ENL 11

Step 9, Structuring the Transaction

Structure is all about minimizing taxes-for both the buyer and seller. And most of the time what's good for the buyer is bad for the seller and vice versa. Structure is how the sale price is allocated to individual elements of the sale and how the payments and security for payments are handled.

In this issue, we'll cover some of the tax situations you need to be aware of as you sell your business. The state taxes I refer to will be California State taxes. Your state may be significantly different so you will be alert to the taxes in your state.

And we'll touch briefly on payments and security.

Taxes is a boring and unpleasant subject. However, you need to know the basics or you may find the Uncle picking your pocket.

I hasten to add. I don't claim to be a tax expert. There are thick books written on this subject; each tax concept has myriads of subtleties. Make sure all structures are passed by your tax advisor prior to final signing on the dotted line of the Letter of Intent.

Business Entities

Businesses can be proprietorships, partnerships, limited liability companies or corporations. Proprietorships, partnerships, limited liability companies are taxed at the individual level. Corporations are taxed at the corporate level (except S, see discussion below).

Asset Sale or Stock Sale

There are two ways you can transfer your incorporated business: you can sell your stock to the buyer (stock sale) or your corporation can sell the assets of the business (asset sale) to the buyer. Usually, after an asset sale, your corporation will be liquidated and the cash distributed to the owners.

While there are some subtle differences, sales of proprietorships, partnerships, limited liability companies and S corporations are similar, tax wise to asset sales 

S and C Corporations

There are two classifications of corporations for federal tax purposes: S and C.

S corporations are taxed like partnerships. This means that there is no income tax at the corporate level. The corporate profits or losses are passed through to the individual owners who report taxes on the corporate profit or loss at their individual level. S corporations have restrictions on number of stockholders and other criteria; however most privately owned companies qualify.

So when you sell your S corporation, either the stock or the assets, there is no double taxation as would be the case with the C corporation.

In an asset sale, C corporations are subject to double taxation. Once at the corporate level and again at the individual level when the corporation is liquidated and the cash is distributed. (At the individual level, any gain over the basis of your stock is at capital gains rates.) .

It gets worse. There are no capital gains rates at the corporate level. All taxes on the gains on the assets at the corporate level are at ordinary income tax rates. I've seen the overall taxation rate be as high as 60% in these double taxation situations.

Most corporations with stock listed on the national exchanges are C corporations. Being a C corporation is not a problem for a public company, because that company is not likely to be sold in an asset sale transaction.

Structure Strategies for C corporations

Typically buyers want to buy assets (not stock) because of the potential contingent or unknown liabilities of the corporation. In addition, the buyer can write off the goodwill in an asset purchase, whereas there is no goodwill to write off in a stock purchase.

There is no easy structure strategy answer for the seller. Here are some strategies to evaluate.

1. Ask the buyer to do a stock sale. If the answer is, "no," try to see if there is a discount the buyer would work with in considering a stock sale. The discount may be less than the incremental taxation cost of the double taxation.

2. Try to put some of the purchase price outside of the corporation. For example, non-compete agreement directly with you. Non-compete is ordinary income for you and the buyer gets to write it off over 15 years. Even though this is ordinary income for you, it will probably be less tax overall than the double tax on a C corporation. The non-compete value has to be realistic. (Non-compete payments do not carry the employment tax load.)

3. Also you can have a consulting or employment agreement directly between the buyer an you. However these also have to be realistic. Employment and consulting carry the salary tax load, which is about another 15% on top of the ordinary income tax.

If you intend to be an active consultant or an active employee, that is not a part of the purchase price.

4. Royalties. Occasionally, the seller may own the technology personally. In this situation, a case can be made for allocation of part of the purchase price to royalties, outside of the corporation. Royalties carry ordinary income tax rates without the employment tax load.

Asset Sales General

Goodwill is defined as the excess of the purchase price over the book value of the business.

As mentioned above, the gain from goodwill in a C corporation asset sale is taxed at ordinary income rates at the corporate level. In the other entities, where the goodwill is recognized at the individual taxation level, it is taxed at capital gains rates.

It is to the seller's advantage to allocate as much of the sale price to goodwill as possible. The buyer has to write goodwill off over 15 years, so the buyer will try to allocate monies to assets that can be written off over shorter periods.

In California, there is no capital gains rate either at the corporate or individual level.

Fixed Assets

Sometimes buyers will want to value the fixed assets high so they will have a higher depreciation base (any money allocated to fixed assets will come from goodwill which has a 15 year write off vs. 5 to 7 years for the fixed asset.) Use caution when agreeing to this because any gain (up to the purchase price) over the book value of your fixed assets will be taxed at ordinary rates. In California, there is sales tax on the transfer of fixed assets, so that adds 8+% taxes to the fixed asset valuation.

