Buy-Out Transactions: Private Wealth Considerations

Transcription

1 Buy-Out Transactions: Private Wealth Considerations During the period approaching and immediately following a buy-out transaction, business owners selling a company have numerous tax and wealth planning opportunities that may result in significant tax savings. This paper addresses some of the tax and wealth issues that often arise in buy-out transactions and potential planning techniques for business owners, including: Taxes and overall planning considerations Gift and estate tax planning before a transaction: specific techniques Income tax planning: the importance of structure and timing Reducing and deferring federal tax on a sale: potential and problems Post-transaction issues: wealth management To observers of the business community, it is apparent that recent conditions have created a favorable market for mergers and acquisitions. Private equity buyers have been a major force in this development. Given this favorable climate, many business owners may be in a position to consider a sale. And although acquirers continue to use their own stock as currency for acquisitions, a large number of transactions rely on cash consideration. The prevalence of these transactions produces unique issues business owners should consider when planning. Selling allows an owner to realize the value of the business, and a complete sale can represent the culmination of many years effort. A transaction may also, however, represent a succession in leadership, or a combination of the business with a larger enterprise that the buyer operates. In any of these situations, the sale process provides a number of opportunities to accomplish important personal goals. Among the considerations: Planning in advance of a sale can help owners to take advantage of valuation opportunities in transferring wealth to younger members of the family Evaluating long-term philanthropic goals and implementing a plan in connection with the sale may fund a charitable strategy at a minimal income tax cost Integrating the transaction structure and financial analysis with the owner s individual planning can prevent potential unintended, and often unfortunate, consequences 1

2 TAXES AND OVERALL PLANNING CONSIDERATIONS Maximizing after-tax proceeds is one way to help build net worth over time, and proper planning can significantly reduce the tax cost of the trans action. Many factors affect tax planning and the consequences to sellers, including the consideration paid, the capital structure of the business and the type of legal entity (corporation, S corporation, partnership or limited liability company). Valuation and the importance of planning early In many cases, the valuation of a business prior to a sale may be significantly less than the eventual sale price. Because gift and estate taxes are based on the value of assets transferred, taking advantage of lower valuations could allow the owner to transfer assets at a lower tax cost. Consequently, valuation, as much or more than clever planning techniques, can be crucial in accomplishing personal goals. In 2015, the maximum federal estate and gift tax rate is 40%, and gifts or estates over $5.43 million (potentially $10.86 million for a married couple) are subject to federal estate and gift tax. Additionally, the generation-skipping transfer (GST) tax has a flat rate of 40%. In addition to the federal estate, gift and GST tax, many states, [including New York, New Jersey, Connecticut and Illlinois], impose an estate tax on amounts above the state exemption amount, which varies from state to state. Moreover, Connecticut imposes a gift tax. The following example illustrates the point. An appraiser estimates the value of a family business to be $40 million and the parents sell about half the stock of the company ($20 million in value) to a family trust for an interest-bearing note. The business expands significantly, and eight years later the family negotiates to sell the business at a price in excess of $350 million to a private equity firm. As a result of the timely planning, more than $150 million in value would escape estate or gift, and potentially GST, tax, saving over $55 million in transfer taxes for the family s younger generations. Keep in mind, however, that capital gains taxes might still be due. Lower valuations present valuable gift and estate planning opportunities, but keep in mind that the IRS will have the opportunity to question valuations when using privately held assets. Making gifts of stock at lower prices uses exemption amounts more effectively. If the stock appreciates, using the exemption today can convey much more wealth to heirs free of transfer taxes (income tax may still be due). Of course, while efficient use of exemption amounts can substantially reduce transfer taxes, the total exemptions may not be sufficient to shield the family s wealth from federal transfer taxes, to the extent the husband and wife s estates exceed $10.86 million. In that case, one of the main benefits of lower pre-transaction valuations is to facilitate transferring the gift as well as post-gift appreciation with little or no gift tax. Making valuation decisions: determining discounts In an initial public offering (IPO), the value of the company in the period leading up to the IPO date is fairly clear. SEC regulations, particularly regarding stock awards, also require companies preparing for an IPO to value shares periodically. Privately held companies, however, may not undergo the standard valuation process. 2

