Mergers & Acquisitions: General Tax Concerns When Structuring the Sale of a Business 

ALTERNATIVE TAX STRUCTURES 

1. Cash Sale of Assets: Stock Sale vs. Asset Sale  - The first objective:  The avoidance of corporation level tax  
1. Covenant Not to Compete
2. Employment Agreements
3. Past Due Bonus Compensation
4. Qualified or Non-Qualified Retirement Plans
5. Corporate Taxes 

2. Liquidation of Corporation, Distribution of Assets

2. Mergers: Taxable and Tax Free  

1. A Taxable Reverse Triangular Merger - 

This would be a transaction where the purchaser forms subsidiary to be merged into Target Corp. and the shareholders of Target Corp. are "cashed out".
2. Tax Free Stock for Stock Merger  - 

This form of transaction would tender to each shareholder of Target Corp. shares of the purchaser, in a tax free transaction. Target Corp.'s shareholders will then pay taxes upon their sale of the purchaser's stock, if able to be sold. 

4. Deferred Gain: Installment Sales Method; Use of Beneficial Interest in a Trust as Security

A business owner may eventually face the prospects of selling his or her incorporated trade or business ("Target Corp."), to a purchaser, who may be a relative, an employee or a third party. Each transaction will have to be structured to accommodate the relationship and business deal between the buyer and seller, as well as the form and tax status of the business being sold. 

This article addresses some of the tax concerns for the shareholders of an incorporated entity that operates a business that is being sold to a third party. It is important to remember, as previously stated in other articles by STEPHENS & KRAY, that each planning situation is different. As a result, the client must be able to rely upon the skill of his or her attorney and advisors who hopefully fully understand the client's objectives and the parameters of the proposed transaction, and who can thereby devise a structure that will accommodate most if not all of these issues, in the most cost and tax effective manner. 

Please review this article with the idea that the solutions proposed may not be applicable to your particular fact situation. This article is intended to provide significant insight into how to proceed to negotiate a sale or purchase of a business, and who to engage as part of your counsel and advisory team, without offering an entire treatise on the subject. 

Please note that the mechanisms discussed in this article may be used to design other forms of purchase and sale transactions, such as sales between family members, or sales to key employees, however those form of transactions call into play a variety of other issues that may not be specifically addressed, and as a result, require their own independent evaluation. Similarly, structures generally used in other forms of transactions might be just as applicable for this form of transaction, and just because they might not be mentioned in this article, should not be discarded. 

ALTERNATIVE TAX STRUCTURES 

I. Cash Sale of Assets: Stock Sale vs. Asset Sale

A sale of assets involves the direct sale and transfer of assets by Target Corp. to the purchaser. This is distinguished from a stock sale, wherein the shareholders sell and transfer their shareholdings in Target Corp. to the purchaser, who then becomes the sole shareholder of Target Corp., and, will either operate it as "Target Corp." or thereafter liquidate Target Corp. in order to directly own the operating assets of Target Corp.

Stock Sale vs. Asset Sale

The stock sale is generally more beneficial to the shareholders of the Target Corp. because it generally enables them to report their gain from the sale as a capital gain, which rates are typically capped at a 20% federal tax rate.  This both avoids a corporate level tax and the allows the use of the lower capital gains tax rate. However, the stock sale is less preferable to the purchaser, because (a) they must acquire the entire entity, inclusive of contingent and "unknown" liabilities; and (b) they generally cannot take tax deductions against the purchase price of assets being acquired (such as depreciation or amortization), unless they comply with the provisions of Internal Revenue Code ("IRC") section 338.

Under IRC 338 the purchaser of a corporation can elect to treat a stock purchase as an asset purchase by liquidating the newly acquired Target Corp., provided that the liquidated Target Corp. must first pay all corporate level taxes in connection with income that is to be recognized upon its liquidation, including any depreciation recapture (the difference between the sale value of the asset and its depreciated book value).  In many transactions purchasers will entertain a stock sale, but will want the Target Corp. to pay these corporate level taxes before the closing, or charge these taxes to the Target Corp. shareholders, directly or through some form of compromise in the purchase price.

