A 100% stock sale of a C-corporation is one of the most popular options for divesting a business and also one of the easiest to perform.
Shareholders simply sell their stock in the seller entity to the buyer entity.
In this scenario, the buyer simply becomes the new owner of the stock in the seller entity.
The seller entity is not a party to the transaction itself, and thus recognizes no income when the deal occurs.
The only income recognized for tax purposes in a 100% stock deal of this kind is the taxable capital gain event that occurs at the shareholder level.
In this case the shareholders will be taxed at a capital gains rate for the excess over their basis held in the seller entity.
There are some downsides in this scenario. The buyer tends to lose the tax benefit of future tax write-offs because there is no basis step-up at the corporate level for the additional value paid by the buyer. From the buyer’s perspective, there is generally a basis loss that is accounted for as goodwill in this type of scenario. Because the buyer is the loser on a tax-basis in this type of scenario, the buyer will generally require a reduction in the price paid for shares in the transaction.
But consideration for how much of a haircut the buyer will require to be amenable in this type of transaction is not as cut and dry as it appears on the surface. There are several factors to consider. First, stock sales and asset sales have write-off periods that differ in length. So, while the 100% stock sale may not allow the buyer to write-off as much, such a deal would generally allow the buyer to front-load tax write-offs more quickly. In other words, tax benefits would come more quickly. This is especially difficult given that tax rates are always changing. I think we can safely assume that tax rates are more likely to increase than decrease. Some disagree, especially when it comes to corporate taxes. In any event, finding the after-tax benefit to the buyer will require using financial modeling to discount the amount owed to the present on both a stock and asset sale basis and then comparing apples to apples. In many cases, the present value of the lost tax benefits for doing an asset sale over a stock can be significant, even given the longer time horizon and discounts. In nearly every scenario, the seller will require the buyer to reduce the asking price by the difference in tax the seller will have to pay.
Many sellers need to be careful in thinking such a deal is bad for the seller and the seller’s shareholders. In many cases, a decrease in the price, but a change to an stock sale over an asset sale can still provide the shareholders with an increase over the asset option, even with the reduction in the closing price. Depending on the shareholders’ stock basis, the new closing price can often reduce the tax burden of the shareholders and bump up their net yield from the deal. In other words, both buyer and seller win.
Another key consideration in calculating the difference between asset vs. stock sale of a C-corp is in the event that the stock is owned by another C-corp and not individual shareholders. When this is the case it is important to note that sellers may not claim a 243 dividend received reduction (thus reducing the previously onerous tax burden). Unfortunately, because the transaction is an independent business purpose and would be used solely for tax avoidance, it is not allowed under the 243 reduction rule. The proceeds from a stock sale, even if the proceeds flow to another C-corp, will be treated as sales proceeds and not a dividend. The event would still trigger at tax at the C-corp level.
There are a myriad of creative techniques when it comes to getting a deal done in this type of scenario, which usually include purchasing only portions of the shareholder’s ownership in the selling entity. As in other merger opportunities, tax is a huge consideration, but often not the only consideration. When doing the deal, deal makers need to learn to see the forest through the tree. In this scenario, the complexities mount, but the core principles of basis and redemption for exchange and transfer remain. We’ll dive into more of this later when we discuss 388 elections in stock transactions.
The plan design for successfully transitioning business wealth from one generation to another usually includes a program for transferring stock to other family members while one or both of the parents are still living. The strategic options include gifts of stock to other family members or the trust established for their benefit, sales of stock to the corporation, sales of stock to other family members or to trusts, and compensation transition strategies. No option is clearly superior to the others. Each has disadvantages and limitations that need to be carefully evaluated. Often a combination approach is the best alternative. Plus in some cases, as we’ll illustrate, the need to actually transfer stock may be mitigated or eliminated completely by business restructuring techniques that have the effect of transitioning future value without actually transferring stock.
