Government Contract Considerations During an Acquisition - Part 2

HOST: BRENDAN HALLORAN: Hello, and welcome to Cherry Bekaert's GovCon Podcast, where we discuss current government contracting trends, compliance matters, and best practices to guide federal contractors forward.

HOST: BRENDAN HALLORAN: I'm Brendan Halloran, a senior manager with Cherry Bekaert. With me today is John Ure, a partner in Cherry Bekaert's Tax Services. Today we're doing part two of our podcast series on considerations during an acquisition, specifically where a government contract or contractor is involved.

HOST: BRENDAN HALLORAN: In part one of the series we talked about due diligence and what companies need to consider when they're being acquired or acquiring a company that has federal contracts, especially when that business is a significant part of the company.

HOST: BRENDAN HALLORAN: Following on that, we want to cover some administrative steps and tax considerations. One area we get many inquiries about is what a novation, or contract novation, is and the process and steps associated with it.

HOST: BRENDAN HALLORAN: Novation is a topic with a lot of detail and coordination with the government, particularly the Administrative Contracting Officer, or ACO. We won't cover everything today, but we will cover some basics about what to think about if novation applies and the initial steps to start planning.

HOST: BRENDAN HALLORAN: The government sees potential risk with any transfer of contracts and wants to review the details when a company is bought and performance of government contracts will transfer. FAR addresses this in FAR 42.12, which recognizes a successor in interest to government contracts when contractor assets are transferred.

HOST: BRENDAN HALLORAN: The process requires identifying the ACO who will review and execute the novation agreement. In some cases the agency could be DCMA, the Defense Contract Management Agency, and the process is similar across agencies.

HOST: BRENDAN HALLORAN: The novation agreement format is expressly stated within the FAR, so there is limited latitude to change how it is written. There may be circumstances where the government permits particular details to be called out, but it must follow the FAR.

HOST: BRENDAN HALLORAN: Typically there's a checklist available that companies can work through with their ACO to determine expectations for the novation package. The contracting officer will review functional specialists such as financial capability and legal counsel will play an integral role.

HOST: BRENDAN HALLORAN: The government wants to understand the before and after state, so they will request financials and detailed contract information. They will notify individual contracting officers to ensure those contracting offices don't have reservations about the novation.

HOST: BRENDAN HALLORAN: Expect a lot of coordination and time at the onset. Individual contracting officers may request additional, nonstandard details and they have the latitude to do so. In my experience, contractors should engage their legal counsel as well as the ACO's legal counsel at the beginning to save time and align expectations.

HOST: BRENDAN HALLORAN: In terms of timing, novation is typically a month-long process. Do not wait until the last minute and expect to obtain a novation agreement quickly. The number of contracts is a key factor in the coordination effort and notifications, so ensure your data is prepared for the agreement.

HOST: BRENDAN HALLORAN: Moving on from novation, assuming you've made an acquisition and are integrating the acquired organization, many companies may delay integration but it is a hot topic in today's market. John, we have many government contractor clients, many of whom are S corporations. What are some standard considerations for S corporations in acquisitions?

JOHN URE: Many smaller companies that are acquired are partnerships or S corporations, while C corporations are a different animal. S corporations are often more complicated because a few items that arise during due diligence can cause issues later if not clarified.

JOHN URE: Standard considerations depend on whether you're the buyer or the seller. If you're a shareholder selling the company, you generally want long-term capital gains treatment rather than ordinary income on the proceeds, minimize state income taxes, potentially defer recognition of rollover equity, and defer gain on deferred payments.

JOHN URE: Sellers typically prefer to sell stock so liabilities transfer to the buyer. Buyers, in contrast, typically prefer to purchase assets to avoid liabilities and to obtain a step-up in the basis of the assets, allowing depreciation of the purchase price.

JOHN URE: Buyers also want to avoid risk related to the S election and typically want to maintain the target's EIN. Those are often non-tax considerations tied to contracts and other issues.

JOHN URE: After a letter of intent is signed, due diligence looks at two major issues for S corporations: confirming the S election is valid and confirming there is only one class of stock. Confirming the S election involves checking whether Form 2553 was filed and whether tax returns have been filed treating the entity as an S corporation.

JOHN URE: S corporations can only have one class of stock. Sometimes owners create different types of equity or compensation that result in a second class of stock, which invalidates the S election and converts the corporation into a C corporation. That change can be retroactive and is a major issue that can kill a deal.

JOHN URE: When sellers want a stock sale and buyers want an asset sale, one commonly used mechanism is a Section 338(h)(10) election. This allows the buyer to treat a stock purchase as an asset purchase for tax purposes so the buyer can get the step-up in basis.

JOHN URE: Another option is an F reorganization, which can be more flexible than a Section 338(h)(10) election and can help satisfy both buyer and seller concerns. These structures are generally good options for both parties depending on the circumstances.

HOST: BRENDAN HALLORAN: From a government perspective, when you talk about stock versus asset and the before-and-after financial reporting that is part of the novation process, the government wants to confirm that assets are in place to continue successful performance of the contracts for the duration.

HOST: BRENDAN HALLORAN: Determining how your deal is structured is a major area of government focus. What are the more popular or frequently used sale structures you see?

