Tips for Effectively Negotiating Incremental Tax Reimbursement

At a glance:

• The main takeaway: To fine-tune the process of tax incremental reimbursement in such a way that it mitigates overall tax liabilities, ensuring an economically favorable exit.
• Impact on your business: A comprehensive tax minimization strategy can determine the difference between an economically favorable exit and one that leads to financial hardships.
• Next steps: Engaging with experts helps you unravel complex regulations and equips you to traverse this important phase of your professional journey with confidence and preparedness.

Schedule a consultation with Aprio’s Government Contracts Consulting Team today.

The full story:

As a government contractor, if you’re planning to exit, it’s important to minimize taxes for a successful negotiation. This is especially important as a typical government contractor exit transaction involves a Private Equity (PE) buyer seeking a step-up basis asset purchase transaction for income tax reporting. To do this, you need to purposes recover the purchase price allocated to ordinary income items over less than 12 months, and all purchase price allocated to intangibles assets such as trade name, contract rights, IP, and goodwill over a 15-year period[1].  

Complicating the tax incremental calculation is the customarily required rolled-over participation for legacy owners who will be part of the continued management team. This usually involves a tax-deferred contribution arrangement, but there are important considerations to keep in mind, especially if you report income on a cash basis. For example, if you are a cash basis reporting government contractor for income tax purposes, under industry norms, you must pay all your federal and state deferred income (franchise) taxes attributable to 100% of your cumulative cash basis measured at closing[2].

In today’s negotiation landscape, government contractor sellers must be mindful of minimizing state taxes, particularly when it comes to the additional state income (franchise) taxes that would be incurred to accommodate the PE buyer who desires an asset sale tax treatment. According to current laws, with some exceptions beyond this blog[3], the capital gain from the sale of equity ownership is only taxed in the resident state of the selling owner. This means that if you reside in a tax haven state, the difference in your tax liability between an asset sale and the sale of equity interest would be the additional state income tax you’d incur.  

Negotiating for incremental tax reimbursements after signing the letter of intent (LOI) can result in missed opportunities for favorable terms, so it is strongly advised against. To enable negotiation in the LOI language, legal counsel must be enlisted.  The mechanical calculation of your incremental reimbursement is a comparison of the federal and state income tax burden that you would incur compared to agreeing to an asset sale tax treatment election. If the reimbursable federal income tax rate is the same under either scenario, the incremental tax would be the additional state income (franchise) taxes. This is treated as a purchase price adjustment, and the reimbursed sum is calculated by multiplying the quotient based on a 20% federal long-term capital gain rate plus the effective state taxing rate[4]. The objective is to help ensure that the gross-up reimbursement calculated sum, net of the imposed tax, results in the actual out-pocket additional incremental tax incurred.

For example, if you calculated additional state incremental tax incurred to be $100 and your state effective calculated state rate is 5.50%, your gross-up calculation quotient would be 74.5% (1 minus 25.5%) and your incremental gross-up reimbursement sum would be $134.23 per every $100 of additional state incremental tax incurred [($100 divided by 75%) minus $100]. Proof of calculation: $134.23 times 25.5% tax equals $34.23.

The incremental calculation negotiation process has a life cycle with four phases.

• Phase 1- The first phase of the auctioning process should start with an education phase. It’s important to conduct this phase before signing a letter of intent agreement with exclusivity rights that typically last for 90 days. An expert tax M&A advisor typically employs a baseline projection approach using pro-forma adjustments to come up with a pre-closing trial balance. These preliminary calculations serve as placeholders during the education phase, and can help illustrate all the negotiation options and pressure points that might arise.
• Phase 2– It’s important to ensure that any additional taxes incurred beyond those that would have been incurred through a simple equity sale are compensated for or by the buyer, especially if this was not explicitly stated in the LOI. It is best if the LOI includes a provision for the buyer to cover any extra taxes according to industry standards, but buyers typically do not take on additional tax liabilities resulting from advantageous accounting methods unless specified.
• Phase 3- As negotiations enter their third phase, parties involved will discuss a methodology for incremental tax reimbursement that will be integrated into the final agreement. This methodology must incorporate a look-back mechanism based on the final numbers, which will help to avoid inaccuracies arising from unreliable placeholder information and fluctuating apportionment factors. The best practice is to have a mechanism based on the agreed format that will be conducted post-closing with the final balance sheet and apportionment factor information.
• Phase 4- The fourth phase necessitates accurate documentation that outlines the agreed-upon reimbursement methodology and/or minimization agreed planning techniques to be included in the final sales agreement. These details are commonly presented as numbered paragraphs that are labeled as “Tax Matters” and are normally towards the end of the signed sales agreement document.

The bottom line is to maximize your incremental tax reimbursement ability, you must timely engage the services of a seasoned M&A Tax advisory team who can guide your through education, negotiation, and the execution of Phases 1 through 4 as discussed above.

Related Resources:

Aprio’s Government Contract Compliance Services

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[1] Please note under current law for those government contractors involved in Research & Development “R&D” activities, your previous, unamortized, capitalized Sec 174 capitalized costs component is subject to special recovery rule provisions beyond the scope of this blog that will require that such costs under certain sales transactions will continue to be amortized by the seller party over the remaining recovery period left.  

[2] The mechanism for the tax recognition of the ordinary income items with zero tax basis attributable to the deferred equity rolled over component being contributed could be mandated by the buyer party to be recognized via implementation of a change accounting method (i.e., the cash basis selling taxpayer will be required to change to accrual basis) and/or the calculation and payment as indebtedness item to the buyer at closing (based of the future tax to be incurred by the buyer on the recognition of the ordinary income items post-closing).

[3] For example, not all-inclusive, there are some states like CA, MA, MD, OH, NY, VA, etc., that have passed statutes and/or regulations imposing non-resident taxation of certain partnership equity sales transactions arrangements that are beyond the scope of this blog.

[4] The effective state taxing rate depends on whether the incremental tax reimbursement component will be taxed inside of the seller entity operating tax structure, and it will be subject to non-resident state taxes or it will be paid post-closing and perhaps only taxed at the beneficial owner level (i.e., only subject to resident state tax implications, and thus, effective resident tax rate, if applicable.)