Maximizing Your Business s Value How Presale Tax Planning Increases Your Return By Bill Nicholson and William J. Butler In working with individuals who have sold or are contemplating the sale of their business, we have identified several opportunities, related to both income and estate taxes, that business owners should be aware of prior to beginning the business sale process. While getting proper advice throughout the sale process is of great importance, often the tax implications of the transaction can have a significant impact on the ultimate return. This paper presents tax-related transaction structures and opportunities in connection with the sale of a privately held business. The alternatives presented here are intended to encourage understanding of the seller s situation and identify strategies that are most effective at reducing taxes when begun well in advance of an actual sales transaction. Although the strategies outlined in this paper may provide benefits at any given point during the sales process, we have found that the greatest returns are derived from the strategies implemented as part of a well-planned exit strategy even years before a sale is even considered. Business Structure The origin of any discussion determining how a business sale will be taxed is often, How is it presently held? The existing structure will influence the way a sale is structured for tax purposes and can even limit the potential buyers. Before entering into the process of selling a business, it is important that the business owner understand the consequence of proceeds received by a company structured as a C-Corporation versus one that acts as a pass-through entity. C-Corporation If the seller is a C-Corp and the assets of the business are sold, the proceeds that it receives will trigger a gain that is taxable to the corporation itself. Then, once the cash or assets are distributed to the shareholders, the shareholders will have to pay tax a second time to the extent that the cash and other property received exceeds the relevant shareholder s basis in the C-Corp stock. This is clearly an inefficient way to conduct a sale, and, practically, is not a realistic alternative.
In order to avoid this double taxation, the shareholders need to sell the stock in the company itself. This often proves unattractive for purchasers due to the inability on the part of the purchaser to obtain tax deductions for the premium paid for the business (through future depreciation and amortization deductions). In addition, the new owner is responsible for any pre-existing liabilities of the corporation in connection with the purchase of stock. Partnerships, Limited Liability Corporations and S-Corporations The formation and operation as a passthrough entity constitutes the preferred approach for privately owned businesses because the liability for income taxes passes through directly to the equity owners generally without an entity level tax. While still able to conduct asset or equity interest sales, pass-through entities are generally more tax-efficient because they avoid double taxation. While there are important differences in the rules that apply to each of these entity structures, we will treat them as equivalent structures for purposes of this paper. It is possible for an existing C-Corp to convert to an S-Corp, and thus avoid the double taxation on its income. However, there is a special caveat for shareholders contemplating a sale. Any unrealized appreciation existing in the assets of the corporation at the time of the election is referred to as a built-in gain. For a ten-year period following the conversion, any disposition of those assets would be taxed at the highest corporate rate. For the past few years, the period was temporarily reduced to five or seven years, but it has reverted back to a tenyear period. Regardless of duration, this holding period is an important timeline consideration if the C-Corp is exploring conversion to an S-Corp prior to a sale. Asset Sales vs. Stock Sales In an asset sale, one price is paid to the seller for the business, but the allocation of the purchase price among assets can have an impact on the income tax consequences to the seller and its owners. The buyer will typically want to maximize the amount of the purchase price allocated to the inventory and the fixed, depreciable assets of the business, such as equipment, with the remainder applied to goodwill, which is amortized over fifteen years. This allows the buyer to take larger deductions in the early years following the sale. On the other hand, assuming the owners of the seller are individuals, trusts and estates, the seller will want as little of the purchase price as possible allocated to inventory (which will produce gains taxed at ordinary rates) and depreciated property (which can trigger ordinary income in the form of depreciation recapture) to preserve as much of the gain as possible being subject to the preferred capital gains rates. Despite opposite goals, the parties usually can agree on a mutually beneficial purchase price allocation. The alternative to an asset sale is to sell all or a portion of the equity in the company. This approach is routinely the most favorable structure for the seller, as it is tax-efficient and often easier to complete than an asset sale. However, selling stock of a C-Corp will not permit the seller to realize the premium a purchaser is willing to pay if it can instead acquire assets. If the target is a C-Corp that owns all the valuable assets, a stock sale is going to be the most preferred sale method. There is only a single level of tax on a stock sale. (An additional reason a seller might favor a stock sale is because the company carries with it all of the existing and unknown liabilities of the business.) Section 338(h)(10) of the Internal Revenue Code provides an opportunity for a sale to be conducted as a stock sale but viewed as