Let’s start first with gifting strategies. A gift strategy is clearly the simplest and the easiest to comprehend. The challenge is to structure the gifts to avoid or minimize all gift taxes on the transfers. In our case study, Steve and Betty could commence a program of gifting corporate stock to Dave, the child involved in the business, and gifting other assets to other family members. For gift tax purposes, the value of any gifted stock may qualify for lack of marketability and minority interest discounts which together may equal as much as 40%. Steve and Betty each have a gift tax annual exclusion that shelters from gift taxes any gifts of present property interests up to $13,000 that they make to a single donee in a single year. All gifts of stock and other assets that fall within the scope of this $13,000 annual exclusion will be taken out or removed from Steve and Betty’s estates for estate tax purposes.
Steve and Betty have 10 potential family donees: 3 children, 3 spouses of children and 4 grandchildren. At $26,000 per each done – that’s $13,000 for each of them – Steve and Betty’s annual gift tax exclusions would enable them to collectively transfer tax-free $260,000 of assets each year to immediate family members. If discounts are factored in at 40% on the stock, this simple strategy could shift up to $400,000 of value out of Steve and Betty’s estates each year. In addition to their annual gift tax exclusions, Steve and Betty each have a gift tax unified credit that enables each of them to make tax-free gifts during their lifetime that are not otherwise sheltered by the annual exclusion.
For 2011 and 2012, the unified credit has been expanded to gift tax protect up to $5 million for each spouse – that’s $10 million for a couple. So, there’s a huge gifting capacity in these years. Starting in 2013, the free amount drops back to $1 million unless congress changes the law again. Truth is, no one knows what the lifetime gift tax-free amount will be after 2012.
Now what happens if they actually exceed these gift tax free limits and actually start paying gift taxes, is that a good thing to do?
Many parents will consider a gifting strategy so long as no gift taxes need to be paid. The strategy becomes much less appealing when the possibility of paying gift taxes is factored into the mix. In our case study, the issue would be whether Steve and Betty should consider making taxable gift transfers, transfers that exceed the limits of their annual exclusions in their gift tax unified credit in hopes of saving larger estate taxes down the road.
There are two potential benefits to these taxable transfers. First, all future appreciation on the gifted property will be excluded from the parent’s taxable estates. Second, if a taxable gift is made at least 3 years before death, the gift taxes paid by the transferring parent are not subject to transfer taxes resulting in a larger net transfer to the donee, usually the children.
Do these potential benefits justify writing a big gift tax check now in hopes of saving bigger estate taxes down the road? Most business owners have little or no appetite for this potential opportunity. As a result, many families confine their gifts of stock to transfers that are fully tax protected by the annual exclusion or the lifetime unified credit. Although the gifting strategy may result in a reduction of future estate taxes and a shifting of taxable income, it has its disadvantages and limitations.
For many parents, the biggest disadvantage is the one-way nature of the gift. They receive nothing in return to help fund their retirement needs and provide a hedge against the non-certain future. You will recall that financial security was Steve and Betty’s primary goal. Their insecurities may be heightened as they see their stock being gifted away over time.
Another disadvantage of the gifting strategy relates to Dave’s plans for the future because a gifting strategy is usually implemented over time in incremental steps that take place over many years. The plan may frustrate or at least badly dilute Dave’s goal of garnering the fruits of his future efforts for himself right now. If Dave is successful in expanding and growing the business, his success will be reflected pro rata in the value of all of the common stock including the stock retained by Steve and Betty and any common stock that may be gifted to Kathy and Paul or other family members or trusts for their benefit.
Finally, there’s an income tax disadvantage to any gifting strategy. The tax basis of any stock owned by a parent at death will be stepped up to the fair market value of the stock at death. If Steve and Betty made gifts of stock, their low basis in the stock will be carried over to the donees, the ones getting the stock and the opportunity for the basis step0up at death is lost forever. This can be significant if a donee sells the stock down the road. These potential disadvantages need to be carefully evaluated in the design of any transition plan. The result in many situations is a gifting program that starts slowly, perhaps geared to the limits of the annual gift tax exclusion, then accelerates as the parents become increasingly more secure in their new uninvolved status and then shifts into high gear following the death of the first parent. In other situations, the fear of future estate taxes prompts the parents to aggressively tackle the strategy upfront.
The complexities in any transaction are as broad as they are deep. Any single discussion about process, structure and timing in a deal will not fully do justice to anyone seeking a broad-stroke solution to the issue. The reason: there seldom is one. What follows is therefore helpful in understanding the process and structure when determining some of the disadvantages of a stock transaction, but may be too broad for some larger, more complex deals. Having been warned, we proceed with the nuances and downsides of pursuing an stock-based acquisition over an asset-only strategy.
