The Tax Tree Falleth

THE OMNIBUS TAX RECONCILIATION BILL OF 1993 HAS SENT A CRASH REVERBERATING THROUGH THE TAX FOREST THAT WILL GREATLY AFFECT BUYERS AND SELLERS OF PEST CONTROL BUSINESSES. IS ANYONE LISTENING?

An old brain teaser goes, "If a tree fell in the forest and no one was listening, would it make a sound?" In the forest of tax regulations a giant redwood fell recently. Very few were listening, it seems. But if you are interested in selling your business or buying another, or if you simply need to place a value on your business, you should have heard a very loud crash.

That "crash" is Section 197 of the Omnibus Tax Reconciliation Act of 1993, which became law in August 1993. And the sound is the crash of falling prices being paid for service businesses.

Like most service businesses, pest control companies do not have extensive depreciable assets. The bulk of the value of most service businesses lies in its "goodwill" with customers. When a pest control, company changes hands, the buyer and seller must agree on the value of the assets.

In the past, private buyers allocated as much of the purchase price as possible to intangible assets that can be depreciated to avoid paying taxes. These intangible assets were typically depreciated over five years, creating a "tax shelter." This shelter allows the buyer to flow tax-free dollars out of the business to pay the seller.

Any portion of the purchase price allocated to goodwill could not be written off against taxes, making this a category to be avoided by the private buyer. Interestingly, however, most publicly-owned companies favored allocating a larger portion of the price to goodwill because it could be written off over periods as long as 40 years. A publicly held company is less concerned about taxes than maximizing profits.

TIM-BERR! OK - now comes the "crash." Section 197 says that beginning in August 1993, covenants not to compete, customer lists and goodwill all can be written off against taxes. Good news, you think? You forget we're talking about the federal government. Read on.

While the U.S. Internal Revenue Service now recognizes the buyer's right to take tax deductions when depreciating these assets, the write-off period is fixed at 15 years. This means the tax shelter the private buyer relied upon to generate cash to pay for the purchase just got a lot smaller because the write-off period has gone from an average of five years to 15 years.

It also means the public company's extended write-off on goodwill to improve profits just got compressed from 40 to 15 years.

In addition, any "excess" compensation paid to the seller through continued employment by the buyer must also be written off over 15 years, even though the employment period may be shorter.

AN EXAMPLE. Let's see what this means in dollars and cents by looking at a hypothetical buy-sell transaction. Let's assume Bob purchased Joe's $500,000 pest control business for $450,000. Bob made a down payment of $100,000. Joe financed the balance of $350,000 for Bob through a five-year note at 7% interest.

According to Bob's calculations, Joe's Pest Control would generate an $85,000 profit. So Bob budgeted annual payments of $85,361. In the first year this equals principal of $60,861 and interest of $24,500. Bob and his wife plan to manage the business, taking a minimal salary until the notes are paid off. Bob and Joe agreed to allocate the purchase price as follows:

Five-year covenant not to compete	$125,000
Customer list	$150,000
Five-year consulting agreement	$100,000
Other equipment	$25,000
Accounts receivable	$450,000
Purchase price	$450,000

Bob had also projected his first year's tax statement would appear as follows:

Operating profit	$85,000
Interest expense	($24,500)
Amortization of
Covenant not to compete	($25,000)
Customer list	($30,000)
Consulting agreement	($20,000)
Net loss	($14,500)

It's important to bear in mind that Bob wasn't losing $14,500. He was sheltering the $85,000 operating profit so he would have the cash to pay Joe. Additionally, Bob had organized his new business as a Subchapter S corporation so that he could take the $14,500 loss on his personal taxes.

Unfortunately, Bob's advisors had let him down. They had not apprised him of Section 197 of the tax bill. And to make matters worse, he closed the deal after the bill became law. Here's what happened to Bob's tax return once the IRS got done correcting it for him:

Operating profit	$85,000
Interest expense	($24,500)
Amortization of
Covenant not to compete	($8,333)
Customer list	($10,000)
Consulting agreement	($6,667)
Taxable income	$35,500
Federal income tax	($9,940)
State income tax	($2,118)
Net income	$23,442

Now, instead of having $85,000 to make Joe's payment, Bob has $72,942 ($85,000 minus federal income tax of $9,940 and state income tax of $2,118). This is a critical difference, considering how tightly Bob has leveraged the deal. In addition, Bob lost the $14,500 Subchapter S deduction off his personal taxes. Starting to get the picture?

Had Bob known of Section 197, he would have realized the amount of cash available from the business was going to be substantially reduced. His alternative would have been to lower the price he was willing to pay to match the cash flow available. This would have reduce the purchase price by more than 10% to approximately $399,000 ($100,000 down payment plus $299,077 financed over five years). Joe might have refused to sell. But that might have been preferable to Bob, who is now scrambling to come up with Joe's payment.

THE MORAL. The lesson to be learned is this: The true basis for measuring the value of a company is not a multiple of its revenue; rather, it is the amount of after-tax cash flowing out of the business.

In the past, a buyer cold write off most of the purchase price and use the taxes he or she avoided to retire debt. The ability to do this has been considerably diminished by Section 197. This means the value of a business has also been diminished to varying extents because of this new economic reality. This is particularly true of service companies with smaller amounts of fixed assets.

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