an asset sale for income tax purposes. The Section 338(h)(10) election is only available when the target is an S-Corp or a subsidiary of a consolidated group. Generally, an election is made when there is a substantial premium inherent in the assets. Since the buyer will gain additional cash flow benefits in the form of higher tax depreciation and amortization deductions, the seller will be able to command a higher price. However, there are often tax costs to the seller or the target that need to be considered. A Section 338(h)(10) election, and any income tax savings it produces, is appropriate when the value of the additional tax deductions to the buyer exceeds the additional tax cost to the seller (see Case Study 1). It then becomes a negotiation to determine how to share the net benefit between the two parties. If the target is (and will remain) a tax partnership and the buyer is acquiring less than 100% of the equity interests in the target, a Section 754 election provides an opportunity for the buyer to obtain a basis step-up in the buyer s pro rata share of the target s assets to the extent the equity owners realize gain on the sale. If 100% of the interests are acquired, the asset sale tax treatment is automatic i.e., it occurs regardless of whether a Section 754 election is in place. Opportunities to Defer Income Taxes In addition to understanding and negotiating the price and structure of the sale, structuring the timing of the payment can also be an opportunity to tailor the transaction to the seller s needs. Timing the Proceeds The use of an earn-out provision or buyer note may bridge a gap between the buyer and seller regarding the purchase price. An earn-out provision, where the seller accepts some of the risk of company performance following the sale, may facilitate a transaction when the seller wants to make the deal despite high expectations for growth in the near term. Receipt of a buyer note or an earn-out right is generally not currently taxable. A seller is only taxed as payments are made on the note or part of the earn-out provision. For a buyer note, the seller is only taking on the risk that the buyer will be able to make the payments, and not on the performance of the sold company assets. In either case, the deferral of proceeds (and tax) remains the chief economic benefit, but the likely maximum sale price will be less on an installment sale than on an earn-out. The seller will likely be able to defer some of the proceeds or achieve a higher net price while lowering and/or deferring the tax bill, in exchange for accepting some degree of risk for the performance of the company going forward. Private Annuity Company As an alternative to accepting a note from the seller, the seller could make full payment to a private annuity company that will provide some flexibility. Utilizing a private annuity company to affect an installment sale can lock in any negotiated gains while deferring the receipt of the proceeds (and, thus, any tax). The annuity can be structured so that the payments correspond to the timing of the needs of the seller, and the deferral of the tax liability can be spread over several years. However, in this low-rate environment, often deferral is not the chosen alternative. Sale to an ESOP Selling your business to an Employee Stock Ownership Plan (ESOP) can be significantly tax-advantageous. The sale to an ESOP allows the seller to defer the tax on the gain (and possibly eliminate the gain if the investments purchased with the proceeds are held until death), provided the ESOP owns at least 30% of the company (which must be a C-Corp) and the seller complies with several other requirements. Because an ESOP is not currently subject to tax on the income from the S-Corp (though the Case Study 1: Utilizing a 338(h)(10) Election Sam Davis founded and runs SportSense, a sporting goods distribution company and family-owned S-Corporation. The stockholders of SportSense enter into a contract to sell 100% of the stock of the company to a corporate acquirer. Sam knows that the purchaser should be willing to pay more if the transaction can be structured as an asset purchase for income tax purposes due principally to the step-up in asset basis and the resulting depreciation and amortization deductions that the purchaser obtains in that instance. SportSense s stockholders can offer to jointly make a section 338(h)(10) election with the acquirer. A properly made 338(h)(10) election results in the transaction being treated as a sale of assets for income tax purposes, which provides significant tax benefits to the purchaser without significant additional tax to the selling stockholders. Experience shows that the value of the step-up in basis can be 20 25% of the premium paid for the business and, in most cases, not result in any significant tax cost to the selling stockholders. SportSense s advisors determine that a 338(h)(10) election can in this case create approximately $15 million of additional value to the buyer in tax benefits. Although the section 338(h)(10) election should be negotiated as part of the sale terms, in a situation like this, it can also be negotiated after the transaction has closed (though the relative negotiating position of the partners may have changed). (The election is not due until the 15th day of the ninth month following the acquisition; however, both parties must consent to the election.) Because the selling stockholders have to make the election but the purchaser gets the tax benefits, SportSense reaches an agreement to evenly split the tax benefit resulting from the 338(h)(10) election with the acquiring company, netting the shareholders an additional $7.5 million in pretax proceeds.