In order to provide to a purchaser retain some of the benefits of tax benefits that would be  available through a purchase of assets and not stock, a transaction structured as a stock sale can in many cases characterize a good portion of the consideration as payable as part of the purchase price, as consideration of a covenant not to compete with the Target Corp's shareholders.  This will allow the buyer of stock to obtain tax deductions and write-offs to eliminate for the value of the covenant, which the law will allow to be deducted over 15 years.  That portion of the purchase price that is allocable to the shares of Target Corp., once in the hands of the purchaser, must be capitalized by the purchaser and becomes the purchaser's basis.  This basis in the shares is available to reduce taxes if the stock is later sold, or if the Target Corp. enters into a plan of liquidation that will allow it to allocate this basis to depreciable assets. 

Unfortunately the purchase price allocated to a covenant not to compete, or other "deductible" items that benefit the purchaser's desire to write off his or her costs of acquisition as part of a stock purchase and sale, will generally be taxable to the seller at ordinary income rates. 

This will typically become the major  point of contention and negotiation between buyer and seller.  The seller wants to pay taxes at capital gains rates, and the buyer wants to take a tax deduction for the purchase. 

In the case of the sale of a Target Corp. that is valued at $2.0 million, if the purchaser is not entitled to any tax deduction for the price paid, the purchaser must have earned that $2.0 million "after taxes." This in many cases means that the purchaser must have earned some $4.0 million in order to net $2.0 million to pay for the acquisition.  It is the case that upon a subsequent sale of the stock, the original purchaser, now a seller will be able to reduce the taxable income from the second sale by this basis, however, this tax savings will in most cases be delayed for many years. 

In the case of an asset sale, the purchaser and seller will negotiate the selling price for each asset, and each asset at the purchaser level will be entitled to its own depreciation or amortization, and at the seller level will be subject to its own form of tax, ordinary from depreciation recapture, or capital gains taxes.  However, the selling shareholders may have to pay a second tax to get the cash paid for the business out of their corporation, which second tax most likely will be a capital gains tax.  However, there will be two taxes paid by these shareholders, one at the corporation level and the other at the shareholder level.

It also has to be noted that in an asset sale, the value attributable to items of tangible personal property may be subject to a California sales tax, unless the sale can come within any one of the established exemptions from sales tax. If Target Corp. does have not a California "resale" number, it is more than likely that the "occasional sale exemption" may apply to avoid a sales tax.   If a sales tax is required, the parties then have to negotiate who is to pay the tax.

The savings to a purchaser by being able to take a tax deduction of the purchase price will yield a far greater savings to the purchaser, than the possible additional tax that the selling shareholders may have to suffer.  This is because the loss of the tax deduction means that a purchaser must gross up the actual purchase price by the tax it will have to pay, in order to generate the "net" cash to make the purchase.  As discussed above, a $2.0 million purchase price may gross up to $4.0 million in actual pre-tax revenues.  However, the seller will suffer a tax on the net sale proceeds, or between $400,000 to $1.0 million in total taxes, which is less than the $2.0 million that the buyer will pay if they are not entitled to a timely tax deduction. 

The process of negotiation and compromise over the proper structure of the purchase and sale before the entering into any binding letters of intent or agreements will help to eliminate the payment of any unnecessary taxes.  This is not always possible or desired, however, it is important that the parties understand their options and the significant of taxes before agreeing in principle to any agreement to purchase or sell.   The above example illustrates that the sale of a $2.0 million business can cause one party to net $1.0 million after tax, or cause the other party to pay $4.0 million pretax, or anywhere in between.  That is a $3.0 million spread that far exceeds the value of the business being sold.  The balance of this article discusses ways to  effect deferrals of the  selling price and sales proceeds in the hands of the seller, to defer the taxes from the sale, or to restructure these sale proceeds to taxable ordinary income in the hands of the seller, to possibly give both the buyer, and the Target Corp. seller a tax deduction, and avoid a double tax to the shareholders of the Target Corp. 

The first objective for a successfully structured cash sale of the assets of Target Corp. would be to avoid to the extent possible any and all taxes at the corporation level (commonly known as the "double tax"), and instead pass all taxable income and tax liabilities directly to the ultimate recipients and beneficiaries of the cash proceeds, i.e. the shareholders, free of the intermediary corporate level tax. 

A second objective to a successfully structured asset sale for Target Corp. would be to defer to the extent possible any and all tax obligations that are finally required to be paid. Generally, this type of deferral is very difficult in a cash sale of assets, and will be discussed below at IV. Deferred Gain: Installment Sales Method; Use of Beneficial Interest in a Trust as Security."
 

