March 2011 Archives

California is Focusing on Cancellation of Debt Income

March 28, 2011,

Over the last two years I have often been asked to answer the question of what the consequences will be if a client walks away from a property, letting the bank take it back. The previous decade of incredible real estate appreciation resulted in many people without previous real estate investment experience becoming real estate investors. The most common situation I see is the condo owner who had enough income to keep his condo as a rental and still buy himself a single family residence. Then the recession hit and both properties are now underwater. Now, he thinks he can walk away from the property thanks to the Mortgage Debt Relief Act. Unfortunately, that Act was put into place to help people who were losing their homes, not to help people with investment properties. Even more unfortunate is that a lot of these beginner real estate investors thought that they could handle their taxes themselves without an accountant.

California is now focusing on finding those people and making them pay tax on the cancellation of debt income they should have recognized on giving up their underwater investment property to the bank. According to Spidell's California Taxletter, (March 1, 2011, Volume 33.3), California is mailing letters for tax years 2007 and 2008 to taxpayers who had debt relief on properties that were reported on Schedule E and therefore, probably do not qualify for the principal residence exclusion. The letter calculates the potential additional tax owed as well as a 20% accuracy related penalty and interest on the unreported income.

If it is too late and you have already been given notice of an audit on cancellation of debt income, there are still some other exclusions that you may qualify for, such as business and farm indebtedness. If you are thinking of giving an investment property back to the bank, be sure to bring in a good accountant to analyze the tax situation for you first.

An Incomplete or Improperly Formed Corporation or Limited Liability Company Can Hurt Your Silicon Valley Business in Several Ways, Part IV: Shareholder/Partner Buy-Sell Agreements

March 21, 2011,

Just like estate planning is so important for those we leave behind when we die, a good shareholder or partnership agreement is crucial for the well-being of a business after a traumatic event for one of the owners. Death, disability, retirement, bankruptcy, insolvency, divorce, and even a partnership disagreement can be traumatic events for a company to endure, and could result in the end of a business if they are not planned for in advance. Planning includes deciding whether the company or the other owners have an optional right or a mandatory requirement to purchase the interest of the subject owner, at what price, and on what terms.

Any business with more than one owner needs a good shareholder, LLC or partnership agreement. It is equally as important for family owned businesses. For years, I worked with a real estate investment family business in Saratoga. When the father died after years of working together with his adult children, the LLC agreements we put in place were absolutely critical to keep the management control in the one child who was capable of running the business. In this case, the agreements put in place the succession plan which enabled the business to go on after the death of the majority owner.

A good shareholder or partnership agreement should consider what restrictive covenants the owners want to impose, including restrictions on sale and rights of first refusal. Agreements for companies involving sweat equity should deal with the amount of time, effort and capital (if any) required of each owner, and the vote required to remove someone from the company. Companies that are considering a sale as an exit strategy should consider rights to force the minority owners to go along with the majority owners on a sale, and rights of the minority owners to force the majority owners to include them in any sale.

The value of the company should be decided in advance of an event, and should be reviewed regularly. A formula or a method for valuation should be clear in the buy-sell agreement. And if the death or disability of one owner could materially impact the value of the company, the owners should consider funding the buy-sell agreement with life insurance and disability insurance. The future of the company is dependent on the agreements the business owners put into place now. Failure to have a buy-sell agreement could be a fatal mistake.

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Merger and Acquisition Deal Structure - Stock Purchase, Part II

March 14, 2011,

In my last segment, I mentioned a recent deal involving a Northern California company structured as a stock sale. Having tax advisors assist at the early stages helped keep the transaction on track. The next major issue was allocating the risk of business liabilities between the buyer and the seller.

Like any stock purchase transaction, liabilities of the seller stay with the business. This is often a significant disincentive to the buyer, because it must hold an entity that cannot escape its past liabilities. Two mechanisms are commonly used to alleviate the buyer's risk.

First, a working capital cushion may be created to provide a source of funds to pay the ongoing debts of the business. The amount of the cushion is agreed in the purchase documentation. A portion of the purchase price is then held back at the closing in an escrow. The amount of net assets as of the closing is determined through a post closing audit, and the held back amounts are distributed following the audit to the buyer or seller depending on any difference between the agreed amount and the amount determined under audit.

Second, the seller may cover the buyer for any damages arising out of the inaccuracy of any of the seller's representations made in the acquisition agreement. These provisions, typically structured as an indemnification, are very heavily negotiated and can be quite complex. Issues covered in these provisions include the extent of the liability relative to the purchase price received, the length of time the seller is exposed to the liability, and the responsibility for defending any resulting litigation.

There are other risks associated with stock transactions which are not an issue in asset acquisitions. For example, securities regulations may be a concern. Because an ownership interest is a security, any transfer of the ownership interest will raise securities law issues. Where the buyer is owned by an individual or individuals active in the business, and the buyer is financially substantial and sophisticated, the securities issues are minimal. If there are a large number of shareholders not otherwise involved in the business, and the buyer is not otherwise financially substantial and sophisticated, compliance issues may arise that will add time and expense to the transaction.

An acquisition structured as a stock sale is relatively easy to close administratively, but is more difficult to negotiate because of the liabilities that remain with the business.

Merger and Acquisition Deal Structure - Stock Purchase, Part I

March 7, 2011,

In a recent acquisition that I handled for a company in Santa Cruz, the buyer decided to purchase, with cash, the stock of the company rather than its assets. Acquisitions through stock or equity purchases are a common method of buying a company. From an administrative standpoint, equity purchase acquisitions are one of the easiest deal structures to implement.

In an equity purchase acquisition, a company is bought by purchasing all of the ownership interests of that company. If the company is a corporation, a buyer purchases all of the company's shares of stock from the company's stockholders. If the company is a limited liability company or partnership, a buyer purchases all the ownership interests of the company from its members, in the case of a limited liability company, or its partners, in the case of a partnership. This discussion will focus on a stock purchase, although the basic issues outlined here are the same when dealing with a limited liability company or partnership.

The administrative benefit of a stock purchase transaction is that ownership changes simply by transferring all of the company's shares. Contrast this with an asset purchase structure, where each desk, chair and personal computer must be accounted for and sold to the buyer.

A significant advantage to a stock purchase is that there may be no need for assignments of the contracts of the business (although case law can be inconsistent on this point). Contracts should be reviewed, however, as many prohibit stock transfers, or changes in control, of the business.

Stock purchase transactions, however, can have disparate tax impacts on the buyer and seller. As a result, both the buyer and the seller will need to consult their respective tax advisor early and often to understand the consequences of a stock purchase structure and the specific terms within the transaction. Parties that agree to terms without consulting their tax advisor are often faced with the need to renegotiate their transaction under less than optimal circumstances.

One of the top issues in a stock purchase is the treatment of the company's liabilities. Although purchasing the stock keeps the assets of the business intact, it also retains all of its liabilities. In other words, a stock purchase does not rid the business of its obligations. For this reason, a buyer is not disposed toward purchasing stock, because the buyer ends up with an entity that cannot escape its past liabilities.

In my next segment, I'll discuss some of the available solutions commonly used in a stock purchase transaction to provide sufficient comfort to a buyer to close the deal.