ESOP shareholders will be taxed based on future distributions from the ESOP), an S-Corporation election after the sale provides an even more tax-efficient structure for continuing operations that is not available to a C-Corp making the same conversion. Qualified Small Business Stock Depending on the size of the business being sold and how it is structured, special provisions in the tax code may allow for a reduction or deferment of tax. The Qualified Small Business stock provisions, as defined by Internal Revenue Code section 1202, are one such example. Under the myriad of tax acts passed between 2001 and 2010, gains on QSB stock can be partially or even completely excluded from income tax. To qualify as QSB stock, there are numerous requirements and limitations to the amount of gains that qualify (including that it only applies to stock of C-Corps), but sellers of closely held and private businesses should fully investigate the benefits and requirements of section 1202 and the rollover provisions of section 1245 applicable to QSB stock. Opportunities to Defer Estate Taxes Simple Gifting Although minimizing the income taxes on the sale of a business can be accomplished through careful planning, the period leading up to the possible sale of a business is also an excellent opportunity to remove wealth from a taxable estate. The simplest and most straightforward manner to remove assets from a taxable estate is to simply give them to the next generation, either outright or in trust. Each parent can currently transfer to each child or grandchild $13,000 worth of value each year, indexed for inflation. If a wealthy individual expects to owe an estate tax, this is the most basic form of transfer they should be making, and it can be done at any point. However, the most effective estate planning relating to the sale of a business should be enacted well in advance of exploring a sale. The reason for this is simple: that is when transfers are cheap. By gifting interests in your business before there is an expectation of a liquidity event, the transfer of the interests can be accomplished at a significant discount, often between 20 40% or more. Even if transfers to children or a trust for their benefit are not done far in advance, they can still be effected at a discount the caveat is the sliding scale as to how much risk you will be taking on in terms of scrutiny by the IRS. If you make a gift to your children well in advance of receiving offers to purchase your company, the IRS has limited room to challenge your gift (provided it was properly disclosed and contained no fraudulent components). Contrast that with a gift made one month before a sale is consummated where the IRS may have a strong case to challenge any discount of the property, or perhaps disallow it altogether. Solutions in Trusts Although transferring an interest in a business prior to a liquidity event may be the best way to reduce the owner s expected estate tax bill, it is common for the owner to not wish his/her children or beneficiaries to receive a large sum of cash outright if and when a sale eventually takes place. For this reason, business owners will frequently utilize trusts or other entities that will hold the transferred assets for the future enjoyment of the ultimate beneficiaries. This allows the business owner to lock in the transfer tax consequences at today s valuation, apply a discount to that value, transfer the economic benefit and allow the significant appreciation that follows the sale to accrue to the beneficiary without the drain of the transfer tax. Below are further descriptions of the benefits of some effective means to accomplish this. Grantor Retained Annuity Trust An alternative to a direct gift that can achieve the same result is to make the gift to a Grantor Retained Annuity Trust. The
concept behind a GRAT is that the assets are contributed to a trust, and the trust pays the grantor an annuity amount, over a minimum of two years, based on a rate prescribed by the IRS and the fair market value of the assets transferred to the GRAT. The grantor continues to be treated as the owner of the transferred assets for federal income tax purposes. The GRAT s promise to repay the grantor can even be calculated such that the gift made by the grantor is reduced to zero: the grantor is receiving payments over the next two years that equate to the value of the property contributed to the trust. The best time to set up a GRAT is when interest rates are low and values of investment property are depressed. Similar to a straight gift, private and closely held equity interests contributed to the GRAT are subject to discounting. As the assets in the trust appreciate at rates in excess of the interest rate attached to the payments, the excess appreciation passes to the beneficiaries of the trust tax-free (see Case Study 2). The GRAT can also be constructed to protect your gift against challenges by the IRS by including language in the drafting that allows the annuity payments to be measured in respect to the valuation of the stock initially contributed. If the IRS successfully challenges the valuation of the assets contributed to the GRAT, the annuity payment will automatically adjust to fit the revised valuation, and more assets will be distributed back to the grantor (and