The first objective: The avoidance of corporation level tax in an asset sale. In order for Target Corp. to avoid taxable income, it must either: 
 

1. reduce the amount of cash proceeds that it is to receive from the sale and/or 
2. increase its tax deductible expenses in the period(s) that it receives cash proceeds from the sale of the assets. 

Briefly, all proceeds that Target Corp. receives will generally constitute gross income. In addition, any depreciated assets, to the extent sold and valued at greater than their book value, will generally create income characterized as depreciation recapture (the difference between the sale value of the asset and its depreciated book value). When conducting an asset sale, a tax paying purchaser will want depreciable tangible assets to be valued as highly as possible, to give the purchaser a shorter time to effect a tax write-off. Intangible assets, such as covenants not to compete and customer lists, will generally only give the purchaser a 15 year amortization schedule for write-offs. These tax matters may be of less importance for a not for profit purchaser who will be more interested in justifying the consideration paid for the assets, in particular, the fair market values associated with the property being acquired. As a result, Target Corp. shareholders will have to evaluate its own tax impacts based upon how its purchaser is willing to acquire the business, write-off the costs of the acquisition, prepare and present its own financial statements, and justify the consideration paid for the assets being acquired. 

A. Covenant Not to Compete

Covenants not to compete negotiated directly with significant Target Corp. shareholders, will reduce the proceeds payable directly to Target Corp. These are legitimate devices to shift the income burden directly to the shareholder, in situations where the shareholders are available to work and/or consult and where their competition can injure the value of the assets being acquired by the purchaser. Any income generated from the covenant not to compete would become payable directly to each shareholder and taxable to them as ordinary income. A for-profit purchaser's ability to deduct this payment will generally be over a 15 year period. Payments characterized as covenant not to compete will generally not be subject to payroll tax nor the 2.9% social security medicare tax. 

The value placed on the covenants not to compete will enable Target Corp. to allocate the selling price in accordance with any formula for extraordinary and previously accrued bonus compensation that its board of directors has adopted that may be different from the respective percentage interests of its shareholders. That portion of the purchase price properly allocated to the covenant not to compete will avoid any taxation at the corporation level, since the covenant monies will not be paid to the corporation, but directly to the shareholder- employees. 

As noted above, the purchaser would book the covenant as a capital asset amortizable against taxable income over a 15 year period. This would be the case for all "intangibles" acquired by the purchaser, including customer lists. However, the ability of the purchaser to accept a substantial allocation to a covenant not to compete may be a point of further negotiation with your purchaser. 

As mentioned above, the covenant not to compete is an appropriate device to achieve write-offs for the purchaser in a stock sale, as well as for the seller in an asset sale. However, in a stock sale, the seller trades capital gain's tax rates for ordinary income tax rates, in order to accommodate the purchaser's tax write-off. 

B. Employment Agreements

Sign-up bonuses can also be negotiated, for services to be rendered by shareholder employees who will continue to work for the purchaser. This form of consideration will work well if the shareholder employee will work directly for the purchaser, or if they form a new entity that will work for the purchaser. However if Target Corp. is to remain in existence and its shareholder employees are to consult or otherwise tender services to the purchaser through Target Corp., an allocation of this form of consideration ultimately payable to these individuals, in order to effectively reduce the tax impact of the transaction, may have to be handled differently, such as in the form of qualified or non-qualified deferred compensation for past or future services, or a past accrued bonus. The fact that there would be a continuity of employment between Target Corp. and these individual may render the use of a "sign-up" bonus difficult to justify. Further, the concept of a sign-up bonus was designed to avoid payment of monies to Target Corp., to avoid the need for Target Corp. to find a legitimate "expense" against the income, and if these monies have to be paid to Target Corp. because of the structure of future services, an alternative to this form of allocation should be considered. 

It should also be noted that any form of "sign-up" bonus regardless of how allocated, when ultimately paid to the shareholder employee, will be subject to social security and medicare taxes and therefore the significance of these taxes, in particular, the unlimited nature of the medicare tax, should be evaluated. If the compensation payable is generally "reasonable", they should afford the purchaser an immediate tax deduction at the time paid. 

While there is tax authority that supports the position that when consulting and employment services are integrated as part of a covenant not to compete agreement, the consulting and/or employment services are generally held reasonable. In the case of a for profit purchaser, the Internal Revenue Service ("IRS") may attempt to challenge efforts by the purchaser to recharacterize significant proceeds, that should otherwise be amortizable over 15 years, into payments that are immediately deductible. As noted, this potential problem will primarily be of concern to a purchaser. 