The greater number of stockholders in the company, the more difficult it may be to “corral the cats,” so to speak. If we are under the assumption that the buyer desires to acquire 100% of the target company, a contract between each of the selling shareholders must be implemented. In the event that even one of the selling stockholders refuses to consummate a transaction with the buyer, the deal could implode. It’s an unfortunate truth that the entire deal could hinge on a single stockholder digging-in. There are, of course, ways to avoid this impasse. For instance, a merger transaction can eliminate the need for complete agreement amount the shareholders, but still result in the same desired outcome for completing the deal.
As always, tax considerations hold a huge weight in any deal, particularly when a stock transaction is involved. In many cases, an asset sale can help to avoid some of the sticky tax disadvantages of a stock sale. Typically stock transactions are most appropriate when the tax costs or other issues of doing an asset deal make the asset sale more tainted than it otherwise would have been. In many larger transactions, asset sales can produce much larger tax costs. In addition, stock deals are also helpful when the transfer of assets may require costly or difficult third party consents or where the size of the company makes an asset deal too burdensome.
Avoiding the tax disadvantages of a stock sale can often be accomplished through a Section 338 election. The 338 election provides the benefits of an asset transaction while avoiding some of the ancillary non-tax pitfalls of an asset transaction.
Most sellers prefer stock deals because the buyer will take with them all of the corporation’s liabilities, assets and everything in between. The seller can completely absolve itself from most liabilities. While this sounds good in practice, in principal it is more difficult as most acquirers will seek immunity through indemnification against undisclosed or unforeseen liabilities that may have resulted from previous management or shareholders. Reps and warranties can also be a boon to avoid some of the potential skeletons in the closet.
The inverse is true in the case of a company buyer. Buyer’s typically prefer asset acquisitions for both tax and liability reasons, but the route taken typically depends on a number of factors, including some of the downsides of asset purchases, which we’ve discussed previously.
Stock sales do not always involve direct cash payment to the seller. When public companies elect to make purchases, they often do so using stock as consideration in the transaction. In rare cases, this can also occur with private companies as well, particularly if the private company has a good growth story or is expected to go public soon. Again, the structure of any transaction will require the trusted insight of attorneys, accountants and investment bankers to ensure the deal is structured in a way that makes sense for all involved.
Selling a business through traditional M&A is not the only exit option. One diversification strategy to take some risk and money off the table and out of the business is to perform a piecemeal stock sale. In this instance, a business owner is converting non-liquid stock within the business into either cash or interest-bearing debt not tied directly to the company itself. When a stock sale to a party other than the business is performed, it generates a single taxable event that is taxed at the capital gains rate as a recognized gain on sale. This helps to ensure any gain in the proceeds of the business are paid out over time and not in a single lump sum.
Who will you sell to?
Who is going to purchase stock in a privately-held business owned and operated by a small, select group of people? Here are some fairly popular candidates:
A piecemeal stock sale of your business is also referred to as a redemption. It generally triggers a single taxable event, but the proceeds are generally treated as a taxable dividend from the business. In some cases, the piecemeal sale can be treated as a non-dividend producing exchange only if it meets the “substantially disproportionate” standard of Section 302(b)(2) or the “not essentially equivalent to a dividend” in Section 302(B)(1). If the dividend rate is equal to the long-term capital gains rate (which is currently at the glorious level of 15%) the only difference would be the tax-free recovery between the dividend tax and the exchange tax. In many cases, this will turn up as negligible, especially if the shareholder has a low stock basis.
Performing piecemeal stock sales can be helpful in taking money out of the business and placing in more diversified assets. The Section 1045 piecemeal stock sale is like a standard cash or debt stock sale from an owner with an interesting twist. Section 1045 allows for the deferment of a taxable gain from a non-corporate shareholder. In the event of the sale of stock, if the sale of the business’ stock is immediately followed by the reinvestment of said stock in another new qualified small business within 60 days with no taxation whatsoever. The stock must be held in the newly-invested business for a minimum time of six months for the taxation deferment to be valid.