less to the beneficiaries). While this decreases the GRAT s effectiveness, as the assets remain in the grantor s estate, it reduces the potential for additional gift taxes that would be due had the gift been made directly and subsequently challenged by the IRS. Intentionally Defective Grantor Trust Similar to a GRAT, an Intentionally Defective Grantor Trust can be established for the benefit of a business owner s Case Study 2: Grantor Retained Annuity Trust Bill Smith owned 100% of the common stock of Smith Corporation. Bill did not have any children who were interested in owning or operating the business, and Bill was interested in exploring ways to transfer wealth to his children in a taxefficient manner. Bill s main competitor approached Bill about buying the business, and Bill pursued discussions with the competitor. Before a letter of intent was submitted, Bill met with his estate planning attorney and decided to create a GRAT. The GRAT would be funded with 20,000 shares of Smith Corporation, valued at $1,000/share for a total value of $20 million. The GRAT would pay Bill an annuity for a five-year term, and when the GRAT terminated, the trust assets remaining after the annuity payments would be distributed equally to his children. One year after creating the GRAT, Smith Corporation was sold at a 50% premium over the gift-taxappraised value. At the termination of the five-year GRAT, more than $10 million was distributed to his children, free of any gift or estate tax. Since the company was sold while the shares were owned by the GRAT, during which time Bill was treated as the owner of the shares for federal income tax purposes, Bill paid the capital gain tax out of his own assets, thus further augmenting the wealth transfer to his children.
Case Study 3: Sale to Intentionally Defective Grantor Trust Joe Brown was the 100% owner of Brown Bearing Manufacturing Inc., which was valued at $40 million. Joe wished to control the corporation, but he also realized that the company was continuing to grow, and he wanted to transfer the economic growth to children and grandchildren. He met with his estate planning attorney, who recommended that Joe recapitalize the company into voting stock and non-voting stock, and then sell the nonvoting stock to a long-term generationskipping trust for the benefit of his children and grandchildren in exchange for a promissory note. Joe liked the idea, because while he would continue to maintain control of the company through the retention of his voting stock, a 90% interest in the company was being sold income-tax-free to the trust for his children and grandchildren because Joe continues to be treated as the owner of the assets held by the trust for federal income tax purposes. Several years after Joe created the trust, he decided to sell the company at a price of $115 million far greater than the value of the company at the time he created the trust. Though the trust still owed Joe the balance of the note, the trust for the benefit of the grandchildren was now flush with cash, and approximately $75 million transferred to the children and grandchildren free of gift and estate tax. children or other relatives (see Case Study 3). The IDGT is typically funded with seed money, either using the lifetime exemption or taxable gifts. The owner then sells equity interests in the business, with a discount attached, to the IDGT in exchange for a note payable to the seller. This transaction is not subject to income tax based on the unique nature of an IDGT i.e., the grantor continues to be treated as the owner of the transferred assets for federal income tax purposes. As interest rates are currently low, the rate that the IDGT has to pay to the seller should be far less than the expected appreciation of the equity interest, transferring additional value to the beneficiaries. Furthermore, because the seller continues to be liable for the tax on the income generated by the assets held by the IDGT, the grantor s payment of the income tax liability amounts to an additional tax-free gift. Charitable Trusts Charitable trusts are available to closely held business owners who anticipate transferring value to not only their heirs, but charities as well. Some of these trusts, such as a Charitable Lead Trust, work exceedingly well when the stock is transferred at a low valuation, before the business takes off. When a business owner contributes property to these trusts, a specific amount or percentage is given each year to a charity and the remainder transferred to the owner s children tax-free. The benefit is that the value of the amount given to charity is determined based on interest rates at the time the assets are contributed to the trust. If the assets inside the trust appreciate at rates greater that the rate assigned to the trust, the beneficiaries are able to capture the difference tax-free. These trusts are most favored by those who intend to leave a portion of their estates to a charitable cause, and work particularly well in a low-interest-rate environment. It should be noted that certain charitable trusts are not eligible to own S-Corp stock. Family Limited Partnerships Another common approach to transferring value in a closely held business is to first package the business inside a Family Limited Partnership. FLPs