The Succession Bulletin - September 2022

Vol. I, September 2022

This quarterly newsletter explores the emerging legal topics related to business succession planning. Thought-leading attorneys from Moritt Hock & Hamroff’s Closely-Held/Family Business Practice Group share their legal insight, experience and best practices on this rapidly evolving area of law.

About The Group

Succession planning is a linchpin of any profitable, enduring business and is of critical importance to its continued success. Succession planning becomes more complex when a closely-held business or family business is involved because it raises emotions tied to planning for the succession of the business. As a result, business owners tend to focus their energy on operating and building their business, and put off the important step of planning for the future.

Continuity & Harmony

A successful business succession plan will facilitate a smooth transition of the business from one generation to the next, with minimal disruption to the day-to-day operations. Current owners will phase out of the company as both managers and owners in a manner so as to enable them to maintain a degree of control as the company changes hands (e.g., the succession plan may entail an extended buy-out period or even a sweat equity component). Early and ongoing planning, with our assistance, helps to ensure the longevity of the business as well as the harmony of each owner’s and their family’s unique needs.

Governance

Businesses require a well-structured, written agreement among the owners that sets forth, among other things, their agreement respecting: (i) the management and operation of the business (e.g., who will execute daily operations, who will approve major decisions and actions of the company, who will honor the strategic vision of the company, etc.), (ii) the imposition of restrictions on transfers or other dispositions of ownership interest so as to maintain continuity in ownership, along with provisions concerning the future disposition of ownership interests upon the occurrence of certain events (e.g., disability, divorce, retirement and death) and (iii) restrictive covenants, including non-competition, non-solicitation, and confidentiality provisions, to protect the financial viability of the business in the event of various contingencies, including an owner’s departure from the business.

Income, Estate and Gift Tax Planning & Compliance

The ever changing Federal and State tax laws require the need for constant analysis of a business’ (and its owners’) current situation with a focus on the future. This component can directly impact both the continuity and governance issues addressed above. For this reason, the agreement among owners requires ongoing review and revision from time to time. Moreover, the necessity to properly comply with tax laws and report requirements is essential and often requires the assistance of professionals.

Risk Management

Protecting the business, its owners and the owners’ family members requires, among other things, a review of life insurance, property and casualty insurance, disability insurance and business continuity insurance. We work with insurance professionals to help spot and minimize potential risks.

Questions to Consider

The following is a list of some, but certainly not all, of the items to consider when thinking about your closely-held business or family business:

  1. What are the current, and intended future, roles of the owners and their family members?
  2. Will the owners all be active in the business or will any be passive owners?
  3. At what age or under what circumstances can the next generation join the business and what requirements must they have to handle the job?
  4. How often do the owners or family members meet to discuss the goals of the business and its current state of affairs?
  5. How do you preserve the business culture, family harmony and desires of multiple owners?
  6. What is the mission of the family planning and business? Are the mission and the culture compatible?
  7. Who makes decisions concerning salaries, distributions and capital structure – and what are distribution priorities?
  8. How can non-family key employees be rewarded and incentivized to stay on board?
  9. Will the business support family members outside the business to pursue other careers?
  10. Should the business provide loans to owners or their family members?
  11. Does the business have both a real estate component and operating component? If so, are leases structured for income to beneficiaries or protection of the business continuity or both?
  12. What is the ultimate goal for the business? Will the owners sell the business to a third-party strategic buyer or should the business be sold or gifted to the next generation of family members? Should the business be partially monetized? Do family discounts or minority discounts apply?
  13. Should use of trusts be incorporated? If so, what is the purpose of the various trusts and who should be the trustee?

The foregoing is not an exhaustive list of considerations. Best practice should always be to consult with counsel to plan for a successful transition of your business to the next generation or other exit strategy.

Earn-Out Payments In M&A Transactions: Purposes, Taxation & Drafting

by Robert M. Finkel

The world of M&A experienced a record-breaking year in 2021 with $5.8 trillion dollars’ worth of deals occurring. According to Reuters, this was a 64% increase in deal value from a year earlier. One of the factors leading to the record high year was an increase in valuations across all sectors. Prior to the 2021 record year, it became increasingly common in M&A transactions that the consideration paid to the sellers include amounts contingent upon later events. “Earn-out” payments pre-2021 were often used when the seller and buyer could not reach an agreement on the value of the target. Currently, earn-out payments can be a useful tool for bridging any valuation gaps that may arise. Earn-out payments allow buyer and seller to close the deal and mitigate risk that can arise from a high valuation or market volatility.

Strategic Purposes of Earn-Out Payments

  • Earn-out payments can mitigate uncertain business valuations and market volatility.
  • Buyers can defer paying a portion of the purchase price and fund payment via the target’s earnings.

The tax treatment (to both the buyer and seller) of the earn-out payments can vary upon the application of basic income tax principals. Buyers and sellers may have conflicting interests in the characterization of the payments, so advance planning with both the attorneys and accountants is highly recommended.

When earn-out payments are conditioned upon services provided by a seller, the question of whether the payment is properly viewed as a purchase price or as compensation for services rendered arises. For sellers, earn-out payments characterized as a part of the purchase price are more favorable due to the capital gains tax rates sellers will receive. On the other hand, buyers may want earn-out payments to be characterized as compensation for services since payments for compensation are generally tax deductible, whereas purchase price payments are not tax deductible. For sellers, earn-out payments characterized as compensation will be taxed at higher ordinary income tax rates in addition to employment taxes.

