge you lots of money for it.
The Taxation of SMB Acquisitions in Plain English
Taxes are the price we pay for a civilized society.
Oliver Wendell Holmes
Lawyer fees are the price you pay to avoid (some) taxes.
Another (Slightly Less) Wise Lawyer
The epigraph on top of this page may be true, but the tax system of this particular civilized(?) society has become rather more complicated since Mr. Holmes’s days. Many an ETA entrepreneur finds herself rather confounded by this complexity. This little essay will try to lay out the basic tax considerations in SMB acquisitions in the common tongue so the herselfs and himselfs of the ETA world are a little less confounded.
I will only discuss taxable acquisitions here, both because most SMB acquisitions will be entirely taxable (with the most notable exception being some deals involving rollover equity which are carefully structured with the advice of smart lawyers like the humble one writing these words). And yes, there are various forms of acquisition that are not taxable, in whole or part, primarily because some or all of the same people owning the company before the acquisition still own it after in modified form.
In general, under the U.S. tax system, you only pay tax when you realize income. Your meme stocks may have gone through the roof, but until you turn them into cash in your pocket, you don’t pay tax. Once you sell, the tax man wants his share so he can keep your society civilized. (Query if meme stocks and civilized should be used in the same paragraph.)
When you take the big bucks you’ve cobbled together from your life savings, your brother, uncle, SBA loan, pari passu lender, and six investors who want daily updates, and hand them over to the seller, it’s tax time.
But how exactly that tax time plays out is very important to you, so you either (1) shouldn’t be an idiot about it, or (2) you should hire someone who is not an idiot about it so you can get idiot-proof guidance. I’m writing this so that you can do option one, and then realize you might want to do option two too. (Sorry, the phonics of that sentence ending are compelling me to drop ballet shoes here
from Harvard University in Lynbrook, NY 11563, USA
The first step in reducing your tax idiocy is understanding that there is a difference between buying the company (an equity deal or “stock” deal as it’s commonly called imprecisely) and buying its assets. When you buy a legal entity (i.e., the company), you are actually buying a legal person. In certain cases we’ll discuss, the tax law ignores that legal person and treats you as having bought the assets directly. But those cases aside, when you buy the company, you’ve bought a legal person that in turn owns those (possibly-inflated?) EBITDA-generating assets you’re salivating over. The tax attributes of that person’s assets won’t necessarily change just because their corporate owner is now indentured to you.
(Side note: It's important to learn to take this legal personhood fiction very seriously. Modern economies exist because of it and many an entrepreneur has fallen because of a failure to respect the independent personhood of a legal entity.) This has important implications so let’s dig in, but first a word on tax status.
Tax Status
Life was simple in old Oliver’s days (my law school professors would kill me for that collegiality but I’ve been infected by the collegial spirit found on all big law firm websites). You could be a sole proprietorship, a partnership, or a corporation. There were no S corps (born in the late 1950s) and certainly no LLCs (mostly born in the 90s). Although there was depression of the financial sort, you could at least be certain of death and tax status.
Things got a bit more complicated since the birth of S corps and LLCs. A corporation could now choose to be taxed as an S corporation or a C corporation. An LLC could choose to be (1) ignored for tax purposes if has one owner (a disregarded entity or DRE in tax jargon), (2) taxed as a partnership if it has at least two owners, (3) taxed as an S corp, or (4) taxed as a C corp. An LLC can be anything for tax purposes and so knowing it’s an LLC doesn’t tell you much. If you just remember that, you’re already less of a tax idiot.
To reiterate, you cannot know the tax status of a corporation or an LLC without more information (ideally, seeing its tax documentation). Especially if you may do a stock deal (using that term to mean anytime you buy the legal entity), you must know what kind of tax entity you are buying early on so you can plan accordingly. Many a buyer has been surprised way too far into a deal when his lawyer finally gets the tax returns and tells him his LLC target might look soft and appealing but has a thick corporate tax skin.
Ask the seller, and then verify it by looking at the company’s tax returns. The top of the first page should give you your answer. If it’s form 1065, it’s a partnership; Form 1120, a C corporation; Form 1120-S, an S corporation; and if it’s form 1040 with a Schedule C, it’s a disregarded LLC owned by an individual (form 1040 is a personal tax return which you all file, or so I hope).
TBC...