JOHN URE: From a tax perspective, one straightforward option is a one-time sale where the owner sells all ownership in a single year and recognizes the entire gain that year. The benefit is receiving money up front; the downside is recognition in the highest tax bracket.

JOHN URE: Another option is an installment sale where the purchase price is paid and taxed over two or more years. Spreading payments can reduce tax liability over multiple years and provide security of ongoing payments, which can be useful if owners are retiring.

JOHN URE: A common and attractive option is rollover equity or deferred payments. In this structure the seller receives part of the consideration as equity in the new entity. Rollover equity provides a financial stake in future growth and can be very valuable if the buyer expands the business.

JOHN URE: Rollover equity aligns incentives because the seller often stays on as a consultant or in a leadership role to help grow the company, knowing they will be bought out of that equity later. It is popular when owners want to participate in future upside.

HOST: BRENDAN HALLORAN: Are buyers usually willing to consider rollover equity, or does it depend on what the owner brings, such as program relationships or consulting value?

JOHN URE: It depends on the scenario, but rollover equity is common when founders or owners are integral to the business—when they influence morale, employees trust them, or they have irreplaceable client relationships. Buyers often want that figurehead to stay on to ensure a smooth transition.

JOHN URE: Sellers sometimes require as part of the deal that they remain in the business for a defined period, which buyers will accept if the seller's continued involvement is important to the success of the acquisition.

HOST: BRENDAN HALLORAN: C corporations are taxed differently than pass-through entities. What sale structures are popular for C corporations?

JOHN URE: Some of the same structures apply to C corporations, but one often-overlooked strategy is the Section 1202 exclusion for qualified small business stock, or QSBS. Section 1202 is available only for C corporations and is an incentive for small businesses.

JOHN URE: Section 1202 can allow eligible stockholders to exclude gain from federal income tax—generally a minimum exclusion of $10 million—on the sale of QSBS held for more than five years. The exclusion may be the greater of $10 million or ten times the owner's adjusted basis in the stock.

JOHN URE: Owners must have originally received the stock from the corporation and held it for five years, and there are size and other requirements. When Section 1202 applies, the federal tax savings can be substantial and some states also conform to the exclusion.

JOHN URE: Section 1202 eligibility can be lost by certain estate planning or ownership transactions prior to sale, which has caused significant issues when overlooked. Keeping track of transactions that may negate 1202 is critical.

HOST: BRENDAN HALLORAN: What tax and planning steps can owners take before reaching the letter of intent stage?

JOHN URE: One of the most beneficial steps is estate planning. Owners can transfer stock or ownership interests into a trust or gift them before a LOI is signed. Doing so can achieve a larger valuation discount and allow the owner to use estate tax exemptions effectively.

JOHN URE: By placing interests into a trust before an LOI, future appreciation grows outside the owner's estate. That planning can preserve the owner's estate tax exemption for other uses and prevent future estate tax exposure.

JOHN URE: The federal estate tax exemption is currently approximately $12 million, adjusted for inflation. It increased significantly with prior law changes and is scheduled to revert in 2026 to a lower amount, adjusted for inflation. The IRS has confirmed there will be no clawback for gifts made under the current exemption.

JOHN URE: As a result, many owners are gifting up to the current exemption if they have significant assets. For government contractors, transactions are often in the tens of millions, so estate planning with advisors can be a powerful way to avoid federal estate tax and state-level estate taxes.

HOST: BRENDAN HALLORAN: Those are significant potential savings and important planning opportunities for owners preparing for a sale.

JOHN URE: Brendan, one final non-tax question: what are some scenarios for integrating an acquisition that are specific to government contractors or at least can help when bringing on a new purchase?

HOST: BRENDAN HALLORAN: Depending on the size of the organizations, there are a couple of main approaches. One approach is to dissolve the acquired entity and begin integrating it into the acquiring organization.

HOST: BRENDAN HALLORAN: From a government contract perspective, dissolving and integrating requires that you be far along in planning for contract novation, business system changes, and accounting practices. You need a plan for migrating systems that support contract performance.

HOST: BRENDAN HALLORAN: Another common approach, especially for larger acquirers, is to run the acquisition as a wholly owned subsidiary for a period of time—often two or three years. This avoids heavy administrative and regulatory lifts initially and allows the subsidiary to operate under existing accounting practices and systems while planning for integration.

HOST: BRENDAN HALLORAN: Operating as a subsidiary buys time to plan for novation and systems integration and to determine the right point at which to dissolve and fold the entity into the acquiring organization. Each approach has benefits and challenges, and preparation and understanding of oversight and contract requirements are key.

HOST: BRENDAN HALLORAN: There are many combinations of ways to integrate acquisitions, and groundwork helps determine the right path for each situation.

HOST: BRENDAN HALLORAN: Thank you, John. I know we've covered a lot of territory and only scratched the surface of considerations for companies at this stage, especially when federal government contractors are involved. I appreciate your time and insight.

HOST: BRENDAN HALLORAN: If you have any questions, email john.ure@cbh.com or brendan.halloran@cbh.com. Please join us again for our next podcast.