Liabilities for the Seller After a Sale

tipsLiability is a nasty word when being used in terms of a transaction or negotiation being undergone by two parties regarding a healthcare business.  While it is very common for buyers to acquire liabilities in a transaction, the seller needs to be aware that once the ink has dried, they are not completely off the hook for issues that may have occurred during the time of their ownership.

Mac Stewart, partner at the law firm of Hall, Render, Killian, Heath & Lyman says the liabilities for the seller post-sale vary on a case by case circumstance.

According to Stewart, typically post-sale liability for the seller will turn on the representations and warranties that the seller may have given the buyer.

“For example, if a buyer will be assuming the seller’s liabilities the buyer wants a full and complete list and will want a specific rep and warranty from the seller that the list is comprehensive.  If post-sale, a new undisclosed liability crops up then the buyer could assert a breach of warranty claim. There is are interesting potential liabilities for the seller which turns on whether certain reports and information has been given to the Texas Secretary of State, or certain fees have been paid,” Stewart says.

Stewart adds that if those reports are not made timely or the fees are not paid, the seller entity could lose its charter.  In that instance each director or officer of the corporation will be liable for all debts of the corporation created or incurred after the report or fee is due and before any reinstatement. Thus if the seller has not paid attention to these various obligations then personal liability can remain with the officers or directors even after a sale, Stewart says.

Patrick Martinez, partner at McDermott, Will and Emery says that a lot of liabilities, when liabilities are assumed, relate to assumption of employee PTO, like sick leave and paid time off.

“You can negotiate a couple of ways.  A lot of times, purchasers will retain that liability and get a deduct from the purchase price on the value of those liabilities.  The reason why they assume those are really to just keep the employees happy moving forward.  This is so that when they start with their new company they could keep their PTO and try to keep that transition of employment as seamless as possible,” Martinez says.

Martinez says that when discussing assumption of liabilities, the where their treatments diverge are in stock sales and asset sales of a business.  In stock sales, Martinez says essentially, that company being bought moves forward with the buyer as the new equity owner. This means all of the liability of the company will remain in place moving forward.  What Martinez suggests buyers do is negotiate an indemnity package related to pre-closing liabilities with the seller on the points of liability issues.

Martinez says that the easiest area to think of where a seller would remain on the hook is the are a of litigation where the facts arose pre-closing.

“In a common example, let’s say there is a sexual harassment claim resulting from employee actions before the closing.  When you are talking about healthcare, another fairly common one are over-payments where there is bad billing or over-payments that happened before the closing,” Martinez says.

In these instances, according to Martinez, the purchaser will often go back to the seller and discuss that any issues involved at the time of their management are the seller’s issues.  Martinez says the common term in these situations is “our watch, your watch;” meaning the buyer will deal with issues on their watch and the buyer deals with problems on theirs.

In a stock sale, in the legal sense, Martinez says it is natural for the liabilities go along with the company.  Martinez says purchasers generally prefer asset deals because there is the legal barrier when it comes to liabilities.

“Those liabilities really reside in the previous entity, and it is very hard if not impossible for a claimant to go after a successor entity.  There are certain cases where the law allows that to occur by public policy.  This is sometimes through employment related issues, and tax.  Generally they are isolated to the previous entity,” Martinez says.

“What you have to do is negotiate a strong indemnity and have to be comfortable that the previous seller who is giving you that indemnity is going to be around and solvent to fund that indemnity.  That or you negotiate an escrow to keep around a period of years.  This will keep you as a buyer more comfortable knowing that there is a pile of cash, sitting around in an escrow account for you to draw from if an indemnity claim was made.”

Stewart says that in addition, the buyer could asset a claim for breach of the agreement if the seller did not meet all the terms.  One of the keys for a buyer is to get full disclosure, for example, is to find out if there are any lien’s on equipment, does the seller really own the property, is the corporate status of the seller as it claims, Stewart says.
Stewart says in the instances where a facility based or practiced based seller is involved there really is not a difference in terms of seller liability.

“A facility sale is more complicated and thus the reps and warranties are perhaps more important, but the sale of a practice may have issues with poor documentation that existed before the sale.  My experience with physician practices for example is that they do not want to spend the money to have good documentation and thus if there is a dispute things become complicated fast,” Stewart says.
Stewart says that in most instances a buyer will understand that they are most likely acquiring liabilities from the seller.  However, Stewart says there are cases where the buyer may have buyer’s remorse and will want pass liabilities back onto the seller.