Any C-corp shareholder wishing to diversify may find this option useful, especially if he/she wishes to avoid taxes.
Remember the key definition here is “small business stock.” Which means the business stock being sold and the business stock being acquired must both qualify as a small business. Here are some other key considerations:
This option is very similar to a 1031 tax exchange often performed by real estate investors who can avoid tax by reinvesting in other real estate properties. In the case of buying and selling businesses, cash flow may be better and returns are always higher when you can effectively avoid the hairy issue of paying more taxes to Uncle Sam.
Depending on the shifts in the preferential dividend and capital gains rates, there can be wildly different strategies on how to tackle the nitty-gritty of a piecemeal stock sale or business redemption. It is best to talk to a knowledgeable M&A advisor to better understand this and other issues in the piecemeal sale of your business.
Today we’ll discuss a proper stock redemption strategy. A corporate redemption of stock, a purchase of stock can be used to transition stock in the family business but as we will see, it is not a viable option for many. In our case study, the corporation would contract the purchase to redeem all of Steve and Betty’s stock in the corporation for a price equal to the fair market value of the stock. The corporation would pay the purchase price plus interest over a long period of time, as much as 15 years. Immediately following this redemption, this purchase, the only outstanding stock of the corporation would be the stock owned by Dave. So although Dave is not a party to the redemption, Dave would end up owning 100% of the outstanding stock of the company and would be in complete control.
The corporation would have a large debt that would then need to be paid off to Steve and Betty over time. This debt would be retired with corporate earnings. The interest and principles payments on the indebtedness would provide Steve and Betty with a steady stream of income during their retirement. If they die prior to a complete payout of the contract, the remaining amounts only on the contract would become part of their estate and together with their other assets would be allocated to their children in equal shares.
There’s a primary tax challenge with every corporate redemption. Is the character of the payments made by the corporation to the departing shareholders, the parents, will they be taxed as corporate dividends a bad thing? Or will they be considered true principle and interest payments made in exchange for stock? If the amounts paid are treated as stock consideration payments, the parents will be allowed to recover their basis in the transferred stock tax-free. The interest element of each payment will be deductible by the corporation and the gain element of each payment to the parents will be taxed as long-term capital gain. In nearly all cases the planning challenge is to structure the redemption to ensure that the payments qualify as consideration for stock, not as corporate dividends.
For the Wilson clan and just about all other family businesses, this tax objective will work only if it is a complete all or nothing goodbye for the parents. It requires one, that Steve and Betty sell all of their stock to the company in the transaction; two, that Steve and Betty have no further interest in the business other than that of a creditor; three, that Steve and Betty not acquire any interest in the business other than through inheritance during the 10 years following receipt of any payment made to them; four, that Steve and Betty, not have engaged in stock transactions with family members during the last 10 years with a principle purpose of avoiding income taxes; and five, that Steve and Betty sign and file with the secretary of treasury on appropriate agreement. If all of these conditions are met, and they often are, then the parents are able to treat the payments as consideration for their stock, not as dividends.
Usually, the most troubling condition is the requirement that the parents have no interest in the corporation other than that of a creditor following the redemption. In our case, neither Steve nor Betty could be an officer, director, an employee, a shareholder, or a consultant of the corporation following the redemption. This complete exit requirement is often an insurmountable hurl by a parent who is departing and turning over the reins with the hope that the payments will keep coming over a long term. Plus, there are other compelling disadvantages with the redemption approach that provide a strong incentive for many families to look for an alternative.
These disadvantages cause many companies to reject the redemption strategy and the plan design. They prefer a strategy that can be implemented on an incremental basis over time and that will allow the parents to have a continuing but reduced role in the business, which brings us to our third option – the cross purchase strategy.
Multiple shareholders make everything tougher. The planning for the business takes on a new dimension as multiple family members in trusts began acquiring stock in the company. Care must be exercised to avoid certain tax traps that can surface as the parents implement their stock transition plan. A buy-sell agreement between all of the shareholders becomes essential once the transition process begins. The agreement should include provisions tailored to the unique needs of the parents which are not applicable to the stock owned by the children. The agreement also must address the stock held by the kids to ensure that that stock stays in the family and that each child has a fair exit sell-out option if the child dies or needs to cash in because of a bankruptcy, a divorce, a disability, sibling discord, or some other compelling circumstance.
