In an acquisition of a closely held company, acquirers often ask the selling employee/shareholders to continue to provide services to the company for a transition period post-sale. This is done to ensure an efficient transition of the sellers' relationships with the company's customers, suppliers, and employees.
This practice is particularly common in the acquisition of both professional services firms and service-related companies.
The term of the post-transaction seller employment is typically a matter of negotiation between the corporate acquirer and the company sellers. Post-transaction seller employment transition periods of one to two years are common. However, longer transition periods do occur.
Of course, the employee/shareholder sellers would expect to be fairly compensated for their professional services during the transition period employment.
Transaction advisors are often asked to consider these two questions related to such post-transaction transition period payments: (1) How much should the company buyer pay to the employee sellers for these transition period services? and (2) How should these transition period payments be structured?
The structuring and characterization of transition period payments can have a direct income tax consequence to both (1) the corporate acquirer and (2) the selling employee/shareholders.
Such payments may be categorized as compensation expense for services provided by selling shareholders or contingent purchase price earn-out payments.
A compensation expense classification would qualify as current period tax deductions for the acquired company, but would represent ordinary income to the selling employee/shareholders.
Earn-out payments would represent capital gains to the selling employee/shareholders, but would only adjust the buyer's tax basis in the acquired company stock or assets.
In other words, the acquired company would not receive an income tax deduction for these payments.
This article discusses a number of factors a transaction advisor—and the transacting parties themselves—should consider when characterizing these payments. These factors include the transition services conditions, the proportionality of the transition payments, and the target company price valuation, among others.
This author further highlights judicial and administrative guidance related to transition period payment characterization questions.
Transaction participants should consider the transition period payment characterization issue when negotiating and structuring a company sale transaction. Both transaction parties may consult tax and legal advisors.
Both parties may also consult with their transaction advisor to assess (1) the reasonableness of the post-transaction employee/sellers’ compensation and (2) the reasonableness of the total amount of the transaction purchase price.