In summary, the use of sign-up bonus compensation or consulting or employment agreement compensation is an appropriate device to achieve write-offs for the purchaser in a stock sale, as well as for the seller in an asset sale. The fact that Target Corp. may want to be the recipient of the "sign-up" bonus, may defeat the purpose of its implementation. It must also be noted that in a stock sale, Target Corp. would receive the lower capital gain's tax rates, whereas, although these alternatives can mitigate the impact of the "second" corporate level tax, the shareholder employee will receive ordinary income, taxable at ordinary income tax rates, plus social security and medicare taxes, in order to accommodate the purchaser's desire to avoid a stock purchase. 

C. Past Due Bonus Compensation

Past due bonus compensation would consist of compensation actually payable and paid by Target Corp. out of the proceeds from the sale to its key employees (such as the shareholder employees), to achieve a tax deduction and comply with the adopted allocation formula. The payment would constitute a deduction to Target Corp. and therefore reduce the tax impact of otherwise taxable cash proceeds from the asset sale. These payments would constitute ordinary income subject to both social security and medicare taxes. 

As noted above, if the "sign-up" bonus is to be paid to Target Corp., the use of the sign-up bonus loses its impact as a means to create tax deductions, in that Target Corp. must still find a form of deduction when it pays these proceeds to its employees. As a result, Target Corp. may have to utilize this form of deduction to justify the distribution of proceeds to its shareholder employees in a manner that offsets the income with a legitimate expense. 

When the total amount of bonuses sought to be paid approach and/or exceed 100% of the ordinary compensation of the shareholder employees, or are substantially greater than historic compensation levels, the corporation and the board of directors would be advised to obtain a salary survey or compensation study that can justify the compensation sought to be paid. It is not unrealistic to be able to justify a payment that may be a substantial multiple of current compensation through the engagement of a reputable salary consultant firm. 

This form of expense is probably the most significant expense available to the corporation, to eliminate any and all taxable income that may remain, after allocating proceeds to the covenant not to compete and to any sign-up bonuses and avoid double taxation. 

D. Qualified or Non-Qualified Retirement Plans

The general benefits of a qualified retirement plan, such as a defined benefit plan or a profit sharing plan, are that it offers the corporation a tax deduction and at the same time, defers the taxable income to the participant employees. However, the dilemma of the qualified plan is that it must generally cover and benefit all employees of the employer and, in the case of "professional service corporations" and "affiliated service groups," both the entity hiring the shareholder employee possibly the employees of the purchaser, to whom the shareholder employees will render services. 

In many cases an actuary would have to be engaged to evaluate the benefits of a plan and the existence or non-existence of an affiliated service group. The matter of comparability will affect the type of plan that any separate entity hiring Target Corp. physicians can implement and the size of annual contributions that are available to benefit Target Corp. physicians. 

The most advantageous qualified plan for older employees is the defined benefit plan. This plan bases its annual contributions on the level of benefit that the retiree is to receive at retirement, which is directly related to current levels of compensation (and sometimes historic levels of compensation). However, the formula becomes fixed and as a result, changes in events, such as death, disability or retirement, or other changes in levels of current compensation while they will affect the amount of annual contribution that must be set aside for a particular shareholder employee, may not affect that contribution and deduction "prorate". What this means is that it may be difficult to adopt a formula allocating proceeds from the sale among shareholder employees that will be fixed in concrete, and that events can occur that could significantly affect how those proceeds are ultimately and finally divided up. 

In addition, the use of any qualified retirement plan must be based on actual compensation that has been paid and reported as social security and medicare wages. In addition factors such as age, and actual compensation paid, that will limit annual contributions that may be available, there are significant annual limits as to how much money can be put aside for each employee physician. Therefore the use of a retirement plan will generally require a several year commitment. If use of a plan is intended to defer proceeds from the sale received beyond the initial year's cash proceeds, the purchaser may have to defer the making of cash payments against the purchase price in accordance with a schedule that will defer the payments over a several year period, so that Target Corp. can time income with tax deductible plan contributions. An actuary will have to analyze these various issues to help achieve both: 

1. the proper timing of income with 
2. the proper timing of contributions and 
3. the equitable division of the proceeds from sale, to the extent possible 