“The more common circumstance is when the seller did not make a full disclosure.  The buyer knew of a liability and was prepared to take in on, but once the transaction closes then it turns out the buyer was not told everything.  That is why due diligence is so very important,” Stewart says.

Zandra O’Keefe, CPA and Managing Director at CBIZ says that there are not only legal areas involved with seller liability; but often, there are tax implications that are overlooked by physician owners eager to sell.  Fortunately sellers can take steps to avoid surprises.

O’Keefe warns, be careful in an asset sale.  If an asset subject to a liability is sold, the debt that transfers is treated as “boot” or sales proceeds to the seller.  This can trigger ordinary gain recapture.

“Be sure that you include your CPA up front or you could end up with an unexpected tax liability when your tax returns are due.  The amount can be significant; particularly with a piece of radiology equipment such as an MRI machine valued at $1M or so that was subsequently refinanced.  For example assume that the tax depreciation deduction was already taken resulting in a zero tax basis.  Assume further that the $900K total debt transferred to the buyer.  The debt that transferred from you can trigger $900K of ordinary income taxed at 45% or so (federal and state); resulting in about $400K+ in taxes.  Now that’s a painful surprise, particularly if you don’t find out about it until March or April of next year,” O’Keefe says.

“Oh and where’s the cash to make that tax payment?  Maybe you only received $100K in cash.  Ouch!”

O’Keefe says one of the tax areas that are overlooked involve stealth sales tax liabilities.  In an example, she says the seller and buyer intend a friendly arrangement as a merger- type transaction and agree not to sell the assets, but simply lease them to the buyer at fair market value.

“The seller may want to retain the assets, particularly if selling those triggers a tax liability such as the example above.  So both parties agree to lease equipment to the new owner of the business.  Easy…right?  Not so fast,” O’Keefe says.

“In some states such as AZ, there is a tangible business property sales tax filing requirement and tax obligation that is attached to the cash flow lease stream from the buyer to the seller.  Depending on the state, sales taxes can be imposed at the state, city, county and local levels.  Oftentimes the parties are unaware of the additional cost involved when setting the lease rate in the contract and the seller wasn’t aware of the new compliance obligation.  This affects the economic deal and will lead to a new obligation that the equipment owner will have to bear.”

O’Keefe says in this case the seller may now have up to 8-10% more in cost than originally anticipated creating the need to renegotiate the lease contract.

“Ignoring it isn’t good.  If you don’t file, there is no statute to protect you.  Late filing, late payment penalties and interest pile up as time goes on,” she says.

According to O’Keefe, that same kind of issue for sellers can also arise with commercial property as well.

“If you keep the building and are going to lease it to the buyer’s practice then you need to make sure the sales tax is being paid if required.  You may not have been doing that when you owned it in your practice, because you were either unaware or may not have had a filing requirement because there was a related party exclusion.  Since the equipment is now leased to the merged company with different ownership, that new structure may be in-eligible for a related-party rental sales tax exclusion,” O’Keefe says.

As of the transaction date, the commercial property sales tax filing and payment obligations are triggered for the owner.  O’Keefe says that when this occurs, somebody on the selling side had better have that on their radar otherwise they will see some back taxes, penalties and interest and a negative economic impact.

“Again, you’ll likely have to renegotiate that lease agreement and get square with the governmental agencies,” O’Keefe warns.

If the parties are negotiating a stock sale, O’Keefe says the buyer is probably going to have a lawyer draw up a protective indemnification for the seller to sign.  The buyer will also likely require due diligence on the seller’s practice in an attempt to uncover any undisclosed liabilities.  O’Keefe says the results of due diligence activities; particularly those engaged by the seller early on, may help reveal liabilities that the seller may not have been cognizant of.

“The buyer will likely find the issues anyway when they deploy their due diligence expert(s) and make purchase price adjustments at best or kill the deal at worst.  Why not identify potential problem  now, instead of waiting for it to come back and haunt you by triggering the indemnification ramifications?” she asks.

 

If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.

 

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