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August 13, 2024
By Nicholas P. Flint

Following up on the earlier article Deal Structures: Part I, this article addresses some nuances and options for the structure of M&A transactions. Although the matters presented in this article are not uncommon in the M&A context, as with the basics of deal structures discussed here, no two transactions are the same, and parties to any deal must carefully consider the factors particular to their deal in arriving at a transaction structure.

Selling Personal Goodwill

As previously discussed, in an asset deal where the seller is a C-corporation, the ultimate shareholder(s) of the selling entity will face double taxation on the transaction proceeds—first at the corporate level, and second at the individual shareholder level. Double taxation is generally unavoidable as it relates to that portion of the purchase price allocated to fixed assets and other non-goodwill items. However, with respect to the portion of the purchase price allocated to goodwill, there may be options for the shareholder(s) of the selling entity to structure the deal in a more tax-efficient manner by selling “personal goodwill”.

The U.S. Tax Court case Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998) ruled that, in circumstances where the goodwill being sold was attributable to the selling shareholder(s) due to their personal relationships and industry knowledge, that goodwill can be characterized as “personal” to the shareholders rather than “corporate” (i.e. owned by the selling company) and sold directly by the shareholders to the buyer. This is typically more common in the context of closely held C-corporations where shareholders are actively involved in the operations of the business.

In such a scenario, not only does the portion of the purchase price attributable to the personal goodwill of the shareholders (sold directly through a separate Goodwill Purchase Agreement) avoid taxation at the corporate level, but this amount is also typically taxed at the lower capital gains tax rate. It is therefore a tax-efficient structure for sellers, particularly shareholders of a closely-held C-corporation selling assets. Buyers rarely object to this structure, so long as the goodwill portion of the purchase price is not increased. From a drafting perspective, the parties must prepare and negotiate the separate Goodwill Purchase Agreement, although this is typically a standard agreement that does not require heavy negotiation.

338(h)(10) Election

Another option that can be used in structuring a deal is the “338(h)(10) election”, where the parties jointly make an election under Section 338(h)(10) of the Internal Revenue Code to classify a stock transaction as an asset deal for tax purposes.  This election is only available for “qualified” stock purchases where the target is an S-corporation, at least 80% of a seller’s stock is being sold, and the buyer is a single corporation (typically another S-corporation, as C-corporations cannot own S-corporation stock). Similar to the 338(h)(10) election, the 336(e) election allows other non-corporate buyers such as LLCs, partnerships, or individuals to acquire stock and elect for the transaction to be classified as an asset deal.

As previously discussed, from a tax perspective, buyers typically prefer asset deals and sellers typically prefer stock deals. The 338(h)(10) election, therefore, is generally more favorable to the buyer than a straight stock deal. One of the primary uses for making a 338(h)(10) election is the scenario where the buyer wants to structure the transaction as an asset deal for tax purposes, but the target company has a number of key contracts or permits that contain language prohibiting assignment and therefore requiring third-party consents to an asset deal (as discussed here). The solution could be to opt for a stock deal to avoid the necessity of obtaining third-party consents, with a 338(h)(10) election to treat the transaction as an asset sale for tax purposes.

The parties to a transaction must jointly file the 338(h)(10) election post-closing, so the Stock Purchase Agreement should contain affirmative obligations of the parties to cooperate in making timely and consistent elections. Further, the parties must agree upon a purchase price allocation among the assets, either in the purchase agreement or post-closing. Although there are limitations on the availability of 338(h)(10) elections, they are a useful deal-structuring tool that should be considered in certain scenarios.

F Reorganization

In some circumstances, a buyer may not be eligible to own the stock of an S-corporation (for example, if the buyer is a C-corporation), but the parties nonetheless intend to structure the transaction as a stock deal with an S-corporation target. The solution could be for the target company to restructure prior to the transaction using what is commonly referred to as an “F reorganization”.

F reorganizations are performed under Section 368(a)(1)(F) of the Internal Revenue Code and involve three steps:

• First, the shareholders of the S-corporation target (Target) form a new corporation (HoldCo), make an S-election for HoldCo, and contribute all of their shares in Target to HoldCo in exchange for 100% of the equity in HoldCo.
• Second, Target makes an election to be classified as a “qualified subchapter S subsidiary” or “QSub” of HoldCo, resulting in Target being classified as a disregarded entity for tax purposes and no longer subject to S-corporation restrictions.
• Third, Target is then converted into a limited liability company (LLC), with HoldCo owning 100% of the membership interests in Target.

When conducted properly, the foregoing steps involved in an F reorganization are nontaxable events. An F reorganization results in the selling shareholders now being able to sell their equity in the original target company (an LLC no longer subject to S-corporation restrictions) as a stock deal to a buyer that otherwise could not own stock in an S-corporation.

A variety of factors must be considered when negotiating the structure of an M&A transaction and the parties to a deal must carefully weigh these factors from both a legal and tax perspective. It is critical to involve experienced M&A counsel and tax professionals at the outset of the negotiation process.

Nicholas Flint is a partner with Flint, Connolly & Walker, LLP who represents domestic and international clients in a variety of corporate and transactional matters, including mergers and acquisitions, joint ventures, private equity and venture capital transactions, financing and lending arrangements, and debt and equity offerings. In addition, Mr. Flint serves as a general business and legal advisor to his clients, counseling on matters such as corporate governance, executive compensation, regulatory compliance, and commercial contracts.