MERGERS: A CASE STUDY
by Larry Morrison and Gary Jacobson
This case study is provided as a companion to our article, 'Mergers: The Six Key Issues.' It shows the financial and legal technicalities involved in an actual merger. Names and certain details have been changed to protect the confidentiality of the parties involved.
Hundreds of thousands of dollars were saved simply due to the tax-free nature of the merger structure, with additional savings of more than $100,000 in the terms alone.
SITUATION
The merger was between two agencies with principal locations in different states. The larger (Axis Corporation) was a 'C' corporation with one shareholder. A key producer at Axis had been promised the opportunity to become a shareholder in lieu of his existing deferred compensation plan.
The smaller agency (Bates, Inc.) was an 'S' corporation with two equal shareholders. For a variety of reasons, Axis was to be merged into Bates.
WHY MERGE? The two agencies wished to expand markets, gain new carriers, increase volume with existing carriers, expand management expertise within each agency, and reduce operating costs. The savings in the first year were expected to be more than $200,000 from cost savings and improved contract volume alone.
SOLUTION
- Conversion of Axis' key producer's deferred compensation into stock. This was taxable income to the producer but deductible to the company. It used up 'accumulated earnings and profits' of the agency and generated a tax refund for the company prior to the merger. A cash bonus was paid to the producer to help cover personal taxes.
- A tax-free statutory merger (type A) of Axis into Bates, followed immediately by a liquidation of Axis into Bates. Because the liquidation was done less than 30 days after the merger, the 'S' corp status of Bates was preserved (although it acquired 'built-in gain' as a result of the merger). This step generated no taxes, but it left the new partners with vastly different ownership positions based on the relative values of their agencies prior to the merger. The largest shareholder in the new Bates was now the former owner of Axis.
- The largest shareholder in the new Bates sold enough of his shares in the new Bates to the original owners of Bates to equalize ownership among the three major shareholders. The ownership percentage of the key producer at Axis was left unchanged.
This step generated capital gains taxes for the seller and non-deductible dollars for the buyers, although the buyers did receive a higher basis in their stock. Although some tax was unavoidable, the terms of sale were planned in such a way as to reduce the amount by more than $100,000. - All shareholders were employed under management contracts with defined compensation and agreements not to compete. The original owner of Axis was specified as the company president, to be paid a higher salary commensurate with his duties.
TERMS
Most of the avoidable tax was associated with the sale of stock to equalize ownership between the three major stockholders. A 25% down payment was arranged, with seller financing at 12% interest over 10 years for the rest. Payments for the first five years were interest only with optional prepayment of a prepayment premium.
BENEFITS
The biggest benefit to this overall structure was that the vast majority of the transaction was subject to no tax at all. This is because it was structured as a tax-free merger.
EQUALIZATION PAYMENTS: Most of the tax was generated by step 3, the sale of stock for equalization purposes. In addition, payments on the seller-financed part of this transaction had the potential of causing personal cash flow problems for the buyers.
CASH FLOW: Cash flow scenario testing was used to make sure the terms of the sale would leave a satisfactory amount of cash for the buyers. This contributed to the decision to make the first five years' payments interest only.
TAXES: Taxes were also reduced by the terms of the equalization payments, in this case by more than $100,000. This was achieved by basing the overall valuation and resulting terms on 12% seller financing rather than the lower rates often seen on a do-it-yourself basis.
The higher rate generated a lower apparent valuation for the business, but the higher interest payments more than compensated the seller for the reduction in price, even considering differences in the seller's taxes.
The biggest advantage was gained by the buyer. Interest on purchase of 'S' corporation shares is immediately tax deductible to an owner involved in the business, so a portion of the purchase price was converted into tax-deductible dollars instead of non-deductible dollars. In other words, both the buyer and the seller came out ahead after taxes.
EMPLOYMENT CONTRACT: The sale price was computed in accordance with the IRS preferred methodology for a sale (the discounted cash flow method). However, this would have been a 'win' for the buyers and a 'lose' for the seller-not likely to promote amicability in a long-term relationship.
To make sure the overall transaction was a 'win' for all concerned, the seller had to be compensated for work he still did even though he no longer owned as big a piece of the company he did the work for. This was easily done through the terms of the employment contract. An added benefit was that the compensation payments were deductible, whereas an artificially high purchase price would not have been.
SAMPLE LEGAL AGREEMENTS
Sample legal agreements required to implement the case just described are provided. Your local counsel may find them a timesaver if you are considering a similar transaction. Obviously, this is a complex event and you should not consider attempting it without competent legal and accounting counsel.
Larry Morrison, CPA, can be reached at the Business Transition Network, Bellevue, WA, Phone (425) 957-4754, Fax (425) 603-9149, or e-mail [email protected].
Gary E. Jacobson, JD can be reached at Vander Wel, Jacobson, & Bishop PLLC, Bellevue Place/Seafirst Bldg., 10500 N.E. Eighth St., Ste. 1900, Bellevue, WA 98004, Phone (866) 498-0008, toll-free, Fax (208) 361-5064, e-mail [email protected].