Often, the actual process of selling a business is unknown to the business owner. This leaves her vulnerable to making significant mistakes. We’re here to offer a road map to guide advisors in attempting to tackle some of the most common issues that clients may face.
In our first installment, we discussed timing, family dynamics and putting together a crack team. In this article, we’ll focus on the different types of potential buyers clients can look to court as well as the importance of financial and tax planning in readying the business for sale.
Potential purchasers of closely held businesses come in many forms. The most common are:
1. Strategic buyers. These are purchasers who want to buy the company because of certain synergies with their existing businesses. Strategic buyers may get more value out of the acquisition than the intrinsic value of the company. As such, they may be willing to pay a premium price. Strategic buyers are sometimes referred to as “synergistic buyers.”
2. Financial buyers. Typically private equity firms, these purchasers are interested in the return they can achieve by purchasing the business. Their goal is to increase both cash flow and the company’s value over a period of years and then either sell the business or take it public.
3. Other family members or management. Closely held businesses aren’t always sold to outsiders. Many times, the business is sold to other family members or to management. These transactions are sometimes combined with employee stock ownership plans (ESOPs).
4. Initial public offering. Although less common, some closely held businesses go public to provide liquidity for shareholders or to expand operations.
5. Patient capital. Patient capital is typically a passive investor who buys a minority interest in the family business to provide liquidity for shareholder buyouts or growth. These investors, which include family offices, are in it for the long term.
Readying the Business for Sale
With the help of relevant advisors, the business owner can take numerous steps in advance of the sale to position the business to maximize the value on sale. Such steps include reducing costs, diversifying the customer base and developing a strong team of nonfamily managers. Business owners should incentivize these managers through golden parachutes, bonuses (including company stock), phantom stock and stock appreciation rights.
Importance of Financial Planning
Financial plans, typically prepared by a financial advisor, can be important foundational documents in the planning of closely held business owners anticipating a liquidity event. A good financial plan begins with the long-term financial goals of the business owner. Using projected after-tax sales proceeds, a financial plan can help determine whether it’s better for the business owner to sell or to keep running the business. Important considerations include whether there will be adequate assets after the sale to achieve the business owner’s lifetime financial goals (core capital) and, once core capital needs are met, whether there are additional assets that can be used to gift to family members and charity (we’ll tackle the value of gifting in more detail in the upcoming part 3, so stay tuned).
Income Tax Planning
A full description of the income tax issues involved in the sale of a closely held business could fill a book, so we have room for only a few highlights.
Structuring the transaction. Structuring the sale of a closely held business in an income tax–efficient manner can have a significant impact on the after-tax proceeds available to the family. Sales of businesses structured as S corporations (S corps), partnerships or LLCs typically have one level of tax. Sales of stock in a C corporation (C corp) also have one level of tax. But sales of the assets of a C corp (or an S corp that converted from a C corp within the prior 10 years) can result in two levels of tax. The first tax is at the corporate level on the sale of assets. The second is at the shareholder level on the liquidation of the corporation. However, income tax on a sale won’t apply if it’s structured as a tax-free merger. Tax also can be deferred in the case of an installment sale. There are even situations, such as an ESOP, in which gains aren’t subject to tax. An ESOP is a qualified retirement plan that purchases company stock. If the business owner keeps the “qualified replacement property” (basically, stocks and bonds issued by U.S. operating companies) until his death, at which point the property will receive a step-up in basis, then the proceeds of the sale may not be subject to income tax ever.
Charitable planning. Charitable planning in advance of the sale of a closely held business sounds like a great way to minimize taxes. Your client gives some stock to charity or a charitable trust and gets a full fair market deduction against her income taxes, subject to certain adjusted gross income limits. Unfortunately, charitable gifts of closely held business interests can cause negative income tax consequences (including unrelated business income tax, violation of the Chapter 42 private foundation (PF) excise tax rules, not getting an FMV deduction for a lifetime gift to a PF and the potential for recognition of income if the gifted property is encumbered under the bargain sale rules).
State tax planning. In addition to federal income tax, many states impose a state income tax on sales of businesses. If the business owner changes her residence well in advance of the sale (ideally in a different tax year) to a state with no income tax, there should be no state income tax on the sale, unless it’s deemed to be state-sourced income.
If changing residence isn’t possible or palatable, another possibility for residents of certain states is an incomplete gift nongrantor trust (ING) set up in a state like Delaware (DING) or Nevada (NING). Such trusts allow individual taxpayers who are resident in certain states with high income taxes (for example, New Jersey) to avoid being taxed on nonsource income in such states. Unfortunately, DINGs and NINGs don’t work to avoid state income taxes in all states based on state law (for example, New York and Connecticut).
We’re now through two installments of this series and we haven’t reached the sale itself yet. In part 3, we’ll address the value of gifting prior to the sale and wrap things up with some conversation about planning for after the sale and any potential second acts the client may have in mind.
This is an adapted version of the authors’ original article in the March 2019 issue of Trusts & Estates.
This article is provided for informational and educational purposes only. The views and the opinions expressed in this article are those of the authors and do not necessarily represent or reflect the views of UBS Financial Services Inc. or its affiliates.