We sat down with Grant Kornman, Partner at Align Collaborate, to explore key issues like tax due diligence and tax structures. Read on for insights on these topics and more. It is important to point out that everyone should seek the advice and counsel of a tax professional and not rely upon any insights or suggestions discussed here.

Q. How important is tax due diligence for independent sponsors today, compared to previous years?

Tax diligence is crucial, with sales tax diligence becoming increasingly important. Traditionally handled late in due diligence, many small businesses remain unaware of their out-of-state sales tax obligations. This oversight can result in significant financial liabilities, often requiring voluntary disclosure agreements and special indemnity escrows, which may threaten the deal's success.

Given the cost-effectiveness and simplicity of sales tax diligence, we recommend independent sponsors prioritize it earlier in the due diligence timeline. This approach helps mitigate potential issues that could surface later in the transaction, particularly when sellers are more susceptible to deal fatigue.

Q. How can independent sponsors leverage their tax structuring to make deals more profitable for themselves?

Independent sponsors typically manage smaller portfolios, making it crucial to maximize their after-tax proceeds from each investment. Many overlook the strategic importance of structuring their fee arrangements to optimize tax outcomes. By carefully structuring these transactions, sponsors may avoid paying ordinary income tax at closing and benefit from capital gains treatment on both invested fees and any subsequent appreciation of those invested fees.

This approach may enable sponsors to invest their entire fee into the transaction, rather than just the after-tax proceeds, allowing them to own a larger percentage of the company without any additional invested capital. This increased ownership can generate a significant windfall when they generate an exceptional investment return.

Q. What kind/level of competitive advantage can be gained by optimizing your tax structures?

Many independent sponsors raise capital from family offices and high-net-worth individuals. These investors are tax-sensitive, and many prefer opportunities structured tax-efficiently.

We are hearing more about Section 1202 transactions. I know enough about this topic to be dangerous, so your readers should learn more from their tax advisors. However, this section of the Internal Revenue Code, also known as the Small Business Stock Gains Exclusion, can be a powerful tool for investors to eliminate capital gains tax on qualified small business stock (QSBS).

The company must be a C corporation, and there are many tests, including the company’s assets, its activity, how long the stock is held, etc. If your transaction qualifies, you may be able to avoid paying any capital gains up to the greater of $10 million or 10 times the adjusted basis of the stock. That can be very attractive so it’s worth talking to your tax advisors.

Q. Why will you be speaking at iGlobal Forum's Independent Sponsors Summit in NYC on September 17-18?

We focus 100% on investing equity into independent sponsor-led transactions. We love meeting new independent sponsors and catching up with friends. The NYC Independent Sponsors Summit is one of our favorite events and one we try not to miss.

Grant will join a panel discussion on ‘Never Underplay The Importance Of Tax Due Diligence! Optimizing Your Tax Structures To Win More Deals.’ They’ll examine topics like using tax structuring as a competitive advantage; helping sellers roll over equity in the most tax-efficient manner; shielding transactions from contingent liabilities; maximizing the tax advantages of certain deal structures; and ensuring correct payment of sales tax when operating in multiple states. Grant will be joined on the panel by Nick Barker (Longhouse Partners), James Illikman (Peninsula Capital Partners), Jason Duzan (Colfax Creek), and Andrew Ferworn (Virtus), and the panel will be moderated by David Zawitkowski (Citrin Cooperman).  Register now to join us this September at the Independent Sponsors Summit.