Cashing Out Effectively
Using transactional tax planning to transfer ownership of your business the right way.
For a business owner, the decision to transfer ownership of a business is arguably the biggest decision that a person will ever face. Whether the owner is deciding between various offers from an outside party or determining which family member is the best choice to take the business successfully into the next generation, the decision-making process can be arduous from beginning to end and include factors known and unknown.
Owners worry if the buyer is the right person or right fit for the company and the employees. They also struggle with other after-sale emotional needs such as, “Will this person work hard to protect the legacy I desire to continue?” But, there is someone else who has after-sale needs as well … Uncle Sam. Business owners should not let the emotional aspects of the transfer take precedent over the cold, hard reality of TAXES. If not structured properly, the tax ramifications on a sale or transfer can diminish sale proceeds significantly or make the purchase of a company unattractive. Both sellers and buyers should engage in transactional tax planning to assess the most tax advantageous means of getting the deal done and fulfilling after-sale needs, both monetary and emotional.
What is transactional tax planning?
Several deals “die” at the table when, for example, sellers suddenly realize the resulting tax obligations substantially reduce their anticipated net proceeds, or when the buyer realizes the return on investment (ROI) will not meet the required hurdle rate (the rate of return that must be met for an investor to invest in a particular project). Transactional tax planning evaluates the commercial transaction or transfer of assets in light of the potential tax implications associated with the proposed structure. By doing this, it is possible to accomplish the desired result with minimized tax consequences.
Essentially, transactional tax planning incorporates concepts from various professional disciplines, including entity structuring, taxation (e.g., deductions, exclusions, credits and deferrals) and estate, retirement, investment and charitable-giving considerations. While tax savings and beneficial tax structuring are the primary focuses of transactional tax planning, many other factors are typically considered, such as funding sources for the transaction, repayment structuring options, health care needs and cost of living requirements for the departing owners.
Types of transactions
Transactional tax planning involves examining the economics and nuances of the transaction, including buyer and seller imperatives and deal breakers. Different methodologies of transfer should be compared to arrive at an approach best suited to optimize a deal structure and reconcile the critical elements desired by both buyer and seller, while minimizing tax obligations. Transactions can range from the relatively simple to the most complex and sophisticated. Structures consist of:
- The formation of new enterprises
- Mergers (forward, reverse and triangular)
- Spin-offs, split-ups or split-offs
- Taxable and tax-free reorganizations (§368, §355, §351)
- Joint ventures (including LLCs, partnerships and other strategic alliances)
- Like-kind exchanges
- Cross-border transactions
- Structuring for investment capital raises (including venture capital and LBO transactions)
- Private annuity trusts
- Installment sales
- Securitizations and other financial instruments and vehicles
- Executive compensation arrangements (deferred compensation plans, golden parachute agreements, stock options and other equity-based incentive plans)
As a basis for the analysis, it is highly recommended the client also engage in a certified business valuation. The valuation allows for a clearer calculation of the tax consequences on the sale and serves as a starting point for the client’s merger and acquisition advisor. Without a professional business valuation, the unbiased opinion of the company’s value is unknown. This has the potential to lead to buyer’s remorse after the fact and a rescission of the purchase. Conversely, it may also give the seller credence to increase the purchase price thus serving as a very valuable negotiating tool.
Factors that can impact the transactional tax plan
The parties involved in any given transaction may be unaware of the numerous tax issues that can present ongoing challenges; therefore, transactional tax planning serves as a proactive, solutions-oriented approach to limit tax exposure. Although there are a voluminous number of factors that can affect the transactional tax plan, there are four core points of focus.
Type of sale: Whether an ownership transfer is via a sale of the company’s assets or the ownership interest inherent in its structure (stock, membership or partnership interests, etc.), the type of sale can have a drastic effect on the after-tax proceeds the owner will receive from the sale. While the general mantra is that asset sales are preferred by buyers (to generate immediate tax write-offs), and stock sales are preferred by sellers (because of the lower capital gain tax rates for individuals), such is not always the case depending on corporate structure, stock basis, total purchase price, allocation of purchase price and the particular type of assets being purchased.
Entity structure: Is the selling or target company a C corporation, an S corporation, a partnership or a limited liability company (LLC)? Entity structure has a direct impact on the type of transaction implemented and the net proceeds received by the owner. For example, C corporations are subject to two levels f taxation on the sale proceeds rather than a single level, as is the case with pass-through entities (i.e., S corporations and LLCs). Sale of ownership in a C corporation can be complicated and requires careful deal structuring and purchase price allocation to ensure shareholders maximize the after-tax proceeds.
Comparatively, pass-through entities present very flexible options for an owner, whereby an asset sale may be structured to “create stock basis” for the business owner, providing more after-tax proceeds from a sale. Buyers typically prefer asset sales because of the immediate tax deductions those assets generate. This can provide a seller of a pass-through entity with a great deal of leverage during negotiations, as the seller may be amenable to the proposed transactional structure given the right set of circumstances.
Repayment options: How the selling business owner will be repaid for the sale of the business, be it an asset sale or stock sale, can have a large impact on the owner personally, not only from an overall taxation standpoint, but also from a timing perspective. Oftentimes, the purchase is paid out over time via an installment note. An installment note allows the seller to only pay the tax liability on the sale when the payments are received on the note, rather than immediately in the year of sale.
Additionally, an installment note structure reduces the amount of funds the purchaser needs to procure immediately in the year of sale to complete the transaction. However, installment sale transactions can vary considerably from asset sales as certain tax liabilities associated with the sold assets may be due immediately rather than when the payments are made on the note. This can leave the selling business owner “holding the bag,” as he is left with a potentially large tax liability and only the initial note payments to cover its repayment. It is important that the repayment schedule account for initial liabilities realized immediately for an asset sale that is to be repaid over time.
Net transactional cost: This concept refers to the amount of funding a company (either the acquiring company or company the family member is succeeding ownership of) will need to expend to complete the ownership transfer. This is primarily applicable in the succession planning context, where the company itself will be largely responsible for funding the departing shareholder’s stream of retirement income (unless outside financing can be obtained). Some transactional structures may appear advantageous due to the lower tax rates; however, if excessive amounts of company profits must be expended to obtain those low rates, their benefit is significantly diminished.
The transactional tax plan can reduce the overall net transactional cost to fund a company’s succession plan by focusing the stream of retirement income on deductible payments rather than making use of after-tax company profits. By minimizing the use of the company’s income as a transactional funding source, the company can retain more funds to reinvest or use as working capital. This concept is also important in the asset sale context, as calculating the amount of funding a third-party purchaser is expending while factoring n all future deductions on the asset purchase helps the seller understand the transaction from the buyer’s perspective and adjust the deal accordingly during negotiations.
Ultimately, all business owners can benefit from the strategies, structures and implementation options of transactional tax planning when transferring ownership. Many factors may affect the taxes paid, but in the end, it is about how much the seller walks away with in after-tax benefits. Sellers need to ask themselves, “If I do this deal, am I going to be okay both financially and emotionally?” Being uninformed about tax ramifications can cost a seller anywhere from 15 percent to 70 percent of net after-tax proceeds and perhaps even the business legacy. Buyers and sellers need to understand that a completed ownership transfer typically cannot be entirely unwound and redone once it is fully implemented. Therefore, proper counsel regarding the transaction is of the utmost importance from the instant a decision to transfer ownership is reached.