Stock Sales

The structure of a stock sale can be simple: the entire purchase price is allocated to the stock. This is usually the best tax situation for the seller. All income over your basis in the stock is taxed at capital gains rates.

However the buyer will probably want a non-compete and maybe even other layers outside the stock sale. These other layers will affect your tax situation and must be analyzed prior to the final signing of the Letter of Intent.

Non Compete (sometimes referred as Covenant Not to Compete)

As mentioned in the discussion above, non compete is at ordinary income rates for you (with no employment load). However, all things being equal, allocation to goodwill is better for the seller than to non compete. The buyer will probably require some money be allocated to non compete, the lower, the better for you. From the buyer's standpoint, both non compete and goodwill must be written off over 15 years.

Consulting and Employment Agreements

Buyers like to make employment and consulting agreements a part of the purchase price because they can write these expenses off directly as paid vs. 15 years if allocated to goodwill. The most important point, however is the one I made above: If you intend to be an active consultant or employee, you should be paid for that work and that is not a part of the purchase price. You may agree to give transition training as a part of the purchase price, but not long term consulting or employment.

Installment Sales

Most notes qualify for installment sale treatment. This means that you don't pay the tax on the money until you receive it.

There is a myth that installment sales save taxes and therefore have an advantage over cash. This is only true if you will be in a lower tax bracket in the future when you collect the installment sale payment. Most sellers I deal with are in the maximum tax bracket and the installment sale has no tax advantage!

Earnouts

Earnout happens when part of the purchase price depends upon some future performance of the business.

Buyers love earnouts-it's a no risk situation for them. If the performance is achieved, they share part of the profits, which they wouldn't have had anyway if they hadn't bought the business.

I don't like earnouts. I only recommend that my clients accept them if they are continuing as the manager of the business and therefore in control of the performance. If you do find yourself in an earnout situation, try to get the basis of the earnout as high up the P&L as possible; gross sales is best, net profits is worst.

Tax Deferral Strategies

Stock for Stock.

Usually you can defer the tax on the sale of your business by trading you stock for the stock of the buyer.

As you can imagine, there are all sorts of buyers out there willing to trade their worthless pieces of paper for your stock in the hope their pieces of paper will then be worth something.

My experience is, if a buyer has valuable stock traded on a national exchange, they are not willing to trade you stock for stock. They have access to cash and cash is cheaper than their stock.

ESOPs

Employee Stock Ownership Plans will allow you to sell your stock to a trust owned by your employees, buy stock of a U.S. corporation with the proceeds and defer the tax until you sell the stock of that corporation. The ESOP trust buys your stock with pretax dollars. There are all sorts of restrictions, costs advantages and disadvantages to an ESOP. Make sure you investigate thoroughly and have expert help should this work for you and your company.

Charitable Remainder Trusts (CRT)

In a CRT, you give your company to a charitable trust, created by you, the trust sells the company and invests the proceeds. The trust agrees to pay you a percentage of the earnings of the trust for your and your spouse's lifetime. When you and your spouse die, the remainder of the trust principal goes to a charity designated by you. You can be the trustee and manage the trust investments if you like.

There is no tax when the trust sells your business, so the principal amount the trust has available for investment is substantially higher than the after tax money you would have should you have sold your business in the normal way. In addition, you get a tax deduction for the contribution to the charitable trust when you donate your company to the trust. While your income from the trust is taxable at ordinary income rates, the income would be higher than similar after tax investments because of the larger pretax principal amount in the trust.

Insurance companies have programs, where combining a CRT with an irrevocable insurance trust your heirs receive the business value on your or your spouse's death and eliminate the estate tax at the same time.

A properly setup CRT can truly eliminate the income tax on the sale of your business and maybe even the estate tax on the business value. Again, there are many potholes in a CRT program. Make sure you have expert advice.

Other Tax Deferral Devices

Hardly a week goes by that I don't have a solicitation from some financial planner who has discovered a great way to defer or eliminate taxes on the sale of a business. Some of these may work or not. You are well advised to have your trusted financial planner as a part of your team as you contemplate selling your business.

Security

Any payment arrangement other than cash at closing need to be evaluated for the security to back up the payment. Security is negotiable. It can be anything: a trust deed on a piece of real estate, a personal guarantee, the stock of the company, the assets of the company etc. etc. or combinations of the above.

The toughest part of the negotiations in any transaction (other than the all cash deal) is the security negotiations. The buyer and seller have to assess what risk they are willing to assume. And the seller has to think through what happens if the payments don't come through.

We have covered just some of the high points of allocation and structure. Taxes are not a reason to sell or not sell your business. But, once you make that decision to move ahead with the selling process, make sure you and your tax advisor have analyzed the options to optimize the tax benefits for you. Don't sign that Letter of Intent until you do!