By: Raj Tanden and Marina Choundas
Are you preparing to sell your company with cash in the bank? A common construct for valuation is on a cash-free and debt-free basis, such that seller can recover the cash in a pre-closing purchase price adjustment. A common scenario in the sale of a target corporation with excess cash is for the target to distribute funds to its shareholders prior to the acquisition transaction.
There are alternative ways to characterize such payments, each with different U.S. tax consequences. Therefore, any payments contemplated to be made by a target corporation to its shareholders in connection with a sale transaction should be carefully structured to achieve the desired U.S. federal income tax treatment.
There are generally three ways that a payment of such proceeds can be treated for U.S. federal income tax purposes:
- as a distribution to shareholders,
- as sale proceeds from the sale of shares to the buyer,
or
- as a redemption of shares.
From a selling shareholder’s perspective, redemption or sale proceeds typically would increase the seller’s capital gain (or decrease a capital loss). A distribution will be taxable as a dividend to the extent the target has “earnings and profits.” Dividends are taxed as net capital gain for U.S. individual shareholders; however, they can attract up to 30% U.S federal income tax withholding when paid to foreign shareholders. Moreover, such dividends may also be deductible in whole or in part when paid to a U.S. “C corporation.” Thus, the structure of the payment could be very important for U.S. federal income tax purposes.
In general, the IRS will typically respect the form of a transaction. Accordingly, if the selling shareholders desire treatment as sale proceeds, the acquisition agreement should make clear that they will be paid for the proceeds through a redemption of some of their stock prior to the sale or as additional sale proceeds from the buyer. If the target pays out the proceeds to the selling shareholders in the absence of a redemption, the proceeds generally will be treated as a distribution to them, and as a dividend to the extent of its “earnings and profits” with the U.S. federal income tax consequences described above.1
If the buyer will acquire the target through a leveraged buy-out, the parties should use care. If a new company will be used to buy the target with borrowing by the new company or the acquisition is completed via a merger, the borrowed amounts usually will be considered to be sales proceeds. However, borrowing by the target in a stock purchase could be treated as a distribution, if not carefully structured.
While most of the issues regarding the U.S. federal income tax consequences relate to the selling shareholders, buyers should consider such structuring as well. For example, is the buyer willing to “buy” the excess cash by increasing the purchase price for it? If the cash is paid by the target, the buyer will want assurance that proper withholding, if any, has been completed. If the selling shareholders maintain that the proceeds should be treated as purchase price even if paid by the target (without a redemption), that position could mean that the buyer will be treated as receiving a dividend from the target. Such a dividend could have adverse tax consequences to the buyer.
Finally, if the target is public and the payment of the proceeds is treated as a redemption, a new 1% excise tax could apply to the proceeds.
1 Under very limited circumstances, it may be possible to treat the proceeds as sales proceeds from the buyer, even though the proceeds are paid from the target. However, the proceeds would then be treated as a distribution to the buyer, which could lead to adverse results, as discussed below.