Pretend you have a preferred equity investment in a company, entitling you to a 2x return before common holders participate in deal or liquidation proceeds. A buyout term sheet arrives, and while the valuation would only get you a 1.8x return, that’s more than enough, and you truthfully just want to cash out now. Alas, the common holders want no part of a sale where they won’t get a cent, and they need to approve the deal.
OK, easy fix, just massage the cap table and funds flow so everyone gets an amount that makes them happy. Sure, the charter and existing investment docs (the “liquidation waterfall”) say that deal proceeds need to be split a certain way, but if everyone consents you can just ignore or amend that waterfall. At the end of the day, everyone is getting deal proceeds from the buyer, so capital gains all around (and maybe even that juicy exemption for QSBS everyone talks about), right?
Unfortunately, the IRS may disagree.
When deal proceeds are divided in a different manner than what the liquidation waterfall provides, there is a risk the IRS views some of those proceeds as ordinary income. Additionally, and perhaps more concerning, there is a risk the IRS views the deal proceeds as having been paid in accordance with the liquidation waterfall, and then reallocated among the investors.[1]
For example, assume in the situation above that you would have received $180x in deal proceeds under the liquidation waterfall. But you’re happy to take $150x, and shifting $30x in proceeds to the common holders is enough to get them to agree to the deal. Instead of realizing $150x on the transaction, there is a risk the IRS argues that you realized $180x, and thereafter made a payment of $30x to the common holders because they approved the deal. Assuming that $30x payment is not deductible, that would be $30x in taxable income you never actually received! If the common holders are service providers, perhaps there is an argument that the $30x should be viewed as having been reinvested in the company, and then paid out as a compensation, but that could mean payroll taxes and withholding apply.[2]
There are arguments that could potentially be made against such an IRS characterization. For example, could the $30x be viewed as being paid by you for the common shares prior to the sale to buyer? Presumably the only reason you’re paying the $30x is because of the voting rights inherent in the common shares, and it therefore may be reasonable to view the transaction as you paying $30x for those common shares.[3] Alternatively, perhaps you could argue you simply gave up some of your investment as a contribution to the company’s capital, in order to make the company more appealing to a buyer.[4] While these arguments may carry some weight depending on the specific facts and circumstances, they are hard to make if the transaction was papered differently.
Ultimately, parties should be aware of the potential tax consequences of not allocating deal proceeds in accordance with a company’s liquidation waterfall, and if a disproportionate allocation is desired, the form of the transaction should match the intended tax treatment.
Martin de Jong frequently advises with respect to mergers and acquisitions. For additional information, please contact martin@mbakertaxlaw.com.
[1] See Rev. Rul. 73-233; Rev. Rul. 79-10.
[2] Regardless of whether the $30x is viewed as compensation, there is a risk the $30x is ordinary income to the common holders. Assuming the common holders held their stock for more than a year, that is a worse result for them (particularly so if the stock was qualified small business stock).
[3] Cf. David A. Delong, 43 B.T.A. 1185 (1941).
[4] Cf. Commissioner v. Fink, 483 U.S. 89 (1987).