Treatment of Selling/Employee Shareholder Reviewed by Momizat on . Transition Period Payments After a Business Acquisition Owner’s of closely held businesses will usually be required to remain active in the business after the s Transition Period Payments After a Business Acquisition Owner’s of closely held businesses will usually be required to remain active in the business after the s Rating: 0
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Treatment of Selling/Employee Shareholder

Transition Period Payments After a Business Acquisition

Owner’s of closely held businesses will usually be required to remain active in the business after the same is sold. This article examines two key questions related to such post-transaction transition payments: (1) how much should the buyer pay to the sellers for these transition period services, and (2) how should these transition period payments be structured?

transition-periodIntroduction

In the acquisition of a closely held services company, the acquirer often requires that the individual employee/shareholders sellers agree to continue to work for the company during a specified transition period.  This type of employee/seller continued employment during a transition period is common in the acquisition of both professional services practices (such as accounting and medical practices) and services-related companies (such as construction companies and architectural and engineering firms).  The term of the post-transaction seller employment is a matter of negotiation between the buyer and seller parties.  Seller employment transition periods of one to two years are common; however, longer seller employment transition periods are not uncommon.

 

In such services-related businesses, the employee/shareholder sellers often have direct contact with the company’s clients or customers.  For example, in the case of a construction company, the clients may have a direct and personal relationship with the individual contractor.  Although no longer a stockholder in the acquired company, that individual contractor may have to continue working for the construction company for a period of time until all clients become comfortable with the new owner.  In addition, the construction company seller may have personal relationships with all of the company’s construction specialty subcontractors.  Again, the selling shareholder may need to continue working for the acquired company for a period of time to successfully transition all of the subcontractor relationships to the new owner.  Finally, the construction company seller may have personal relationships with all of the company’s employees and tradespeople.  The selling shareholder may have to continue working for the acquired company for a period of time to ensure the smooth transition of these employee and tradespeople relationships.

 

Of course, the employee/shareholder sellers would expect to be compensated for their professional services during the post-transaction employment period.  And, the acquirer will want to compensate the selling employee/shareholders in order to ensure an efficient ownership transition and a successful corporate acquisition.  The two questions related to such post-transaction transition payments are: (1) how much should the buyer pay to the sellers for these transition period services, and (2) how should these transition period payments be structured?

 

Of course, the answer to the first question is based on the unique facts and circumstances of the individual deal.  The amount of such transition period payments is typically based on direct negotiations between the business acquirer and the selling employees/shareholders.  Of course, this negotiation should be conducted—and the transition period payment terms should be agreed to—before the business acquisition is closed.

 

The answer to the second question will have direct federal income tax consequences to both the business acquirer and to the employee/shareholder sellers.  And, related to this transition period payment structuring issue, these two transaction parties (buyer versus seller) have adverse income tax consequences to each other.  Therefore, the question of the structure of the employee/seller transition period payments is the subject of this discussion.

 

Basically, the two alternative payment structures are:

 

  • The payments could be compensation for the transition period services provided by the former shareholders; this structure raises the question: what is a reasonable amount of employee compensation for the services rendered; and,
  • The payments could be an earn-out provision that is part of the overall business (whether stock deal or asset deal) purchase price; this structure raises the question: what is the total amount of the purchase price that the acquirer paid for the target company business?

 

In addition to tax and legal counsel, a valuation analyst is often involved in answering these two transaction structure questions.

 

Buyer vs. Seller Considerations in Structuring Transition Payments

The transaction structuring issue is whether the transition period payments to the business sellers represent either: (1) a contingent purchase price amount, or (2) compensation for services provided by the sellers.  In certain circumstances, the total transition period payments could be considered to include both a contingent purchase price component and compensation for services component.  There is an inherent tension between the two alternative payment structures.  This is because either payment characterization will benefit only one party (i.e., the buyer or the seller) to the acquisitive transaction.

 

From the business sellers’ perspective, if the employee/seller is an individual and the transition period payment is characterized as compensation (including a payment for transition services and for any covenant not to compete), the payment will be subject to federal income tax—at a tax rate of up to 39.6%.  In addition, these transition period compensation payments will be subject to the employee portion of FICA and to a state income tax.

