M&A Shop Talk: Exiting Tax Planning Strategies

July 10, 2018

Flexibility and vision are essential ingredients to successfully optimizing your exit tax planning strategy. Here are some tax planning best practices that you should always consider:

Overall Pre-Formation Analysis Considerations

  • What is the right tax structure path for your business model from cradle to exit?
    • Identify your overall exit strategy goals and objectives.
    • Do you have constraints affecting your choice of tax structure, such as investors, regulatory, financing, and personal lifestyle?
    • Can your initial tax structure selection evolve without incurring additional tax burden?
    • Is the Sec 1202 stock sale exclusion a major tax consideration when exiting? If so, your business model can never be an S Corporation.
    • Will your business modeling always lack marketability because of industry and/or regulatory constraints?
    • Is selling to the employee through an ESOP part of your overall exiting strategy?

Business Succession Planning Consideration Strategy

  • Applying freezing techniques using LLC to execute your business succession plan.
    • If required, by using an F reorganization of a newly formed holding company, convert your existing S Corporation to an LLC without triggering tax.
      • Use LLC tax structure to recapitalize the fair market value of your business in the form of preferred equity participation and transfer the creation of post wealth generation with no tax implications to your successors.
      • Key employees taking over the business will, in essence, pay for the redemption of existing owners from the operational profits.
      • The tax implication to departing owners might be all taxed at ordinary tax rates, there is a negotiation process regarding the amount of redemption and preferred rate to be paid and post reevaluation common ownership participation.

Technology/Software Business Modeling Industry Focus Consideration

  • Consider using LLC to leverage the Sec 1202 stock sale gain exclusion upon consummating your exit strategy.
    • The Sec 1202 stock exclusion is ideal for technology/software developing companies and any business model with substantial appreciated value attributable to self-created IP, formulas, and trade secrets that are no longer entitled for long-term capital gain tax treatment. This is applicable under asset sale transaction for sales transaction transacted for taxable years beginning after December 31, 2017.
    • Start your business as LLC taxed as a partnership, with a subsequent conversion to C Corporation to enhance the Sec 1202 exclusion.
    • To qualify for Sec 1202 gain exclusion, the stock must be held for five years and meet certain conditions.

Exiting Transaction Planning Considerations

  • Create a holding company structure to consummate the sales transaction.
    • Substantially lessen minority shareholder/option holders dispute regarding and terms and conditions.
    • Preserves ordinary tax deduction treatment for certain postpaid transaction items.
    • Accommodates unwanted assets and facilitative orderly liquidation within 12 months.
  • Cash basis reporting businesses should consider changing their accounting method to accrual basis during the year before consummating the sales transaction.
    • Unlike cash basis reporting, accrual basis allows the expensing of certain deferred compensation items assumed by the buyer party under an asset sale.
    • Provides a better mechanism for handling seller with a large amount of deferred income permitted to be deferred for books and tax reporting purposes.
  • Maximize by installing a sale accounting reporting method.
    • Optimize state taxation ramifications.
    • Avoid creating a premature acceleration of deemed cash received applicable to asset sale election under Sec 338(h) (10) and/or sec 336 (e) asset sale election.
    • Prevent the whipsaw tax effect for large capital loss allocated to escrow and earn-out components never collected.
  • Under certain conditions consider Roth IRAs, or a rolled over conversion to create future tax-free income at the costs of incurring additional capital gain tax.
    • This is appropriate because of excess ordinary loss generated because of transactions costs allowed to be expensed as ordinary costs.

Key Owner/Employee Exiting Strategy Considerations to Maximize the Overall Deal Value

  • Consider moving part of the earn-out piece into the key employee retention bonus pool to be administered by the buyer party.
    • It will eliminate payroll tax administrative hassles.
    • This is an ideal incentive for post-integration success and achieving financial metrics.
  • Effectively passing through the portion of the earn-out piece and escrow indemnity hold back attributable to the option holders through the use of a holding company structuring.
    • Manage risk of non-collection.
    • Key employees will end up paying taxes when earned.
    • You are entitled to negotiate a discount price for taking all the risk.
  • Using equity rolled-over tax structure planning concepts to ensure key employee/shareholder participation. Keep skin in the game.
    • It can be structured under either stock or asset sale.
    • You can have cash and equity rolled over. There should be no limitation on the mix.

If you have any questions or need additional information, please feel free to contact Jorge Rodriguez or one of our tax advisors at 301.231.6200.