This valuation trap surfaces when the stock owned by a deceased family member is sold pursuant to the terms of the buy-sell agreement but the price paid under the agreement is less than the value of the stock sold for estate tax purposes. The decedent’s estate ends up paying estate taxes on a value that might be much higher than the amount actually paid for the stock. It can be a disaster in some situations. The key to avoiding this trap is to structure the buy-sell agreement so that it fixes the value of the company stock for federal estate tax purposes.
A special section of the Internal Revenue Code Section 2703 lays out the requirements to accomplish this, but the key requirement turning the ball game is that the terms of the agreement must be comparable to similar arrangements between persons who deal in an arm’s length transaction. This comparable arms length determination is made at the time the agreement is entered into, not when the rights under the agreement are exercised. An effort must be made by the family to determine what others in the same industry are doing. Often this will require a valuation expert to get a hand on what others are doing.
If there are no industry standards because of the unique nature of the business, standards for similar types of businesses may be used to establish the arm’s length terms of the agreement. This arm’s length requirement, the importance of it cannot be overstated.
In some situations, the parents desire to use preferred stock to facilitate the stock transition process to other family members. Extreme – and I emphasize extreme – caution is required whenever preferred stock interests are considered in the design of a transition plan.
So, for example, that a C corporation has outstanding common stock valued at $ 3 million and non-cumulative preferred stock valued at $2 million, all of which is owned by the parents. If the parents were to sell the common stock to an unrelated party for $3 million, the parent would simply report capital gain income on the excess of the $ 3million purchase price received over the parent’s tax basis in the stock sold. But if the parents sold that same common stock to a child for $3 million, the parent also would be deemed to have made a $2 million taxable gift to the child. This gift tax would be an addition to the capital gains income tax just because a family member was involved.
This extreme result is mandated by Section 2701, a harsh provision that requires the preferred stock retained by the parent be valued at 0 for gift tax purposes, and the common stock sold to the child would be assigned a value of $5 million which would trigger the $2 million gift. Now there are some limited ways around this harsh result, but usually, they are all problematic. The lesson is to make absolutely certain that someone with the right training is keeping a very close eye on Section 2701 whenever preferred equity interest are part of the mix in designing a plan.
This trap is triggered when a parent transfers stock in a family corporation to other family members and through some means directly or indirectly retains the right to vote the stock. When this condition exists, the stock is brought back into the parent’s estate for estate tax purposes. The transfer will have done absolutely nothing to reduce the parent’s future estate tax burden. It’s as if the transfer never happened for estate tax purposes.
This trap can extend to many situations including those where the parents vote stock transferred to a trust where a parent is a general partner of a partnership that owns the transferred stock, where the parent through an expressed or implied agreement retains the right to reacquire voting authority or has the right to influence or designate how the stock will be voted. The absolute safest way to avoid this trap is to transfer non-voting stock, an option available in both C and S family corporations. That will eliminate the risk of the trap.
As other family members begin acquiring stock, the transition process needs to avoid these traps while addressing the expectations of the new shareholders. They are no longer just family members; they are now owners. Usually, there’s a need for education and dialog on a broad range of basic issues including limitations imposed by the buy-sell agreement, the rationale for using non-voting stock, cash flow prospects of the business, future stock transfers, and more. The goal is to keep all of the shareholders informed and to ensure that expectations stay in line with reality, while also ensuring the business is left to survive when the dust settles.
When an entrepreneur is engaging in the M&A process many times the owner will receive an offer that involves a combination of cash and stock. For example, many times the offer is 60 – 80% cash with 20 – 40% stock. However, some deals are structured more like a merger where the buyer does not want to offer cash at all but simple allow the seller to retain equity after the closing of the deal. While the seller could pass on the deal, there are also ways to structure the M&A deal to ensure the seller receives the cash he or she needs when the stock is sold over the following months and years.
We have all heard the phrase, “risk, risk, risk, equals reward, reward, reward.” The more risk the seller is willing to acquire and endure the greater chance of upward potential. If the seller is confident the deals will be a good fit and that the companies will continue with a northward value trend, then it might be a good idea to retain the equity with the upside potential.