A DST is a structure that sellers can implement to take the “bite” out of a tax bill. Generally, when owners sell their business, a large, one-time tax bill accompanies the sale. An owner is subject to tax because the business sold an asset with a low tax basis, but the asset’s fair market value was much higher. The difference between the fair market value and the tax basis is where tax is applied. For owners who have labored to grow their business, getting stuck with a hefty tax bill may cause them to feel like they are getting the short end of a deal.

Typically, when owners sell their business, the value of the business is greater than its tax basis. A classic example is the stock of a family-owned corporation. If a business owner sells the stock (and this stock likely has a very low tax basis), that same owner will owe capital gains tax on the difference between the purchase price and the tax basis. Despite the owner being taxed at capital gain rates on the asset appreciation, the tax bill could still be a tough pill to swallow. Instead, the selling owner may have saved money if the transaction had been structured differently.

By engaging a DST, an owner sells the business to the irrevocable trust in exchange for a promissory note. Now, the irrevocable trust owns the business, and the owner holds a promissory note payable by the irrevocable trust. Then, the irrevocable trust will sell the business to an end-buyer for cash. With the end-buyer holding the business, the irrevocable trust now has the cash, and the irrevocable trust can pay down the promissory note to the now-former owner. While the irrevocable trust makes payments on the promissory note, the proceeds from the sale are invested, and those investments can generate income to help pay down taxes on the original sale.

A DST structure is a complex arrangement. Before an owner implements a DST, an owner should engage a sophisticated advisor familiar with the tax code, mergers and acquisitions, and estate planning. Without proper implementation, a DST could come under the scrutiny of the IRS. This means that the IRS could challenge the tax deferral of the sale of the business and instead find that the taxes cannot be stretched over a period of years. A skilled advisor, well-versed in structuring these transactions, can help advise owners if preparing for sale with a DST is appropriate for their business.

While a DST is not a panacea for every owner, under the right facts, this structure may provide value to legacy business owners on exit. Because a DST defers taxes while creating an opportunity to invest proceeds, a DST may be the right tool for you to preserve the value on sale.

For more information or to seek counsel from our Mergers & Acquisitions group, please reach out to request a consultation or call us at 216-696-1422.

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*This article was originally authored for publication in Crain’s Cleveland Business. To view this article on the Crain’s website, follow this link.

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Navigating Asset Transactions

Asset transactions have unique contours when compared against a stock deal. From the buy-side, buyers may depreciate assets based on purchase price. However, the downside is business successor liability. Under state law, buying assets may keep the buyer on the hook for unpaid state taxes. From the sell-side, asset sales likely create capital gain treatment. This is beneficial because of the capital gain rate break. However, sellers of assets may have potential “depreciation recapture.” To reiterate, it is crucial to emphasize that seasoned advisers, armed with extensive expertise, possess a range of potential planning opportunities designed to proactively mitigate and address the various tax risks inherent in such transactions.

Deciphering Complexity of Stock Sales

Stock sales, compared to asset deals, are generally more complex. Depending on the business entity form, the Code blesses some transaction structures as tax-free. On the one hand, buyers may choose stock deals for “tax-free reorganization treatment.” A tax-free reorganization is a creature of the Code and requires tax counsel. Sellers generally receive capital gain treatment on the sale of corporate stock. All in all, stock deals are complex, but advisers have levers in the Code to manage parties’ interest in a transaction.

Engaging an Expert for Strategic Deal Structuring

Before inking a letter of intent, engaging a skilled adviser to structure your deal ensures the most value is captured at the bargaining table. Advisers with both tax and transaction acumen have tools in their toolkit to bring a transaction to life while mitigating downstream tax liabilities. These experienced professionals not only navigate the complexities of deal structuring but also assess potential risks and opportunities, providing comprehensive guidance to optimize the overall outcome of the transaction.

For more information or to seek counsel from McCarthy Lebit’s Mergers & Acquisitions attorneys, please reach out to request a consultation or call us at 216-696-1422.