E. Corporate Taxes

It must be noted that the above analysis discusses ways to reduce and hopefully eliminate the potential "double" tax that could be imposed from an asset sale by a C corporation. The term "double" generally tax refers to both 

1. the corporate level tax discussed above, and 
2. the second tax that is imposed at the shareholder level, assuming that property is distributable to the shareholder as a dividend 

1. the result of corporation monies having been previously withdrawn and expensed in a prior tax period, as salary, other deductible form of compensation, or as loans 
2. the result of the sale of depreciable or other assets, that are encumbered by debt in excess of their adjusted basis, or from 
3. depreciation recapture upon the sale of a depreciable asset 

II. Liquidation of Corporation, Distribution of Assets

This structure would entail liquidating the assets of the corporation and have the shareholders separately enter into agreements with the purchaser for employment agreements, covenants not to compete and a sale of their respective undivided interests in the assets. 

This form of structure does not add any significant benefit to the structure described in Alternative I. Cash Sale of Assets and may in fact add more confusion and complication due to the basic nature of a liquidation in advance of a sale. 

Under this structure, Target Corp. would suffer taxable income at the time it distributes its assets to its shareholders, equal to the difference between its adjusted basis in the assets and their fair market value. Target Corp. will also have to incur depreciation recapture income upon the transfer to shareholders of any depreciable assets that have fair market values in excess of their book value. Fair market values can either be established by appraisal (the most prudent means if a liquidation is pursued), and/or by the agreement entered into with the purchaser. However, these two methods may conflict with each other, thereby adding greater confusion when pursuing this alternative. 

This structure may also create a logistical problem as to when and how the extraordinary benefits payable to certain of the shareholder employees are to be handled, whether prior to the liquidation (when there are no cash assets to distribute), or after the liquidation (when each shareholder is technically entitled to a pro rata share of the proceeds). These logistical issues can be overcome through the use of appropriate documentation. However, unless an apparent benefit can be identified to pursue this alternative, in most typical forms of transactions it does not appear to be worth pursuing. 

III. Mergers: Taxable and Tax Free 

A merger is a transaction that generally combines two companies into one. The surviving entity can be a new company, or either of the companies that are parties to the merger. Shareholders of the merged companies can either become shareholders of the survivor company, or depending upon the form of merger, can be cashed out. 

A tax free merger generally involves an exchange of shares, which is essential to make either the entire transaction or a portion of it tax free. A taxable merger will generally involve the payment of cash or other consideration to the shareholders of one of the merged companies, which would be the case in a taxable merger involving Target Corp.. The following discussion briefly analyzes the taxable and tax free forms of merger. 

A. A Taxable Reverse Triangular Merger:  This would be a transaction where the purchaser forms subsidiary to be merged into Target Corp. and the shareholders of Target Corp. are "cashed out". 

As a taxable transaction, this form of merger achieves the same purposes and generally the same results as a stock sale. This form of transaction would be used to simplify the form of the transaction because this form eliminates the need to purchase directly from each shareholder their shares in Target Corp. Instead, this form of merger will rely upon the majority shareholder approval at a duly called shareholder meeting. 

The first and most important question to be asked if pursuing this form of structure is whether or not the purchaser is even interested in a stock purchase. These considerations are more fully discussed above under, Alternative I. "Cash Sale of Assets; Asset Sale vs. Stock Sale."

This alternative creates a logistical problem for the shareholders of Target Corp. that must be overcome with analysis and proper documentation, concerning if there is to be a disproportionate sharing of proceeds from sale among the shareholder employees in the form of past due compensation, and when and how any form of additional compensation benefits are to be made payable to certain of the shareholder employees. Some of these issues may require that these matters be addressed prior to merger (so that they remain liabilities of the newly formed entity and payable by the purchaser controlled entity). Other allocation issues can be handled by the use of covenants not to compete and consulting agreements, that have to be executed concurrent with the merger. 

Other issues presented when considering this alternative include the benefits that it will have to the purchaser and whether or not the purchaser wants to acquire the shares of Target Corp. As mentioned above, in order to obtain deductions and depreciation of Target Corp.'s assets, the purchaser will have to undertake the costs of liquidating Target Corp. and presumably pay the taxes and deal with the depreciation recapture, discussed under Alternative II, above. The purchaser may therefore want to discount the purchaser price to take into account these additional expenses and taxes. 