 

On the other hand, any transition period payment that is characterized as a deferred purchase price (for either the company stock or the company assets) will generally be more attractive to the sellers for income tax purposes.  This is because such transition period payments will: (1) be subject to the lower capital gains tax rate, and (2) not be subject to payroll tax withholding.  Therefore, the company sellers would generally prefer the capital gains tax treatment on the transition period payments.

 

From the buyer’s perspective, it may be advantageous to characterize the transition period payments as employee compensation for services.  This is because the payment of employee compensation will usually generate a current income tax deduction for the acquired company.  Nonetheless, if characterized as employee compensation, the transition period payments may also be subject to the Internal Revenue Code Section 280G deduction limitation on golden parachute payments.  And, such transition payments would have to comply with Section 409A (i.e., income inclusion for nonqualified retirement plans), requiring a consideration of any collateral provisions.

 

Factors to Consider in the Structuring of Transition Payments

Several factors should be considered by the transaction participants when determining whether the transition period payments are contingent purchase price earn-out payments or compensation for services payments.  These factors include, but are not limited to, the following considerations:

 

  • Transition services conditions – Generally, if transition period payments are conditioned on the future services actually provided by the employee/sellers, then those conditions may indicate that the payments should be treated as employee compensation (see, Duberstein, 363 U.S. 278 [1960]).
  • Proportionality of the payments – The parties should consider whether the transition period payments are proportional to the sellers’ sale of the company stock. That is, if there is proportionality (i.e., if all of the sellers receive the transition period payments based on the services provided by only some of the selling employee/shareholders) then this factor may indicate a return on capital and a deferred purchase price treatment.
  • Negotiations between the parties – The actual negotiations between the transaction parties play an important role in the characterization of the transition period payments. To the extent that the parties disagree on the purchase/sale price and the transition period payments are later proposed as a means of resolving that deal price disagreement, these factors may indicate that the transition period payments should be treated as a deferred purchase price.
  • Target company valuation – If the amount of the transition period payments represent a reasonable value for the acquired business, then the amounts of the transition period payments may indicate that the payments should be treated as deferred purchase price.
  • Employee/seller reasonable compensation – If the individual selling shareholders are already being paid a reasonable compensation for their post-transaction services, then such reasonable compensation may indicate that any additional transition period payments may be treated as deferred purchase price.

 

When the post-transaction services are tied to the transition period payments, then the payments may be considered compensation for services under Regulations Section 1.61-2.  However, if one or more of the other structuring factors noted above are present, then the parties should consider whether: (1) there is a compensatory intent, or (2) the origin of the transaction payments represents the intrinsic value of the acquired company stock or assets.

 

From an income tax perspective, some of the judicial and administrative guidance related to these transition period payment characterization questions includes the following:

 

  • Arrowsmith, 344 U.S. 6 (1952) – In the Arrowsmith decision, two taxpayers liquidated a corporation they had co-owned. The two taxpayers divided the liquidation proceeds equally, reporting the profits from the distributions as capital gains.  In a subsequent tax year, a judgment was rendered against the liquidated corporation.  The two taxpayers paid the judgment and they reported the judgment payment as an ordinary business loss deduction.In this judicial decision, the court held that those payments—and the resulting tax deduction—were capital.  This was because the claim on which the judgment was rendered related to the original corporate liquidation.  The court concluded that the basis of the taxation treatment was the origin of the claim.

    Likewise, if the payment of a transition payment represents nothing more than the intrinsic value of the company stock (or assets) that the individual seller owned before the transaction, then Arrowsmith suggests that the origin of the transition payments is the existing value of the acquired shares (or assets).

 

  • Lane Processing Trust, 25 F.3d 662 (8th 1994) – In the Lane Processing Trust decision, an employee-owned company sold all of its assets, and the sale proceeds were distributed to the employee-owners. In this case, both the right to the distribution and the amount of the distribution were contingent upon the individuals being employed by the company at the time of the transaction, their job classification, their length of employment, etc.The court rejected the company’s claim that the distribution payments were not compensation.  The court held that the distribution payments were based on factors “traditionally used to determine employee compensation, specifically, the value of services performed by the employee, the length of the employee’s employment, and the employee’s prior wages.”