have been widely used over the past decade, but have also met significant challenges from the IRS on grounds of validity, business purpose and valuation. FLPs can be used to structure a portfolio of marketable or privately held securities into a business entity that allows the first generation to educate, involve and eventually transfer the assets to a second generation. This approach can be considered aggressive because it discounts the value of the assets on more than one level. First, there is a discount taken on the privately owned business for lack of control and marketability. Then, there may be additional discounts available as the partnership units are used to fund one of the above-mentioned transfer strategies. When combined, the discounts to the value of shares transferred can easily surpass 40%, potentially saving millions in estate taxes. In these types of transactions, following the corporate formalities of the FLP and securing valid, supportable valuations are both of paramount importance. Conclusion While the opportunities mentioned in this paper have the potential to add tremendous value, in many cases they become less effective the longer their implementation is delayed. As a sale transaction draws near, several of the options for planning may become subject to greater IRS scrutiny, or be unavailable altogether. Thus, it becomes even more critical that business owners and executives address these planning options either before or as early in the sale process as possible. The tax consequences of the sale of a business are determined by the owner s actions from the initial incorporation through the closing of a sale. This is a large window that any business owner surely will find him or herself challenged to monitor, especially while running a business. It is imperative that the business owner have sound legal, tax and investment advice consistently through the various processes and recognize those inflection points at which the evaluation criteria change. The business owner has to ensure that all of the advisors involved in planning for the sale work collaboratively to achieve the best possible solution of minimizing taxes and retaining value for the equity owners.
ABOUT THE AUTHORS: Bill Nicholson is Baird s Managing Director and head of Private Asset Management in Chicago, which provides wealth management and family office services to the ultra-wealthy, their foundations and their heirs. Over the course of his career, he has made his mark for cutting-edge advances in managing and preserving wealth and is considered one of the foremost experts in working with the wealthy. He is a noted speaker who appears regularly at national conferences on asset management, alternative investments and financial strategies. Prior to Baird, Bill was Managing Director of Credit Suisse First Boston s Private Advisory and previously founded and led the DLJ Asset Consulting practice. Bill is also the founder of Baird s Investment Counsel Program at the University of Chicago, where he taught wealth management and asset protection for the wealthy. William J. Butler is a partner in the Chicago office of McDermott Will & Emery LLP, where he has focused his practice on serving the tax, estate and administration needs for some of the country s wealthiest families. Bill counsels family groups and individuals on all aspects of wealth transfer planning, with an emphasis on formulating estate plans that maximize and protect wealth while minimizing transfer taxes. Bill represents a number of large family groups and works with their family office executives on family office administration and structure issues. Bill also works with a number of families in assisting them on all legal issues involving their privately owned business, including succession planning and shareholder agreements. Bill has spoken on estate planning topics before bar groups and family office executives and at employersponsored seminars. He is also a co-author of Discretionary Trust Distributions (Illinois Institute of Continuing Legal Education Illinois Trust Administration handbook). Jeffrey C. Wagner is a partner in the law firm of McDermott Will & Emery LLP and is based in the firm s Chicago office. Jeff focuses his practice on federal income tax matters with particular emphasis on structuring mergers and acquisitions, tax-free reorganizations and tax-free spin-offs and split-offs. He also spends a significant amount of time advising closely held businesses and their owners on tax planning issues with a special focus on subchapter S corporations. Jeff is a CPA and speaks often on income tax matters relating to mergers and acquisition and tax planning for closely held businesses and their owners. Jeff is the head of McDermott s Closely Held Business Group practice. For additional information on how these and other strategies can be implemented to help you or your client realize additional value on a business sale, contact Bill Nicholson at 312-609-7077, wnicholson@rwbaird.com, or William Butler at 312-984-7561, wbutler@mwe.com.
Robert W. Baird & Co. does not provide tax or legal advice or services. Please consult with your tax and legal professionals regarding the strategies discussed. 2012 Robert W. Baird & Co. Incorporated. rwbaird.com. 800-RW-BAIRD. First use: 11/2012. MC-33339.