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What is your business worth?

An owner needs to know the business’ value before trying to sell. That goes beyond income, revenue, debts and expenses — it is understanding what the company is worth on the open market. An owner may overestimate the value of their company, only to be disappointed with lower offers from potential buyers. An owner should get a professional valuation from a qualified adviser. There are many variables that go into a valuation so it may not be exact. However, it provides an owner with a clearer view of the state of the business. With that frame of reference, an owner is more equipped to handle offers.  

Assemble your team of advisors.

Owners often try to sell their business by themselves. After all, they know their company better than anyone. However, an owner may not understand how to fairly value their company, how to market it, how to negotiate legal documents, what the tax implications may be or how to manage the proceeds. There are many complexities in an M&A transaction which, if not handled properly, can lead to unfortunate results. Further, an owner still needs to operate the business so that it remains attractive to a potential buyer. An owner should assemble a team of professionals who can guide them through the process. Experienced investment bankers, accountants, M&A attorneys and financial advisers help an owner navigate their transaction, work through issues, and mitigate risks, all of which can lead to a successful transaction closing.

Understand your personal situation.

Selling a business will likely result in the largest liquidity event of an owner’s life. After debts are satisfied and taxes are paid, the owner will need to live off the net proceeds for their remaining days. It is important to confirm there will be sufficient funds for an owner to maintain their lifestyle. If that will not be the case, an owner may need to adjust their plans to avoid an unwelcome situation after closing. It is also important for an owner to have a proper estate plan in place to account for the influx of funds and make use of tax planning strategies.

For more information or to seek counsel from our business & corporate law group, please reach out to request a consultation or call us at 216-696-1422.

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Financial and Valuation Issues:

M&A deals often hinge on financial considerations and valuation. Disagreements over valuation methods, purchase price, and payment structure can instantly derail a transaction and lead to a failed M&A deal. Additionally, the seller’s perceived business value may differ from the market’s willingness to pay. Selling a business is typically the most significant financial transaction of an owner’s life. They must have a clear understanding of net proceeds (post-indebtedness, fees, taxes, etc.) to ensure it is sufficient for future needs. Accurate financial due diligence, transparent communication, and realistic valuation assessments are crucial to ensuring deal feasibility.

Disagreements Over M&A Deal Terms and Conditions:

Negotiating the terms and conditions of an M&A deal can be complex. Disagreements over deal structure, representations, covenants, or indemnification requirements can lead to a breakdown in negotiations and a failure to close the deal. Effective communication, compromise, and creative problem-solving are vital. A detailed and comprehensive term sheet, or letter of intent, is an effective way to reach mutually agreeable decisions at the outset before the parties move forward. This initial document will provide a road-map for preparing documentation consistent with agreed-upon terms, which can aid in reducing disagreements in the documentation phase of the deal.

Cultural and Organizational Misalignment:

Successful M&A deals require a certain level of cultural and organizational alignment between the parties involved. Incompatibilities in leadership style, organizational structure, decision-making processes, or operational practices can create challenges and raise concerns about post-merger integration. Conducting cultural due diligence, open communication, and addressing alignment issues early in the deal process are critical to ensuring compatibility. Furthermore, leadership meetings can help determine if values, approaches, and priorities align.

External Market Factors:

External market conditions and events can significantly impact the likelihood of a failed M&A deal. Economic downturns, industry disruptions, political uncertainties, or sudden shifts in market dynamics can alter the M&A landscape. The current inflationary environment has resulted in higher interest rates which may present financial difficulties, or even the inability to secure adequate funding. Staying vigilant, assessing market risks, and having contingency plans in place can mitigate the impact of external factors.

The above-mentioned factors add layers of complexity to M&A deals of all sizes. Enlisting the help of an M&A attorney with knowledge of transactional law, the art of negotiation, and merger & acquisition etiquette can help buyers and sellers surmount an impasse and achieve their desired goals at closing.

