Let’s say you’re the majority shareholder of ABC, Inc., a C corporation, which just sold substantially all of its assets in a taxable asset sale. The deal consideration consists of three parts (i) $30M to be paid at closing, (ii) $3M which is being held back in an indemnity escrow for 18 months, and (iii) $10M payable two years after closing if certain earn-out metrics are met.
When do you liquidate ABC, Inc. and what will be the tax consequences?
Alternative 1. Leave ABC, Inc. in existence until 2 years after closing so that the company can collect all potential consideration and distribute it to the shareholders prior to its liquidation. ABC, Inc. will be taxed on the installment sale method which generally means it recognizes taxable income in the year it is received. The shareholders recognize taxable income in the year in which ABC, Inc. makes a distribution to them. If the $13M in contingent consideration is never received, it is never taxed.
Alternative 2. Put a plan of liquidation in place prior to signing the asset purchase agreement whereby ABC, Inc. commits to liquidate within 12 months of the execution of the plan. In this case, a value needs to be determined prior to liquidation with respect to the $13M of contingent consideration. It’s best to involve a valuation firm but in any event the $13M should be discounted for risk of not being received and the time value of money. Let’s say the contingent consideration is valued at $7M. In ABC, Inc.’s final tax year it takes the $7M into taxable income and assigns the right to receive the contingent consideration to its shareholders. ABC, Inc. does not get any tax relief if ultimately less than $7M is received nor does it owe any extra tax if more than $7M is received. The shareholders will pay tax on the contingent consideration if and when it is received on whatever amount is received.
Tip: This alternative is particularly useful (could save corporate level tax) if ABC, Inc. has sufficient useable net operating losses to offset the $7M but not the full $13M of contingent consideration.
Alternative 3 (Trap for the Unwary). What happens if you don’t put a plan of liquidation in place requiring liquidation within 12 months but you liquidate prior to receiving all of the contingent consideration anyway? In this case, a value needs to be determined prior to liquidation with respect to the contingent consideration not yet received. Again it’s best to involve a valuation firm but in any event the remaining contingent consideration should be discounted for risk of not being received and the time value of money. Let’s say the contingent consideration is valued at $7M. In ABC, Inc.’s final tax year it takes the $7M into taxable income and assigns the right to receive the contingent consideration to its shareholders. ABC, Inc. does not get any tax relief if ultimately less than $7M is received nor does it owe any extra tax if more than $7M is received.
Here’s why this is a trap: In this case the shareholders have to pay tax on the $7M when ABC, Inc. liquidates/assigns the right, and they will owe additional tax if greater than $7M is received. This is the only alternative where the shareholders owe tax on consideration before they have received it.
Mike Baker frequently advises regarding asset sales. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.