Tax Implications of Exit Strategies for. LLCs

Transcription

1 Tax Implications of Exit Strategies for Corporations, Partnerships and LLCs

2 Agenda Introduction Tax Implications to Buyer Tax Implications i to Sll Seller Mitigating tax differences to Seller Equity Sl Sales treatedt as Asset Sl Sales Intra-Family Transfers

3 Why Sellers prefer an Equity Deal versus Asset Deal Capital Gain versus Ordinary Income All liabilities are assumed by Buyer and Seller is relieved from future liabilities i Typically eliminates or reduces the necessity for transferring individual assets and assigning contracts and permits

4 Why Buyers Prefer an Asset Deal versus Equity Deal Step up in bases of assets Contingent Liabilities

5 Seller Corp. Balance Sheet Tax Basis Fair Value Cash $ 50, $ 50, Accounts Receivable $ 200, $ 200, Machinery & Equipment $ 1,000, $ 600, Accumulated Depreciation $ (600,000.00) Net Machinery & Equipment $ 400, $ 600, Land and Building $ 1,000, $ 800, Accumulated Depreciation $ (250,000.00) Net Building $ 750, $ 800, Goodwill $ 1,200, Total Assets $ 1,400, $ 2,850, Accrued Liabilities $ 100, $ 100, Accounts Payable $ 100, $ 100, Long Term Debt $ 200, $ 200, Total Debt $ 400, $ 400, Contributed Capital $ 50, $ 2,450, Undistributed Earnings $ 950, Shareholder h Equity $ 1,000, $ 2,450, Total Shareholder Equity and Debt $ 1,400, $ 2,850,000.00

6 Quantification of Loss of Future Tax Depreciation/Amortization If Buyer is a C corporation, the loss of the Step-Up in basis results in, approximately, an additional $320, NPV of tax benefits. If Buyer is an S corporation, LLC or partnership, p, the loss of Step-Up in basis results in, approximately, an additional $370,000 NPV of tax benefits.

7 Seller s Tax Consequences of Asset Sale If the entity is a C corporation, there will be twolevels l of tax one at the entity level and one at the shareholder level. If the entity is an S corporation or an LLC/partnership, the tax cost is the difference between ordinary and capital gain rates on certain of the assets.

8 C Corp Shareholder s Tax Consequences Stock Deal w/o Adjustment Stock Deal with Adjustment for No Step Up for No Step Up Asset Deal Proceeds $ 2,850, Basis $ (1,400,000.00) Corporate Gain $ 1,450, Tax 34% Corporate Tax $ 493, Purchase Price/Distribution $ 2,450, $ 2,129, $ 1,957, Basis $ (50,000.00) $ (50,000.00) $ (50,000.00) Shareholder Gain $ 2,400, $ 2,079, $ 1,907, Shareholder Tax 20% 20% 20% Shareholder Tax $ 480, $ 415, $ 381, After Tax Proceeds $ 1,970, $ 1,713, $ 1,575, Effective Tax Rate 20% 20% 36%

9 S Corporation Shareholder Tax Consequences The difference between a stock sale versus an asset sale for an S corporation will be the character differences between ordinary and capital gain Recapture is taxed at the shareholder s ordinary income tax rate 1250 Recapture is taxed at 25%

10 S Corporation Stock Sale Proceeds $ 2,450, Basis $ (1,000,000.00) Gain $ 1,450, Tax Rate 20% $ 290, Effective Tax Rate 12%

11 S Corporation Asset Sale Proceeds $ 2,850, Less Basis $ (1,400,000.00) Gain $ 1,450, Rate 1245 Recapture $ 200, % $ 79, Recapture $ 50, % $ 12, Goodwill $ 1,200, % $ 240, Total $ 1,450, $ 331, Liquidating Distribution $ 2,450, Beginning Basis $ 1,000, Gain $ 1,450, Ending Basis $ 2,450, Shareholder Level Gain $ 20.0% $ Total Tax $ 331, Effective Tax Rate 14%

12 S Corporation Comparison Stock Sale vs. Asset Sale Stock Sale Tax $ 290, Additional Recapture Taxes $ 41, Asset Sale Tax $ 331,700.00

13 LLC s/partnerships Sec. 751 requires that a transferor member/partner recharacterize a portion of his gain attributable to the sale of his membership/partnership interest to the extent of unrealized receivables. Unrealized receivables generally include unrealized accounts receivable, inventory, Sec recapture and Sec recapture.

14 Mitigating Differences

15 Use of Tax Attributes WithoutNOL With NOL Proceeds $ 2,850, $ 2,850, Basis $ (1,400,000.00) $ (1,400,000.00) NOL $ (700,000.00) Corporate Gain $ 1,450, $ 750, Tax 34% 34% Corporate Tax $ 493, $ 255, Purchase Price/Distribution $ 1,957, $ 2,195, Basis $ (50,000.00) $ (50,000.00) Shareholder Gain $ 1,907, $ 2,145, Shareholder Tax 20% 20% Shareholder Tax $ 381, $ 429, After Tax Proceeds $ 1,575, $ 1,766, Effective Tax Rate 36% 32%