To obtain further information or engage one of our M&A attorneys for your deal, please reach out to request a consultation, or call us at 216-696-1422.

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So, how does a majority shareholder, officer, or director of a corporation avoid a trap? The answer is to exercise sound business judgment, in good faith, and in a fair and rational fashion, with input from a disinterested board of directors. 

Ohio law has long since recognized “the rights of the majority to exercise control over the corporate affairs to which ownership of their shares entitled them.” Armstrong v. Marathon Oil Co. (1987), 32 Ohio St.3d 397, 402, 513 N.E.2d 776, 782. “Ohio courts adhere to the ‘business judgment rule,’ and will not inquire into the wisdom of actions taken by majority shareholders, directors or officers in the absence of fraud, bad faith or abuse of discretion * * *. [T]he business judgment rule recognizes that many important decisions are made under circumstances of uncertainty, and it prevents courts from imposing liability on the basis of ex post judicial hindsight and lowers the volume of costly litigation challenging the directorial actions.” Radol v. Thomas (C.A.6, 1985), 772 F.2d 244, 256.

The protection of the business judgment rule can only be “claimed by disinterested directors.” Gries Sports Ent., Inc. v. Cleveland Browns Football Co. (1986), 26 Ohio St.3d 15, 20, 26 OBR 12, 16, 496 N.E.2d 959, 964. “Disinterested directors” does not mean indifferent directors, or directors with no stake in the outcome. If that were so, shareholders could never be directors or officers. Johnson v. Trueblood (C.A.3, 1980), 629 F.2d 287, 292 (“by the very nature of corporate life, a director has a certain amount of self-interest in everything he does”); Asarco, Inc. v. Court (D.C.N.J.1985), 611 F.Supp. 468, 473 (“the fact that Asarco directors own stock * * * is not sufficient to deprive their decision of the benefit of the business judgment rule”).

Disinterested directors are those who “neither appear on both sides of the transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves [641 N.E.2d 273] upon the corporation or all stockholders generally.” Gries, supra, 26 Ohio St.3d at 20, 26 OBR at 17, 496 N.E.2d at 964. The decisions of disinterested directors will not be disturbed if they can be attributed to any rational business purpose. Id. “The burden is on the party challenging the decision to establish facts rebutting the presumption” of good faith of directors invoked by the business judgment rule. Id.

If you have questions regarding your rights and responsibilities as an owner, officer, director, manager, or partner of a business entity, please reach out to request a consultation or visit David’s bio for his contact information to reach out to him directly, or give us a call at 216-696-1422.

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When times are good, the economy is running smoothly, and businesses are profitable, business partners are inclined to “get along.” In other words, when there is enough money and benefits to “go around,” business partners are more likely to overlook minor grievances and treat each other with fairness – at least one hopes. However, when times get tough, the economy slows, and businesses become less profitable, business partners tend lose patience with one another. As a result, we tend to see an uptick in legal disputes between business partners during these less prosperous periods. Those business partners, however, have fiduciary duties which they to one another. When a fiduciary duty is breached, litigation can be difficult to avoid. And, when litigation is brought, the stakes can be very high. When it comes to fiduciary duty litigation, there are several pitfalls and traps to avoid.

Fiduciary duties are typically found amongst business partners, shareholders in a close corporation, members of a limited liability company, officers and directors of a corporation or limited liability company, and trustees of a trust to its beneficiaries. The elements of a breach of fiduciary duty claim, most recently upheld by the Ohio Court of Appeals for the Third District, Shelby County are (in re: Thomas v. Fletcher):

1. The existence of a duty arising from a fiduciary relationship;
2. A failure to observe those duties; and
3. An injury resulting proximately therefrom.