Taxation of Earn-Out Payments

In considering whether an earn-out payment is purchase price or compensation for services, the Internal Revenue Service will consider the totality of the facts and circumstances surrounding the payments in question, including but not limited to:

  • Whether the selling shareholder is required to provide services in order to be eligible for the earn-out payment.
  • Whether the selling shareholder is otherwise adequately compensated for the performance of the required services.
  • Whether the earn-out payments are proportionate to the selling shareholder’s equity in the target.
  • Whether the total payments made to the sellers when viewed together represent a reasonable price to be paid for the target.
  • Whether the buyer and seller disagreed on the purchase price and the earn-out payment subsequently arose.
  • The manner in which non-selling carryover employees are compensated for post-closing services.
  • How the parties report the payments for both tax and financial reporting purposes.

None of the factors raised above is dispositive. Parties should consider each factor when structuring an earn-out and in drafting the related provisions in the purchase agreement and ancillary documents when the seller will provide post-closing services to the target or the buyer.

When an earn-out is properly considered compensation for services, the payments are treated as taxable income when received by the service provider (note that there are special rules under Section 83 and 409A that can affect this timing). The timing of the related deduction will depend upon the accounting method of the buyer. Where the earn-out is properly treated as purchase price for shares of stock, and one or more payments of the purchase price will be made in later taxable period(s), special rules applicable to “installment sales” apply for calculating the gain or loss on the transaction and the timing of that gain or loss for US federal income tax purposes. In simple installment sales, the purchase price is fixed and is paid over two or more tax periods to the seller. The rules provide that the gain is recognized in the proportion that the gross profit bears to the contract price. For example, if a seller sells stock to a buyer for a fixed price of 100 and his basis in the shares sold is 20, with 40 paid at closing and the balance in equal installments over 5 years, the seller’s gross profit is 80. The gross profit ratio is 80/100 (gross profit/contract price). Seller is taxable on 36 (80% x 40) in the year of the closing and 9.6 in each of the following 5 years (80% x 12).

But, suppose the deferred payments are contingent on the performance of the target, such that the total purchase price is uncertain at the time of closing. This may be because the buyer will pay a formulaic amount which has no stated maximum payment, no maximum time period or neither. In such cases, special rules apply to calculating the taxable portion of each payment.

If the earn-out formula has a “maximum sales price” the gross profit ratio is determined using the above formula to calculate a gross profit ratio, which is applied to each payment. An earn-out transaction with a contingent sale price will be treated as having a “maximum sale price” if the maximum amount of purchase price can be determined by the end of the taxable year in which the sale closes. The maximum stated selling price is determined by assuming that all of the contingencies will be met and that payments will be made at the earliest times provided for. If the maximum selling price cannot be determined by the end of the taxable year in which the closing occurs, but the maximum period over which those payments can be made is determinable, then the taxpayer’s basis is recovered in equal shares over the maximum term. Where there is neither a stated maximum payment, nor maximum time period, a question arises as to whether there has been a sale of property at all, or whether the transaction is properly viewed as a lease or license (resulting in ordinary income to the “seller” when received). Where such a transaction is a sale, the seller’s basis is recovered over 15 years.

Because the application of the basis allocation rules can distort or inappropriately defer the recovery of a seller’s basis, the Internal Revenue Service will consider ruling requests for relief in the way of an alternative method of basis recovery. Under the applicable guidelines, a requesting taxpayer must demonstrate that the alternative method is a reasonable method that ratably recovers his basis and he will likely recover the basis at a rate that is twice as fast as the rate at which the seller would recover its basis using the standard conventions.

If the installment agreement does not provide for interest at the market rate, imputed interest rules will recharacterize a portion of the purported principal payments as interest payments taxable at ordinary income rates. Large installment sales of stock are also subject to an imputed interest charge on a portion of the seller's deferred tax liability. This rule generally applies where the seller’s installment receivables exceed $5M at year end.

The installment method is the default method for reporting installment sales. A seller may elect out of installment method. Where such an election is made, the seller will recognize gain or loss in the taxable year of the transaction in an amount equal to the difference between the amount realized and his basis. The amount realized is the sum of any money received, plus the fair value of the property received. Where there are contingent earn-out payments, the value of property received includes the value of the right to receive the contingent payments. Sellers with earn-outs with maximum selling prices that are unlikely to be achieved may consider electing out.

Drafting Earn-Out Payments

For parties contemplating earn-out payments, there are a key number of issues to consider during drafting. The financial metrics preferred by the parties is often at odds. Buyers typically prefer an EBITDA milestone. Sellers are often wary of the EBITDA milestone since the metric may be manipulated by incurring additional liabilities or costs. Sellers will often request gross revenue of the business since manipulation by buyer is less likely to occur. Due to the current uncertainty of the market and the longevity of the current market, parties should negotiate graduated payments to allow room for the current market’s potential volatility. Lastly, the covenants for operating in the ordinary course vs. past practices; maximization of profit or commercially reasonable efforts to operate the business; and receipt of periodic financial statements and information will need to be negotiated, at a minimum.

Key Drafting Items

  • Financial metric used for earn-out purposes.
  • Which accounting standard will be applied.
  • Operations in the ordinary course vs. past practices.
  • Sellers receipt of financial statements and information.

In summary, earn-out payments are positioned to be one of the most utilized tools in M&A. A survey by Grant Thorton LLP reveals that seventy percent of practitioners believe that 90-100% of deals will have some form of earn-out payment during the 2022 M&A year and thereafter. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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