3 One major reason to begin the planning process early is to obtain lower valuations. Valuation discounts may diminish and business values may increase prior to an eventual sale price as the date of sale approaches. The amount of the discounting depends on several factors, and the expertise of a qualified and experienced appraiser is critical in the process. GIFT AND ESTATE TAX PLANNING BEFORE A TRANSACTION: SPECIFIC TECHNIQUES Strategies to transfer wealth range from the most basic outright gifts to complex leveraged wealth transfer structures. The pre-transaction period can be an ideal time to implement such planning. Transfers outright or in trust When considering gifting strategies, families should not overlook the simplest approach: a direct transfer of shares to family members or trusts for their benefit. There are myriad potential benefits to making a gift in trust, including asset protection, GST tax planning, income tax benefits for gifts made to a grantor trust, and oversight for younger beneficiaries or those not in a position to manage assets effectively. As long as the gift is within the applicable exemption amounts (both federal and state), it will generally not produce a transfer tax. Other exemption amount planning For gifts that come within exemption amounts, the benefit of a transfer is easy to see: The entire value of the asset, plus future growth, can escape estate and GST taxes. In addition, for gifts that exceed the exemption amounts, consideration also should be given to paying a gift tax. In certain cases it may make sense to pay some gift tax today. Not only is the gift tax cheaper (you do not pay tax on the tax dollars for a gift as you would with an estate tax), but if the asset appreciates, that appreciation can escape transfer taxes altogether and your estate has been reduced by the payment of gift tax. Example: Parents, now age 65, wish to leave $1 million to a child, but already have exhausted their exemptions. At a 40% rate, making the gift in 2015 would produce a gift tax of $400,000. The total cost of the gift, including the transfer taxes, is $1.4 million. At a 40% estate tax rate, the cost to transfer $1 million at death (excluding state taxes) would be approximately $1.67 million. 3

4 Leveraged gifts The concept of leveraged gifts is similar to the use of leverage in business transactions. By retaining some portion of the asset gifted, the owner can reduce the value of the gift (and therefore his or her gift tax liability, provided the retained interest appreciates by certain thresholds). There are several ways to make these transfers: GRATs (Grantor Retained Annuity Trusts) A GRAT is a trust to which the owner transfers shares of stock or other assets. At the same time, the donor retains an annuity from the trust, payable over a specified period of time. Generally, the amount of the annuity is calculated so that its present value equals the value of the property placed in trust. The present value calculation is based on prevailing IRS interest rates. If the stock or other assets in the trust appreciate in excess of the IRS assumed rates, the excess remains for trust beneficiaries (typically trusts for children or other family members of the donor). During the GRAT term, all income taxes, including any capital gains from the sale of the stock, are paid by the donor and the trust assets can continue to grow tax free. Sales to defective grantor trusts In this type of transaction, a trust created for the benefit of family members by the owner, purchases shares from the owner. As payment, the trust issues the owner a note bearing a specified interest rate. Keep in mind, the trust should have other assets of at least approximately 10% of the trust note value. The trust is structured as a grantor trust, so that the owner is responsible for the trust s income tax liability and the trust s assets grow income tax free. Consequently, the payment of interest on the note is not taxable and any gain on the sale to the trust is not recognized. As long as the interest rate on the note is at least equal to the appropriate prevailing rate published by the IRS and formalities of the structure are observed, the transaction should not be treated as a gift (because the trust has paid full market value for the shares). Preferred/common capital structure Another strategy is to separate the ownership of the business into common and preferred classes. The common class benefits from income and asset growth above the fixed preferred return, while the preferred class bears a stated rate of return. Although you can no longer just give away all the common stock while retaining all the preferred shares, there are still some planning opportunities in using the preferred/common capital structure, but it is among the more complex approaches, and involves special valuation rules imposed by the Internal Revenue Code. Nevertheless, in appropriate situations, the preferred equity approach may be an extremely effective vehicle for transferring value to younger generations. Regardless of the strategy chosen, the pre-sale period, or even years before, can be an ideal time to start implementing a gifting strategy. The potential increase in value after the sale (or even if there is no sale) makes gifts a potentially powerful wealth transfer strategy. 4

