M & A Roundup: Stripping Tax Deferrals From Installment Sales

A troublesome federal tax law change exploded almost without warning on the m&a middle market in early 2000, removing tax advantages for many small deals involving “seller financing” and forcing dealmakers to devise new structures for those affected. The revision, a virtually unnoticed feature of a tax bill passed by Congress last December, reduces the ability of sellers of many small companies to defer taxes when the buyer’s payments are parceled out in installments over two or more years. Dealmakers have differing views as to its impact, which falls mostly on the lower end of the m&a marketplace. Under the change, all taxes are due up front on the complete purchase price if the seller realizes a gain of less than $5 million, is selling assets (as opposed to stock), and the target company has paid federal taxes on the accrual basis. Previously, sellers in these small installment sales, commonly referred to as “seller financing” because sellers usually take notes to represent the delayed payments, could ease the tax bite by paying an initial tax on the down payment and the remaining taxes due when the installment payments were made. Staggered tax payments in larger installment transactions were eliminated by Congress in 1988. Bernard Topper, an m&a tax partner at KPMG Peat Marwick, reported that Congress is considering several proposals to either repeal the provision or restore some type of exemption for the smallest deals. He said that the change has potentially widespread impact because the bulk of corporations pay taxes on the accrual basis. “The Internal Revenue Service felt that accrual and deferral were inconsistent,” he said. Douglas Hubert, COO of Niederhoffer-Henkel Century Group in Atlanta, said the tax law change has required dealmakers to be a “little creative in working around that issue.” One alternative has been to add an earn-out, payable over a few years if the target company meets agreed-on performance, to the base price. He said the earn-out usually is deductible to the buyer. But Hubert and others warned dealmakers to consult with tax attorneys to make sure that the earn-out isn’t itself classified as an installment sale in disguise by the IRS. Stephen B. Blum, an m&a partner at KPMG, said that a carefully done earn-out should be able to pass muster because “it’s still a contingency and the two sides have not settled on an exact amount for the purchase price.” Alan Scharfstein, president of The DAK Group Ltd., Rochelle Park, N.J., said other alternatives to stagger total payouts include consulting agreements and rents on facilities owned by affiliates of the target. “We have to be very cautious on earn-outs to make sure they don’t fall under the installment sales rule,” he added. Scharfstein said the new treatment of installment sales will fall most heavily on S corporations, whose deals are almost always structured as asset sales. But the change can hit other deals as well because many buyers of small companies want only their assets while avoiding their liabilities. “The buyer wants a cleaner deal,” Blum said.