    Therefore, the court concluded that the payments were more closely aligned to employment services than to stock ownership.

 

  • J. Reynolds Tobacco Co., 149 F.Supp. 889 (Ct. Cl. 1957) – In this case, an employer claimed that payments made to certain owner-employees, under a profit distribution plan and proportionate to their shareholdings, were deductible compensation expense—rather than stock dividends. The court held that the payments were not compensation payments, but were instead on account of the employees’ stock ownership.  The court reached this conclusion because of the following reasons:
    1. The payments were in proportion to the employees’ stock ownership,
    2. The payments were in addition to the employees’ existing reasonable compensation arrangements, and
    3. In prior income tax, accounting, and litigation matters, the employer company had treated the payments as dividends rather than as compensation.

 

  • Revenue Ruling 2007-49 – In Revenue Ruling 2007-49, three rulings were issued on the following situations:
    1. No “transfer” for Section 83 purposes had occurred when new services-based restrictions imposed on vested stock caused those same stock shares to become “unvested.”
    2. A transfer for Section 83 purposes did occur when an employee-shareholder exchanged substantially vested stock for unvested stock in a Section 368(a) reorganization.
    3. A transfer for Section 83 purposes also occurred when an employee-shareholder exchanged substantially vested stock for unvested stock in a taxable stock acquisition transaction.

 

In situation (1), Revenue Ruling 2007-49 suggests that an owner can subject its existing stock to services-related conditions and retain capital gains tax treatment.  In situations (2) and (3), the employee shareholder will maintain basis in the property and can make a Section 83(b) election at the transfer in order to have any subsequent gain taxed at the capital gains tax rate.

 

While not directly on point to the transition period payment issue, the ruling suggests that, at the very least: (1) the intrinsic stock value is capital, and (2) any increase in that stock value may (or may not) require a Section 83(b) election to subject any additional upside to capital gains tax treatment.

 

Summary and Conclusion

Closely held business acquirers often ask the selling employee/shareholders to continue to provide services to the company for a transition period after the company sale is completed.  These company buyers want to make sure that there is an efficient transition of the sellers’ relationships with customers/clients, suppliers and subcontractors, and employees.

 

The structuring (or the characterization) of these transition period payments can have a direct income tax consequence to both: (1) the company buyer, and (2) the selling employee/shareholders.  Such transition period payments may be categorized as compensation for services provided by the selling shareholders.  These payments are current period tax deductions for the company, but they would represent ordinary income to the selling employee/shareholders.  Alternatively, these transition period payments may be categorized as contingent purchase price earn-out payments.  These payments represent capital gains to the selling employee/shareholders, but they would only adjust the buyer’s tax basis in the acquired company stock or assets.  In other words, the acquired company would not receive an income tax deduction for these payments.

 

This discussion summarized the transition period payment income tax considerations to both the buyer and the sellers.  This discussion listed many of the factors that the transaction parties should consider when characterizing these payments.  And, this discussion presented some relevant judicial and administrative tax guidance with regard to the compensation versus purchase price determination.

 

Transaction participants should consider this transition period payment characterization issue when negotiating and structuring the company sale transaction.  Both parties may consult tax and legal advisors.  And, both parties may consult valuation analysts to assess: (1) the reasonableness of the post-transaction employee/sellers’ compensation, and (2) the reasonableness of the total amount of the transaction purchase price.

Robert Reilly is a managing director of Willamette Management Associates based in Chicago. His practice includes business valuation, forensic analysis, and financial opinion services. Throughout his notable career, Mr. Reilly has performed a diverse assortment of valuation and economic analyses for an array of varying purposes.   

Mr. Reilly is a prolific writer and thought leader that can be reached at: (773) 399-4318, or at rfreily@willamette.com.

The National Association of Certified Valuators and Analysts (NACVA) supports the users of business and intangible asset valuation services and financial forensic services, including damages determinations of all kinds and fraud detection and prevention, by training and certifying financial professionals in these disciplines.

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