B. A Tax Free Stock for Stock Merger:   This form of transaction would tender to each shareholder of Target Corp. shares of the purchaser, in a tax free transaction. Target Corp.'s shareholders will then pay taxes upon their sale of the purchaser's stock, if able to be sold. 

However, this form of transaction will also have to address the logistical problem if there is to be a disproportionate sharing of proceeds from sale among the shareholder employees in the form of past due compensation. Here again, as with the taxable merger, some of these issues may require that these matters be addressed prior to merger (so that they remain liabilities of the purchaser or its wholly owned subsidiary payable either by the purchaser or its subsidiary). Other allocation issues can be handled by the use of covenants not to compete and consulting agreements, that can be executed concurrent with the merger. Any consideration other than stock is considered "boot" and taxable to the recipient, regardless of the tax free status of the underlying transaction. 

IV. Deferred Gain: Installment Sales Method; Use of Beneficial Interest in a Trust as Security

The traditional deferral method for the sale of a business is the installment sale method. This method will generally defer the payment (and taxes attributable thereto) of the proceeds from sale, whether they are identified and allocable to a covenant not to compete, the sale of assets or the sale of stock. 

The traditional deferral method for the payment of compensation, whether previously accrued or "sign-up" bonus compensation, is through the use of a non-qualified deferred compensation plan. 

While the deferred obligations of the purchaser can be fully secured under any form of the installment sale, any proceeds allocated to a non-qualified deferred compensation arrangement, may pose some risk to the ultimate recipient that his or her payment will be tendered on the date or dates provided under their agreement, if the obligor, in this case the purchaser becomes insolvent and unable to pay its debts. This is because under the Internal Revenue Code, in order to obtain a deferral of "compensation", the obligation of the purchaser to pay the deferred compensation must constitute a general and unsecured debt of the purchaser. Any assets, even if set aside in a trust, must be characterized as general assets of the purchaser and therefore, subject to claims of all of the purchaser's creditors. 

However, these concerns can be easily overcome by allocating to the deferral mechanism those proceeds that are derived from the covenant not to compete, which can constitute the major consideration payable by the able by the purchaser. As long as the covenant not to compete comports with normal business practice and common sense, the courts have approved allocations constituting up to 96% of the total contract consideration. See Molasky v. Comr., 897 F.2d 334 (8th Cir. 1990). 

Therefore, if a deferral is sought, our initial recommendation would be to maximize the value of the covenant not to compete proceeds. As to any shareholders who are interested in a cash payment, they would then be can be allocated that part of the purchase price that is paid directly to the Target Corp. as some form of tax deductible compensation, so that Target Corp. can receive a current tax deduction upon distribution of those sums (payable to these employees, as accrued bonus compensation or some form of tax deductible severance or bonus). 

Alternatively, those shareholders who will continue to work for the purchaser, but are interested in cash only could also receive the larger "sign-up" bonus. The covenant not to compete for these shareholders could then be reduced to reflect their ultimate distributable percentage of the sale proceeds. 

Most traditional deferral techniques, including those that are fully secured, generally utilize a note that bears a fixed or variable interest rate. The interest rate itself limits the investment or opportunity value of the sums that remain due and payable under the note. In many cases the purchaser will not want to bind itself to a note with a high rate of interest, but would prefer to pay cash if the interest rate is too great. However a capped interest rate, clearly limits the growth potential and investment opportunities of the beneficiary of the note. 

The clear benefit of the installment form is that the interest rate, although limited, is based upon the entire note obligation, pre-tax. The beneficiary of the note is able to receive interest on that portion of the principal that would otherwise be payable to the Internal Revenue Service, if an all cash transaction were closed. 

In order to maximize the tax benefits of the installment form, in an effort to take advantage of investment opportunities and the ability to benefit from the tax deferred portion of the installment obligation, we have designed a hybrid form of the installment deferral method that allows the note to bear a rate of interest commensurate with underlying investments managed by one or more major investment bankers and thereby allow the note to participate in value with those underlying investments under management by the brokerage facility. Since managed portfolios can go up and down, it is possible that the note could bear "negative" interest as well as significant "positive" interest. 

The installment note attributable to the deferred purchase price could be fully secured by a fully funded investment or portfolio of investments, selected by Target Corp. and the shareholders participating in the deferral; provided that the investment fund is not considered a cash or monetary equivalent. As the investment portfolio increases in value, distributions from the investments, after expenses to administer the same, are taxable to the note holder, as interest payments. 