For purposes of this discussion, the reader can simply substitute “majority members of a limited liability company,” or “partners of a partnership,” for majority shareholder of a closely held corporation. This is because, for purposes of applying fiduciary law, close corporations bear a striking resemblance to a partnership or a limited liability company. In essence, the ownership of a close corporation, like limited liability companies or partnerships, is limited to a small number of people who are dependent on each other for the enterprise to succeed. Just like a partnership, the relationship between the shareholders must be one of trust, confidence, and loyalty if the business is to thrive. Crosby v. Beam, 47 Ohio St.3d 105, 107 (1989); Gigax v. Repka, 83 Ohio App.3d 615, 620 (Montgomery Cty. 1992).

Majority shareholders owe a heightened fiduciary duty to minority shareholders. That duty is defined as the “utmost good faith and loyalty.” Crosby v. Beam, 47 Ohio St.3d 105, 108 (1989); Gigax v. Repka, 83 Ohio App.3d 615, 621 (Montgomery Cty. 1992); and Thomas v. Fletcher, 2000-Ohio-6685 (Shelby Cty. App.) at ¶15. It is a breach of fiduciary duty for a majority shareholder, to use their majority control of the corporation, for their own advantage, without providing the minority shareholders with an equal opportunity to share in the benefits of the corporation or to deprive minority shareholders of the benefits of their stock ownership in the corporation. Crosby v. Beam, 47 Ohio St.3d 105, 109 (1989); Gigax v. Repka, 83 Ohio App.3d 615, 621 (Montgomery Cty. 1992); Yackel v. Kay, 95 Ohio App.3d 472, 477 (Cuyahoga Cty. 1994).

There are many traps waiting for majority shareholders to fall into when dealing with minority shareholders. Examples of a majority shareholder’s misuse of their majority control of a corporation include:

• Removing a minority shareholder from the payroll of a close corporation which has never paid a dividend and where there is no legitimate business purpose for the removal. Crosby v. Beam, supra at 109; 
• A majority shareholder who derives excessive personal financial benefit from the close corporation that deprives the minority shareholders of their just share of the corporation’s profits; 
• Excessive personal financial benefit can include: excessive salary and bonuses, personal automobile and gasoline expenses, excessive medical insurance benefits, excessive use of credit card to pay personal expenses, which are reimbursed by the close corporation. Yackel v. Kay, 95 Ohio App. 3d 472, 475 (Cuyahoga Cty. 1994);
• A majority shareholder who induces a minority shareholder to extend loans or to post personal assets as collateral for loans to the close corporation at the same time that the majority shareholder is taking action against the interest of the minority shareholder constitutes a breach of fiduciary duty. Estate of Louise Morad v. Task, 1994, Ohio App. LEXIS 921 at 5. Both the Yackel case and the Morad case present analogous fact patterns that are instructive for our case.

A director and an officer of a close corporation owes a fiduciary duty of utmost good faith and loyalty to a minority shareholder as well. Cousins v. Brownfield, 83 Ohio App.3d 782, 791 (Franklin Cty. 1992). The failure of a director or officer of a close corporation to comply with the duties specified by Ohio statute constitute a breach of fiduciary duty owed to a minority shareholder. Id. For example, it is a breach of fiduciary duty for a director or officer to fail to provide a financial statement of the corporation to a minority shareholder who has properly requested one. Cousins v. Brownfield, supra at 785; Ohio Revised Code Section 1701.94(A)(4). The failure to send amended regulations to a minority shareholder violates a statutory obligation under Ohio law and amounts to a breach of fiduciary duty. Ohio Revised Code Section 1701.94(A)(2).