16 Covenant Not to Compete Allocating a portion to Covenant Not to Compete avoids corporate level gain but is subject to ordinary income. Without With Proceeds $ 2,450, $ 2,450, Covenant Not to Compete $ (1,000,000.00) Basis $ (1,400,000.00) ) $ (1,400,000.00) ) Corporate Gain $ 1,050, $ 50, Tax 34% 34% Corporate Tax $ 357, $ 17, Purchase Price/Distribution $ 2,093, $ 1,433, Basis $ (50,000.00) $ (50,000.00) Shareholder Gain $ 2,043, $ 1,383, Capital Gain Rate 20% 20% Capital Gain Tax $ 408, $ 276, Covenant Not to Compete $ $ 1,000, Ordinary Income Tax Rate 39.6% 39.6% Ordinary Income Tax $ $ 396, After Tax Proceeds $ 1,684, $ 1,760, Effective Tax Rate 31% 28%

17 Personal Goodwill Treats the shareholder s goodwill as a distinct and separate asset and not included as a corporate asset. Martin Ice Cream Co v. C.I.R., 110TC 189. By allocating a portion of the purchase price to Personal Goodwill, corporate level gain is avoided but the buyer still purchases an amortizable 197 asset.

18 Illustration of Personal Goodwill Basis $ (1,400,000.00) $ (1,400,000.00) Covenant Not to Compete $ (1,000,000.00) Corporate Gain $ 1,050, $ 50, Tax 34% 34% Corporate Tax $ 357, $ 17, Purchase Price/Distribution $ 2,093, $ 1,433, Basis $ (50,000.00) ) $ (50,000.00) ) Shareholder Gain $ 2,043, $ 1,383, Capital Gain Rate 20% 20% Capital Gain Tax $ 408, $ 276, Covenant Not to Compete $ $ 1,000, Ordinary Income Tax Rate 39.6% 39.6% Ordinary Income Tax $ $ 396, After Tax Proceeds $ 1,684, $ 1,760, Effective Tax Rate 31% 28%

19 Deductions arising from Sale Accrued but not deducted expenses 461(h) Upon assumption of debt, economic performance is deemed to occur. Must be included as part of the proceeds from sale. Deferred Compensation Write-off of specific assets

20 Purchase Price Allocation By allocating the purchase price away from items which generate ordinary income to capital gain assets, the difference between a stock transaction and an asset transaction for sales of S corporation stock will be reduced/eliminated. Buyers should be willing to allocate away from land and building to goodwill. Allocations between parties with differing interests will generally be accepted.

21 TAX DEFERRED REORGANIZATIONS

22 368(a)(1)(A) - Merger Shareholders Stock/$ Target Merger Acquiring Corp. l l Merger Sub 368(a)(2)(D) Forward Triangular Merger

23 368(a)(1)(B) Share Exchange Shareholders Acquiring Stock Target Stock Acquiring Corp > I l l l l Target Merger Sub 368(a)(2)(E) Reverse Triangular Merger

24 368(a)(1)(C) Stock for Assets Shareholder Acquiring Stock Assets/Liabilities Target Acquiring Acquiring Stock

25 Equity Sales Treated as Asset Sales for Tax Purposes

26 338(g) Elections 338 (h)(10) Corporate Elections Acquire 80% or more of stock; Buyer must be a corporation; and Target must be an S corporation or member of an affiliated group Failed A Reorganization (Rev. Rul. 69-6) All cash merger; Cross entity merger 336(e) Election

27 LLC/Partnership Election 754 Election 734 Redemption 743 Cross Purchase

28 Intra-Family Transfers

29 Compensation Grant Pursuant to Sec. 83, a grant of equity is income to the recipient and an expense to the entity. Child Parent Value of Grant $ 400, $ (400,000.00) Cash Bonus $ 262, $ (262,251.66) Total $ 662, $ (662,251.66) ) Income Tax $ (262,251.66) $ 262, Total Cash $ $

30 Gift By gifting the stock to the next generation, all appreciation after the gift escapes gift/estate tax consequences. Drawbacks L f t i b i d Loss of step up in basis; and Transferor may still need income.

31 Value of Gift C U R R E N T V A L U E Amount that Escapes Estate Tax Gift T O D A Y + 20 year

32 Sale to IDGT IDGT is an Intentionally Defective Grantor Trust For income tax purposes, certain trust provisions are included so that the transferor is deemed to be the owner of the trust s s assets for income tax purposes Because the trust is an IDGT, the sale does not generate any gain Transferor must pay tax on all income generated from the IDGT s assets and these payments are not treated as additional gifts For gift/estate tax purposes, it is a completed transfer

33 Sale to IDGT Note Payment Shareholder Stock Note (no gain on sale) IDGT Corp Distribution

34 Benefit of Sale to IDGT No gain is recognized on sale Eligible to be an S corporate shareholder Ideal for use to transfer S corporation and LLCs/partnerships Tax distributions made to trust can be used to pay down debt Note payments can be used to pay transferor s taxes Only seed gift is subject to gift/gst consequences Future payments of tax is an economic gift to beneficiaries but not a taxable gift.

35 QUESTIONS?

36 John D. Gatti, JD, CPA Member Kerr Russell Contact Info: Phone: Fax: Mr. Gatti is a member of the State Bar of Michigan, American Bar Association, Michigan Association of Certified Public Accountants, American Institute of Certified Public Accountants and various selections of these associations. Currently, Mr. Gatti is Vice- Chairman of the M&A Task Force of the MACPA. Mr. Gatti is a cum laude graduate of Wayne State University Law School (Order of the Coif) and a graduate of the University of Michigan where he received his degree in Economics with High Honors.