In this way, the beneficiary of the note can have both the benefits of using the tax deferred share of the proceeds from sale and the benefits of an interest rate that participates as if it were an investment portfolio. 

There may be some logistical issues to overcome if the transaction is pursued as an "asset sale" and the deferred payment is for anything other than the covenant not to compete. Given the latitude in structuring the transaction as mostly a covenant not to compete, this concern may be unlikely in any event. However if for any reason deferred sums must be made payable to the corporation under the final transaction approved by your purchaser, the issue can be resolved by the use of either two or more notes, one for each purchaser's non-corporate covenant not to compete and the other for the purchasers obligation to Target Corp., or a single note in joint name. 

A second logistical issue to overcome in the case of an asset sale when the Target Corp. is the recipient of any portion of a deferral or installment note, is that Target Corp., as a C corporation, will have to establish a means to eliminate any of its taxable income, including interest, that it receives as the note holder. In this case, any monies payable to the shareholder employees as a result of the accrued bonus compensation would have to be timed so that they are to be paid at the time that principal is paid under the terms of the note. In addition, as a C corporation, Target Corp. can only deduct from its taxable income legitimate expenses, such the timed payment of the deferred bonus compensation, and directors' fees or compensation. Therefore, any form of deferred compensation arrangements would also have to bear interest equal to the note interest. Annual director's fees could exhaust any remaining interest income. Each of these logistical issues if they are found to even exist, can be solved with appropriate documentation, however, one cannot deny that it would be much simpler if Target Corp. is not a note holder at all. 

A "stock sale" would not pose these problems. This is because, any monies paid under a stock sale, or a covenant not to compete that is part of a stock sale (or an asset sale) is payable to each shareholder. 

Assuming that this the status of Target Corp. is handled appropriately, the note secured by the portfolio should perform for the benefit of the note holders (presumably the shareholders holding covenants not to compete), in such a way that the ultimate note holders do not lose out on missed investment opportunities as a result of the deferral. 

This type of deferral enables the note holders to defer the taxes which may amount to 40% to 50% of the purchase price. This could be equivalent to an interest free loan to the note holders from the government, because the note holders have the ability to generate income on the entire sum, only remitting taxes attributable to the income or gain from the original proceeds, when principal payments are actually paid. Principal payments can be deferred for 5, 10, 15 years and possibly longer. They can be made payable at such a time that when the note holder may be in a lower tax bracket, or can offset his or her income against legitimate business deductions. 

There are certain expenses associated with this form of deferral and are recommended to be incurred. They can include the cost of life insurance on the note beneficiary (that will be used to cover the income taxes payable in the event of death) and trustees fees to administer the assets held in trust, in addition to brokerage charges in connection with the investment portfolio. As noted above, increases in the value of the portfolio are distributable annually as interest payments and taxable at that time. 

The deferral mechanism also requires the cooperation of the purchaser, as they in essence create the trust to hold the sale proceeds, which are fully secured in favor of the Target Corp. shareholders. In essence the monies in the trust account remain the property of the purchaser, but are titled in the name of an independent trustee of an irrevocable trust. The use of this mechanism also requires that the purchaser retain some interest in the monies held in the trust. This is in order to achieve a legitimate business purpose for the purchaser in compliance with the Internal Revenue Code. However, these interests of the purchaser can be handled in a manner that eliminates any one party from having an unexpected advantage over the other, that was not contemplated at the inception of the contract. 

In summary, this deferral mechanism employs the traditional installment sale device, but eliminates a rate of interest in favor of investment performance of a portfolio, which is a result that was not contemplated under the rules applicable to installment sales. The installment sale rules attempt to limit use of the deferral device when the seller has various elements of "constructive receipt" and "control" over the ability to get paid from the note. As a result, this mechanism was developed to avoid these elements of "constructive receipt" and "control". 

The mechanism is a relatively novel structure and although it may be difficult for the IRS to challenge if properly structured and documented, the form of its implementation and the adherence to formality that prevents "constructive receipt" is important to avoid a violation of the tax laws. For this reason, it should not be pursued by counsel not skilled in the unique and peculiar aspects of the Internal Revenue Code, Trusts, Mergers and Acquisitions and Secured Instruments. Depending upon the size of the transaction and its timing, a seller may want to consider obtaining a private letter ruling from the Internal Revenue Service. 
 
 

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