5 INCOME TAX PLANNING: THE IMPORTANCE OF STRUCTURE AND TIMING The sale of a business raises income tax issues both for the owners and the business itself, and these issues often overlap. Business tax issues: structuring the transaction Cash transactions offer important trade-offs to business owners. On one hand, they provide a true liquidity event (unlike an IPO, for example, in which true liquidity may not exist for months or years after the transaction). In certain cases, cash transactions also offer buyers a way to benefit from tax deductions after the transaction that will increase the value of the business. On the other hand, sellers also face an immediate tax liability on the transaction, and any missteps can have potentially significant adverse effects. Conversion to S corporation status: built-in gains. It often happens that a company begins its life as a C corporation and converts to an S corporation at some point in its development. In such a case, the company has to measure the amount of asset appreciation that has occurred prior to the conversion; a sale of assets within the next 10 years will trigger a built-in corporate tax on that gain. If the gain is large relative to the overall size of the deal, that additional corporate tax could make a basis step-up election uneconomical for the parties. Ordinary income recapture. Even if a company has been an S corporation during its entire existence, owners still ought to be attentive to the form of the sale transaction. Selling stock for cash locks in capital gains treatment, but selling assets (or making a Section 338 election) can trigger ordinary income on a portion of the gain. To the extent the company has inventory or receivables in excess of tax basis, the sale will produce ordinary income. There also may be depreciation recaptures on plant and equipment (or certain real estate) that will be taxable at ordinary rates. The tax cost of an asset sale to owners can be meaningfully higher than a stock sale. State tax issues Surprisingly, clients often neglect to consider the impact of state taxes on a sale transaction, but such considerations can represent a substantial part of the transaction cost. In some situations, business owners who plan sufficiently in advance of a transaction may succeed in deferring, or even eliminating, state tax. Change of domicile. Residents of high-tax states may wish to consider changing their residency for tax purposes. Successfully establishing tax residency in another state before a transaction can substantially reduce the costs of sale. Typically, several factors determine the state of residence for tax purposes, although the rules vary by state. The amount of time the taxpayer spends in the state and his or her domicile are normally the relevant considerations. Domicile is not precisely measurable; the concept reflects a state of mind regarding the principal home of the taxpayer. Objective factors, such as voter registration, driver s licensing, and religious affiliation, are evidence of domicile. Other things that may be considered include where you return following a vacation, where you keep expensive collections of art, antiques, etc., and where you hold family photos or heirlooms. Establishing state tax residency requires careful planning, though, particularly since states are aware of the potential tax savings and carefully scrutinize the residency status of those who move out of state. 5

