Private Equity Transaction Tax Consequences: The Importance of a Sophisticated Tax Advisor

by: Chris Conrad
Verified by: CPA

February 28, 2024

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All parties involved in a private equity transaction must pay close attention to the tax consequences of the deal. For sellers, this transaction is likely the biggest of their life – by far. Understanding the tax consequences of how the sale is structured is key to negotiating a transaction that maximizes the after-tax dollars you receive. 

In any deal, buyers and sellers have competing priorities. That’s true not just in the broader economics of the agreement but also in the details of how the deal is structured and the tax implications involved. Working with a tax advisor to understand these is key to ensuring you don’t face an unexpected tax bill when the sale closes. 

The structure of a deal can have multi-year tax implications for sellers. Many PE transactions incorporate rollover equity agreements or earnout periods that last several years and may be contingent on future earnings results. During this time, the original owner of the business might encounter a variety of tax issues. Again, it’s important to understand these before finalizing a transaction.  

In this introductory guide, we provide a high-level overview of tax issues that business owners should be aware of as they prepare to sell their business to a private equity (PE) fund. 

Key Tax Issues for Business Owners Selling to PE Funds

When you sell your business to a PE firm, it’s rare that they cut you a check and allow you to ride off into the sunset the day the deal closes. Rather, you’ll likely be required to remain in a leadership position for several years, assisting with the transition process and ensuring the business maintains the momentum that made it an attractive acquisition target. 

As part of this process, the seller typically receives part of their compensation for the sale of the business as rollover equity – an equity stake in the new capital structure created by the PE firm. Alternatively, the deal could be structured as an earnout – with provisions that require the business to hit certain performance milestones for the seller to be paid. 

As the owner of the target company, this adds significant complexity to your personal tax strategy. There are several areas that you must be aware of and it’s important to work with a tax professional to perform projections that help you understand your potential tax obligations over the coming years. Below we cover three of those areas.

  1. Understand What is Being Sold

One of the fundamental determinations in any business sale is what is being sold: the assets of the business or your equity in the business. 

In many instances, buyers aim to purchase the assets of a business since this provides for a step-up in tax basis that allows them to depreciate these assets and pass tax deductions through to their investors. On the other hand, sellers typically aim to sell stock in the business. Stock sales are often taxed at the long-term capital gains rate which can be more favorable than asset sales, which will be taxed, at least in part, at the higher ordinary income rate.  Additionally, depending on the entity structure of your business, a second layer of tax may be incurred on the distribution of cash after a sale of assets. 

Understanding this distinction is key to negotiating a deal acceptable to all parties. Since asset sales tend to result in increased tax liabilities for sellers, the target company may negotiate a higher transaction price with the provision that the deal will be structured as an asset sale. 

  1. Rollover Equity and Section 704(c) Allocations

As previously discussed, many private equity transactions use partnerships as the new ownership vehicle and include equity rollovers where the seller of the target company retains an ownership interest in the new entity. 

In these scenarios, it’s important for the seller to understand the concept of IRC Section 704(c). The seller has, in effect, contributed a portion of its business and therefore is coined the contributing partner, while the buyer is the non-contributing partner. The buyer gets a step-up in tax basis on the portion of the assets they purchased and can depreciate and amortize them accordingly.  The seller has a carryover basis in its assets and does not get the same benefit.  The code then prevents a shifting of tax deductions amongst the partners and can lead to a mismatch on the annual tax filings of the new entity. The PE firm may show significant losses due to depreciation and amortization, whereas the seller has significant income since they are unable to leverage those deductions. 

This can be complicated further by the terms of the partnership agreement, which may stipulate that payments will not be distributed to partners unless there is a profit. Without the right approach, this can result in the seller both facing a significant tax liability and receiving no payments to cover the tax due. 

  1. Take Advantage of Strategic Tax Opportunities

While there are several pitfalls for sellers to be aware of, it’s equally important to be aware of opportunities to optimize your tax strategy. 

One area to explore is success-based fee elections. If you retained the services of a broker who received a commission on the sale of the business, these fees are typically capitalized as selling costs. However, taxpayers can elect to deduct 70% of these fees, reducing their overall tax liability at more favorable rates.

Other opportunities include the ability to reallocate a portion of your compensation as the seller toward payments to key employees. These payments can often be considered pre-sale deductible expenses and provide the additional benefit of motivating key employees to stay with the business throughout the earnout period. This gives the seller the experienced leadership they need to ensure the business hits its performance targets.

Alternatively, key employees may be rewarded with an ownership or profit interest in the new capital structure. Previously, these employees likely received a W-2, but as owners of the business, this can cause payroll tax issues. One solution to this challenge is to house these employees in a separate entity by establishing a separate management company. 

Affected employees should also consult with their tax advisor to determine whether they should make a Section 83(b) election, which notifies the IRS that they would like to be taxed on their equity on the date it was granted to them, rather than the date it vests. 

Smith + Howard: Experienced Tax Professionals for Private Equity Transactions

The sale of your company is the deal of a lifetime and it’s crucial to understand the wide-ranging tax implications of the transaction. By proactively consulting with a tax professional, you can enter negotiations with the clarity you need to structure a deal that maximizes your after-tax cash flow and rewards your years of hard work. 

At Smith + Howard, our tax professionals bring significant experience advising both private equity firms and target companies on the tax implications of PE transactions. Our detailed understanding of the tax considerations that both parties face enables us to take a balanced approach that helps both parties work toward an equitable, tax-efficient transaction. 

To learn more about Smith + Howard’s tax support for private equity transactions, contact an advisor today

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