When litigation is filed, the stakes are high. That is because compensatory and punitive damages can be awarded for a breach of fiduciary duty that has caused actual damages to be suffered by the minority shareholder. For punitive damages to be awarded, there must be actual malice, which is evidenced by extremely reckless behavior revealing a conscious disregard of a great and obvious harm to another. Actual malice requires conscious, deliberate, or intentional wrongdoing, in the absence of which punitive damages cannot be awarded. Preston v. Murty, 32 Ohio St. 3d 334 (1987); Cousins v. Brownfield, 83 Ohio App.3d 782, 793 (Franklin Cty. 1992); Yackel v. Kay, 95 Ohio App. 3d 472, 481 (Cuyahoga Cty. 1994). Examples of actual malice can include wrongful termination, breach of majority shareholder fiduciary duty, and increasing personal compensation and maintaining family members on the payroll of the close corporation. Blake v. Faulkner, 1996 Ohio App. LEXIS 5288 (Shelby Cty.) at 17. In one case, Estate of Morad, punitive damages were awarded where the Court found that the majority shareholder, President, and Director of the close corporation fraudulently induced the minority shareholder to extend loans and to post collateral to the corporation and the majority shareholder.

If you have questions regarding your rights and responsibilities as an owner, officer, director, manager, or partner of a business entity, please reach out to request a consultation, visit David’s bio for his contact information to reach out to him directly, or give us a call at 216-696-1422.

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Business and nonbusiness income are important concepts in Ohio tax law. Business income refers to the apportionable income among states where the taxpayer’s business is conducted, and it is generated from the business’ operations. Ohio nonbusiness income refers to the earnings allocated to the business’ state of domicile which is generally produced outside of normal business operations. Ohio law favorably taxes business income at a flat 3% and provides for a business income deduction. These tax treatments are not available to nonbusiness income.

Previously, the Ohio Department of Taxation’s position was that the sale of a business interest did not qualify as business income, subject to the favorable flat tax rate and business income deduction, despite the statutory definition of business income including proceeds from a liquidation of a business interest. Taxpayers that claimed business sales’ proceeds as business income, along with claiming the corresponding deduction, were challenged by the Department of Taxation, sometimes resulting in litigation.

To help resolve the disputed interpretations of liquidation proceeds and sales proceeds, HB 515 now provides two scenarios in which income from the sale of an equity interest in a business definitively constitutes business income eligible for the corresponding deduction: (i) if the equity sale is treated as an asset sale for federal income tax purposes (for example, an Internal Revenue Code §338(h)(10) election was made); or (ii) if the seller materially participated in the business activities during the year in which the business is sold, or in any of the five years preceding the sale. Satisfying either of these scenarios will enable the taxpayer to claim the business sales proceeds as business income in Ohio.

It is important to note that legislation is intended to be remedial, such that it will apply to petitions for reassessment, refund applications, and appeals pending on or after HB 515’s effective date, as well as to any sales transaction that is subject to audit on or after HB 515’s effective date.

If you are contemplating the sale of an Ohio business, we welcome the opportunity to speak with you and discuss the impact of HB 515 on your potential transaction, as well as how McCarthy Lebit’s Mergers & Acquisitions team can further assist you with a successful transaction.

Please reach out to request a consultation or call us at 216-696-1422.

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A term sheet typically covers structural, financial, process, and legal matters such as:

• Deal Structure – Asset vs. Equity
• Purchase Price and Terms of Payment – Amount, Deferred Payment, Seller Financing
• Assumption and/or Exclusion of Liabilities – Payables or other obligations
• Due Diligence – Scope and Process
• Timing – Schedule of Events, from signing to closing
• Closing Requirements – Conditions Precedent, required approvals and consents
• Employment Matters – Retention or Termination, of owner and/or other key employees
• Post-Closing Considerations – Working Capital Adjustment and Business Transition Matters

The term sheet provides a road map for the parties as well as their counsel and advisors moving forward through this process. It will form the basis for drafting definitive documentation. If the parties disagree on certain terms, they will look back to the term sheet for guidance. This will help alleviate potential misunderstandings or sources of conflict.

That is not say that the term sheet is written in stone. Situations change during the course of due diligence and re-negotiation may be necessary in those instances. In such a case, it is appropriate to revisit the term sheet and revise accordingly. Absent such circumstances, however, it is considered bad form to re-trade terms previously agreed-upon in the term sheet as it may sour the relationship between buyer and seller or even derail the transaction.