6 Trust strategies. Given the fairly short time horizon of many sale transactions, it may not be possible to change domicile before a sale occurs (although a change in status after the sale will at least reduce income taxes payable on income generated after the transaction). In some states, it may be possible to use trust vehicles to defer state tax burdens. A tax or estate planning professional can help recommend an appropriate solution for your particular situation. REDUCING AND DEFERRING FEDERAL TAX ON A SALE: POTENTIAL AND PROBLEMS Planning in advance of a sale can help reduce, or at least defer, taxes payable on the transaction. Deferring gain through charitable vehicles One of the most commonly suggested strategies is to place a portion of the owner s shares into a foundation or a charitable remainder trust to shield at least a portion of the gain from immediate taxation. Although there can be advantages to this approach, business owners need to be aware of the important restrictions and drawbacks that arise when using charitable vehicles, and with any gift to charity, timing is critical: If the gift is made too late, you may still owe capital gains on the sale with the shares still owned by charity. Gifts to foundations. With proper planning, a business owner may be able to transfer shares (subject to certain restrictions) in the business to a charity (either a private foundation or a public charity) prior to the transaction. The charity may generally then sell shares to the eventual buyer without paying capital gains tax on the transaction. There are tax liability considerations to private foundations and S corporations as discussed below. If properly structured, this may enable the business owner to endow charitable activity, receive a charitable donation deduction (but see below for a discussion of significant restrictions) and avoid tax on the donated shares. Many high net worth clients prefer to use a private foundation as the vehicle for their philanthropic activity. It is important to note, though, that a contribution of private company stock is deductible only to the extent of the donor s basis in the stock, not its fair market value at the time of the donation. If the donor has a high basis in the stock (e.g., after inheriting shares), or if the benefit of the charitable deduction is not a driving factor in the decision, that limitation may not deter the donation. For sellers in search of a substantial tax deduction, though, this limitation on deductibility will be a major disadvantage. The corporate structure of the business being sold will also be an important factor in the charitable strategy. Donations of S corporation shares will result in taxable income and gains to the charitable entity, whether it is a public charity or a private foundation. Although a tax-exempt charity is generally permitted to be a shareholder in an S corporation, its share of income from the company will be taxable as unrelated business taxable income (UBTI). As a result, planning before the transaction will depend heavily on the form of entity involved. Charitable remainder trusts. Using CRTs is another technique in sale transactions, particularly in a higher interest rate environment. A CRT allows you to sell appreciated assets, defer capital gains tax and build a diversified portfolio, while providing you with annual cash flow and income tax deduction. In addition, a CRT is not subject to the 3.8% net investment income (NII) tax. However, distributions to the non-charitable 6

7 beneficiaries of the CRT may be subject to the NII tax. Eventually, assets in the CRT go to a donor-designated charity, including the donor s private foundation. An important issue in the post-transaction period is managing the liquidity generated by the sale, particularly if proper pre-transaction tax planning occurred. POST-TRANSACTION ISSUES: WEALTH MANAGEMENT The sale of a business raises a number of specific issues in the post-transaction period. An important issue is managing the sale proceeds. Specific investment strategies used to manage the proceeds will be influenced by the nature of the entities in which the family holds the assets, as well as the family s needs, risk tolerance and time horizon, among other issues. If a private equity buyer is involved, this may also produce additional planning issues and opportunities. Financial sponsors often desire management to remain in place after the sale. Management will retain, or roll over, some level of equity in the business and may be eligible for increasing option grants. That equity may provide opportunities for productive tax planning, especially from a wealth transfer perspective. As in the pre-sale context, opportunities arise from the fact that the equity of the business may be worth significantly more in the future than it is today. The private equity buyer, of course, plans on being able to increase substantially the equity value of the business in the future; often such funds have a time frame of three to seven years to exit the investment. As with any scenario in which valuation may increase significantly during a defined period, wealth transfer strategies can be powerful tools to transfer wealth to younger generations without incurring gift or estate tax. CONCLUSION Business owners considering a buyout have numerous opportunities to plan for pre- and post-transaction issues that will arise from the sale of their companies. Tax and wealth planning in advance of the transaction could result in significant benefits, including significant tax savings and higher after-sale proceeds than would be possible if planning were delayed. As with any tax planning strategy, it is critical to seek the advice of a tax professional to determine which of the strategies presented in this paper are appropriate for an individual s particular situation. Neuberger Berman LLC 605 Third Avenue New York, NY IRS CIRCULAR 230 DISCLOSURE: Please be advised that any discussion of U.S. tax matters contained within this communication (including any attachments) is not intended or written to be used and cannot be used for the purpose of (i) avoiding U.S. tax related penalties or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Before acting on any information furnished in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek legal, tax or other professional advice. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results. Tax planning and trust and estate administration services are services offered by Neuberger Berman Trust Company. Neuberger Berman Trust Company is a trade name used by Neuberger Berman Trust Company N.A. and Neuberger Berman Trust Company of Delaware N.A., which are affiliates of Neuberger Berman Group LLC. Neuberger Berman LLC is a Registered Investment Advisor and Broker-Dealer. Member FINRA/SIPC. The Neuberger Berman name and logo are registered service marks of Neuberger Berman Group LLC. P / Neuberger Berman LLC. All rights reserved.