Getting Acquired or Selling Your Software: Tax Issues in the US
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Recently I was asked to help a friend in an attempted deal by one company to acquiring a technology (a software system) owned by my friend’s single founder LLC. The potencial buyer was primarily interested in acquiring the software of the seller, which is one of their primary assets, but was also open to acquiring the entire LLC if that were to be more tax efficient for the seller.
Neither buyer nor target had much experience in this domain, and so things quickly got confusing fast. I did quite a bit of reading and learned quite a bit, which should prove invaluable in the future should I ever find myself involved in a similar situation again.
I’d like to summarize a bit what I’ve learned.
(BTW, for my foreign readers, everything below is rather U.S. and I.R.S centric, as the deal was U.S. based.)
Option #1: IRS Section 368a Tax-Free Reorganizations
At first this seemed like the best option for the seller, as it is a way for one corporation to acquire another which is potentially tax free to the seller to the extent that the sellers receive at least 40% of the value of their company in terms of shares of the buyer (in exchange for 100% of the seller’s shares). The basic concept is that a taxable event is avoided for the share transfer part of the transaction, as the seller is being merged into the buyer, and has not actually ‘sold’ their business. The seller does not get taxed on the shares they receive (until they sell them), only on the cash part, which is taxed at the applicable capital gains rate.
Unfortunately this option turned out not to be immediately viable, as the target company was an LLC and was elected to be taxed as such (ie: a disregarded entity) which disqualifies it from consideration for this type of transaction (had the LLC elected to be taxed as a S/C-corp for IRS purposes sometime in the past, for reasons unrelated to this transaction, there would not have been an issue).
Now, why don’t the owners of the LLC just convert it to a C or S-corp, or check the box right now for it to be taxed as such as part of executing the transaction? Simple right? Well, this doesn’t work, because this violates the IRS’s Step Transaction Doctrine, meaning you can’t get the tax benefits of Section 368a if the conversion to an S/C-corp is done for the primary purpose of minimizing taxes. It has to be done for it’s own legitimate business reasons that are unrelated to the acquisition.
At the very least, for this trick to look kosher, the LLC owners would need to convert to a C/S corp and then wait for some predefined amount of time while they conducted business as usual. They’d also presumably have to demonstrate that this change was done on it’s own merits. What would be the required amount of time, 6 months, a year? Difficult to say, the accountants we talked to said they’d have to research case law (aham, code for, this could be expensive as they charge quite a bit per hour).
However, the above notwithstanding, there is an even more basic practical issue which would have thwarted this strategy. Professional fees. A lawyer we consulted with estimated that the total legal and accounting fees for doing such a reorg would run in the mid four figures ($20K-$50K), which would make this strategy a no-go for the relatively small amounts we were discussing for the acquisition.
So to summarize, it turns out there are real tangible benefits to running a business as a C/S corp and not as an LLC, which do not become obvious until you are a potential acquisition target. LLCs are simpler to administrate, but as I recently found out here, they come with some tax drawbacks which can’t just be immediately patched over by checking a box somewhere on an IRS form. However, the tax advantages of selling a C / S-corp are only likely to benefit you if the acquisition amount is large enough to cover what seem likely to be the four figure transaction costs.
Two references I found quite useful were:
- Tax Free Organizations
- Basic Tax Issues in Acquisition Transactions (Penn State Law Review)
Option #2: Direct Asset Sale (Sale of Software)
From the legal perspective simply selling the rights to the software (and not the entire target company) seemed simplest. Fewer contracts to review, less due diligence, simpler right?
While this may be true legally, it is not necessarily from the tax perspective. Actually it struck me as more difficult. Why?
The reason is that software potentially falls under the category of a copyrightable ‘self-created’ work. Say you are an artist or a software developer. Your method of self-employment is the creation of art or code for the purpose of selling it to another. Well, in this case the sale of said works results in taxations as ordinary earned income. And this makes quite a bit of sense — you produced these works for the purpose of sale to a client (preexisting or not), so this is clearly earned income as a self-employed person.
Now, suppose instead you are a single founder LLC which you very much consider as a startup. You work hard for a year on your startup idea, which involves creating a nice piece of software you aim to monetize via licenses or subscriptions. Besides writing code, you do a bunch of other activities you’d be expected to do as an entrepreneur looking to build a company. However, along comes another company that wants to buy you out.
Morally speaking, you behaved like an entrepreneur, taking a risk, and developed something not with the purpose of selling it as a work-for-hire, but as capital asset in a real business. So the sale should be taxed like capital gains right? Well, if you are not careful, it won’t be! I have done a bit of reading and could not get a clear and sure answer on how to guarantee that the sale is considered as a capital gains by the IRS and not as ordinary income, due to that the work is self-created and copyrightable.
However, the trick seems to be to assigning most of the value of the work to the intangible parts (know-how, goodwill,etc) and not the tangible part (the copyright). It also seems you need to ensure that you can show that the spirit behind creating this work was in the context of creating a legitimate business around it, and not selling it off to another as part of regular self-employment.
Anyways, all of the above is pending another discussion with a good CPA, who should be able to clarify these issues.
A few references, which are mostly confusing but do give you a sense of the issues you need to worry about and have clarified with your CPA:
Option #3: Direct sale of LLC (software included as asset)
This option is similar to option #2, since when a business is sold directly, for IRS purposes the transaction is done as if a collection of assets were sold piece by piece, each with their own tax consequences. Assuming we are talking an LLC with one man asset (its software), this list might look something like this:
- the software rights (further broken down into copyright and intangibles such as know-how, goodwill, etc).
- the goodwill of the business (another intangible)
- customer lists
Each asset will be subject to different taxation rates, either capital gains or ordinary income.
Goodwill and know-how as I currently understand are to be taxed as capital gains. So perhaps the advantage of doing the deal this way as opposed to the much simpler Option #2, would be that there is more leeway to assigning most of the value to be put under the goodwill and know-how umbrellas, leading to favorable capital gains treatment for the seller, and this would appear to be more credible in the context of the sale of the entire company as opposed to just the software. Still, this option is significantly more complicated than option #2 both legally and the perspective from accounting, and so is sure to involve much higher professional fees.