While most terms are non-binding, there are certain provisions which are binding upon the parties such as:

• Exclusivity – Buyer has the exclusive right to consummate a transaction for a set period of time
• Confidentiality – Agreement not to disclose confidential information
• Non-Solicitation – Seller will not seek or entertain other offers
• Governing Law – Which State law governs with respect to interpretation of the letter of intent

The term sheet is the critical first step for a transaction and will set the path going forward. Before signing, a seller should consult with counsel and financial/strategic advisors to confirm that it accurately reflects their understanding of the pending transaction and properly accounts for all the material deal points.

For assistance reviewing your term sheet, please reach out to request a consultation or visit Mike’s bio for his contact information to reach out to him directly.

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This series breaks down the sale of a business into three distinct phases:

1. Phase 1 or the Infancy Stage – the business owner (the “Owner”) starts to think about his succession plan and begins to prepare for Phase 2;
2. Phase 2 or the Childhood Stage – the Owner proceeds down the chosen path towards the sale/transfer of his business; and
3. Phase 3 or the Adulthood Stage – the Owner sells his business and fulfills post-closing obligations, if any.

Phase 1:  Infancy

In the next 10 to 15 years, approximately 12 million businesses owned or control by the baby boomer generation will close or change hands.  A 2016 survey of small business owners found that 90 percent of small business owners anticipate selling or transferring their businesses, as opposed to closing them.  This same survey found that 72 percent do not have a current succession plan and are not taking any action at the moment in anticipation of a sale.

Owners must first sketch out potential transfer options.  There are countless ways to structure a transfer, but some of the most common are:

1. Transferring to children that are active in business;
2. Purchase by a current management team; or
3. A third-party sale.

Owners must also decide what role they see themselves taking on post-sale.  The Owner may wish to retire altogether, stay active but transfer all or most of the ownership, or the Owner may desire to remain with the company in a reduced capacity for a period of time.  Often times the Owner takes a role as a transition consultant while retaining a piece of ownership for a potential second bite at the apple.

As the Owner begins to formulate succession options, there are some steps the Owner should take to maximize the value of the business and facilitate a smoother transfer.  The company’s books and accounting records for the past three to five years should be in order and prepared in a consistent manner, and the Owner should discuss with his accountants the possibility of a transfer or sale. The Owner should take a thorough look at operations to determine if there are efficiencies not being utilized.  The Owner and his attorneys should review material contracts and the Company’s compliance with laws.  Phase 2 will touch more on these issues, but it is crucial that the Owner begins to think early in the process about all the various facets of the company that a potential buyer’s due diligence team will scour.

As the Owner begins to formulate his succession plan, it is imperative that he brings the right team to the table.  Engaging qualified and experienced advisors in Phase 1 is crucial to the success of a sale. The right investment banking team can add significant value to a deal by determining the fair market value of the company, guiding the Owner through the transaction, and locating potential strategic buyers or private equity buyers. Experienced M&A attorneys help the Owner navigate each turn in the arduous sale process and strive to minimize the Owner risk while maximizing value.  Lastly, the Owner should confirm that his accounting firm has relevant M&A experience to ensure that the deal structure is tax efficient for the Owner and that the firm can assist with the transaction as needed.  Rather than focusing on price, Owners contemplating a sale should concentrate on the value that each advisor brings to the transaction.

Lastly, the Owner needs to step back and determine what they want from a transition and what they need.  A seven-figure sale price might not be sufficient for an owner in his early sixties if he was previously taking a generous salary and regular distributions from the company.  Factor in taxes, the cost of healthcare, and the Owner’s retirement dreams and what the Owner needs from a transfer may be different from what he gets for his business. The sooner the Owner’s goals and necessities are determined, the quicker the Owner and his team of advisors can chart the path toward realizing those goals.

Next month’s blog will discuss Phase 2 – Childhood and Adolescence.  Phase 2 consists of finding the right suitor, preparing for and surviving due diligence and negotiating the deal terms.

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