The following article is adapted and reprinted from the M&A Tax Report, Vol. 8, No. 9, April 2000, Panel Publishers, New York, NY.
SMALL DEALS SUFFER UNDER NEW PROVISION
By Robert W. Wood
By one estimate, the vast majority mergers and acquisitions in the US are valued between $500,000 and $2 million. (I'm talking the whole deal value here, not the value of the target.) Yes, these are small. The dollar volume of these transactions (even in the aggregate) may pale compared to some of the momentous deals that seem to be happening today (take AOL for example).
Yet, there is an enormous volume of transactions that are well below the radar screen of, say, the Hart-Scott-Rodino $15 million antitrust filing threshold. It can be argued that any tax provisions having a disproportionate effect on smaller deals may also be more likely to be overlooked simply because less sophisticated advisors may be involved in these smaller transactions.
Not So Fast...
One provision that escaped wide notice until after its enactment in December of 1999 is the seemingly nonsensical repeal of the installment method for certain taxpayers. Like much tax legislation these days, one has to hunt and peck through the keyboard of the Tax Code to figure out where this took place. This tax change was passed as part of the Ticket to Work and Work Incentives Improvement Act (H.R. 1180, Public Law 106- 170). (Huh?) Apart from the ridiculous name of this bill (which must mean something, just not about this topic), what Congress did was to repeal the installment method for most accrual basis taxpayers. This hits accrual method taxpayers that wanted to sell their company under the installment method. Now, Section 453(a)(2) states that "the installment method shall not apply to income from an installment sale if such income would be reported under an accrual method of accounting without regard to the section."
Is This Fair?
It may be crying over spilled milk to lament this repeal, but the new law was signed by the President on December 17, now requiring taxes on proceeds from the sale of businesses to be paid all at once, even if the proceeds are received in installments over several years. M&A Tax Report Advisory Board Member Dick Lipton was quoted in the Wall Street Journal on the provision as saying "people were asleep at the switch." Wall Street Journal, January 26, 2000, p. C14. That seems the most succinct description for what happened.
Small business lobbyists and other groups are now up in arms over the provision, but this one slipped through right at the end of the year when too many other things were happening. There was at least a slight bit of advance notice (before the President signed the bill anyway), with brief press coverage about how this installment sale repeal would negatively impact seller financing. The Wall Street Journal noted a mere two weeks before the President inked the bill that the installment method is used frequently in small transactions, allowing sellers of small companies to defer capital gains until they actually receive the proceeds, a kind of pay as you go arrangement. See Ho, "Tax-Bill Provision Could Deal a Blow to Seller Financing," Wall Street Journal, November 30, 1999, p. B2.
Shortly after passage, there is already a movement to create ways to avoid the net of the instant gain recognition the new law seeks to require. Most obviously, one can avoid the new law altogether (it seems) by effecting a stock sale, not an asset sale. Small buyers generally avoid stock sales, of course, but now there is a big reason for the seller to push hard on this issue. M&A Tax Report Advisory Board Member Bob Willens (also quoted in the Wall Street Journal) noted this trend. See Hube, "Tax Rule Crimps Small-Business Deals," Wall Street Journal, January 26, 2000, p. C1. Earnout arrangements might also be a solution, especially if the cap on the earnout is effectively designed to emulate what would have been received under an installment sale arrangement. Sure, the IRS could come in and attempt to recharacterize the earnout as a note with a payment certain, but we can expect these techniques to be tried.
There is some debate about whether the installment sale repeal for these accrual method taxpayers is justifiable or not. One noted commentator has argued vigorously that there is no big deal here and that small businesses ought to be on the accrual method anyway. (The name of this silly commentator is being withheld!) But it does seem disingenuous, if not outright wrong, not to note that this repeal literally applies to sales of assets by accrual basis S corporations and partnerships, even if the taxpayers (the ones who receive the income or loss from the partnership or S corporation) are cash method individuals. Is this a fundamental change or what?
Not for Long?
Perhaps not surprisingly, lawmakers have already looked at repealing the harsh change. In mid-February, a bill was introduced (HR 3594, the Installment Tax Correction Act of 2000), to repeal Section 536 of the Ticket to Work and Work Incentives Improvement Act of 1999 (PL 106-170). The bill would apply retroactively to sales occurring after the day of enactment (December 17, 1999). In addition to HR 3594, a similar bill was introduced in the Senate (S 2005), to do the same thing.
Small business owners have been fairly vociferous in their criticism of the installment sale repeal. Although not exactly an uproar, there has been a significant mumble of complaint given the immediate tax that sellers incur. Apart from the fairness of the almost Christmastime change (who said tax law has to be fair anyway?), part of the complaint was that the installment sale repeal took people by surprise. Small business representatives have been lobbying, now saying that they had understood the provision was geared toward curtailing installment sales of large companies.
It may seem like a long-shot in this election year for a tax bill such as this to get passed. For discussion, see Glenn, "Lawmakers Set Sights on Repeal of Installment Method Change," Tax Notes, Feb. 14, 2000, p. 906. Some appear to believe that administrative guidance can solve the problem, even if legislation does not pass. Recently, the Treasury Tax Legislative Counsel announced that administrative guidance would be retroactive to December 17 (the date the 1999 legislation passed) and would address the availability of the installment method for most common disposition transactions, supposedly solving the problem for small business — regardless of the entity's form. See Glenn, "Installment Method Repeal Ultimately Needs Legislative Fix," Tax Notes, March 6, 2000, p. 1328.
Small Deals Suffer Under New Provision, Vol. 8, No. 9, M&A Tax Report (April 2000), p. 5.