Inside ownership sales, where business ownership is transferred internally to employees, executive groups, co-owners, and/or family members, pose unique challenges. One of many includes the significant hurdle of double taxation. As business exit planners, understanding and navigating these complexities is crucial for ensuring a smooth and financially efficient transition. The proper strategy in these scenarios can also open up new potential paths for a sale compared to the occasionally limiting ideas of selling to the highest bidder. Depending on the business and the owner’s value-based goals, sometimes a more strategic approach than Fair Market Value is necessary. This comprehensive guide delves into the pitfalls of double taxation and outlines advanced strategies to circumvent them, enhancing the overall process of business exit planning in this fashion.
Understanding Double Taxation
Double taxation occurs when the same income is taxed twice before reaching its final recipient:
- Corporate Level Taxation
- The company incurs taxes on gains from asset sales.
- Shareholder Level Taxation
- Proceeds distributed as dividends are taxed again on personal income tax returns.
This leads to a reduced net gain from the sale, impacting all parties involved, putting additional pressure on the business, the buyer, and the seller.
Common Pitfalls of Double Taxation
- Financial Burden
- Shareholders receive less than the business’s value due to taxes at multiple levels (see image above).
- Shareholders receive less than the business’s value due to taxes at multiple levels (see image above).
- Complex Transactions
- Avoiding double taxation often requires complex and meticulously planned transactions. Typically, an installment sale will be necessary, and this can last several years.
- Avoiding double taxation often requires complex and meticulously planned transactions. Typically, an installment sale will be necessary, and this can last several years.
- Demotivating Buyers
- Potential internal buyers may be discouraged by the high tax burdens, reducing their incentive to invest. Without avoiding the double tax, the buyer will have to earn a lot more to pay the seller in this environment.
Strategic Planning to Overcome Double Taxation
Enhancing Transactions with Discounts and Deferred Compensation:
- Discounted Purchase Price
- Reducing the sale price lowers immediate tax liabilities and potential estate taxes, making the transition more feasible. This is accomplished through Minority Shareholder Discounts, Lack of Marketability Discounts, Deferred Compensation, and more.
- Non-Qualified Deferred Compensation (NQDC)
- This allows the seller to defer income, spreading tax liabilities and aligning new owners with the business’s success. NQDCs can be used as an employee retention strategy and are also used for inside sale installment buyouts and/or earnouts.
- This allows the seller to defer income, spreading tax liabilities and aligning new owners with the business’s success. NQDCs can be used as an employee retention strategy and are also used for inside sale installment buyouts and/or earnouts.
- Direct Payments to the Seller
- This is another strategy for decreasing the total value of the business during an inside sale. While the owner is still on the business’s books, making direct payments to the owner will lower the value of the business as well, lowering the tax liability as it decreases the company value.
Further perpetuating the strategy of selling your business for the Least Defensible Value, all three of these items are seen as liabilities on the company’s balance sheet, lowering the lump-sum-amount the buyer would have to give to the seller upfront.
Leveraged Buyouts (LBOs) and Seller Financing:
Asset Sales and LBOs –
Selling business assets rather than shares and using leveraged buyouts can minimize tax impacts through deductions like interest.
Seller Financing –
Extending credit to buyers spreads tax liability over time as the seller receives payments, easing immediate tax burdens.
Entity Structure and ESOPs:
Optimal Entity Structure –
Utilizing structures like S Corporations or LLCs can provide pass-through taxation, avoiding corporate-level taxes.
Employee Stock Ownership Plans (ESOPs) –
ESOPs facilitate inside sales with tax efficiency, as the company can sell stock to a trust, benefiting from tax-deductible contributions. Partial ESOPs can be used as well.
Importance of Buy-Sell Agreements and Direct Payments:
Buy-Sell Agreements –
Essential for clarifying the terms of ownership transfer, these agreements prevent conflicts by establishing clear valuation and transaction protocols. The Buy-Sell also protects against the risk of the buyer or seller passing away before the company sale is complete. Rather than starting the transaction over from the beginning, this gives the seller breathing room to straighten out their affairs and new approach. This can also be part of continuation planning, as it protects the buyer and company from the seller’s early demise as well.
Impact of Direct Payments –
Recording direct payments as liabilities reduces the business’s valuation, lowering the tax impact of the sale while ensuring the seller is compensated fully over time.
Navigating the complexities of double taxation pertaining to inside sales requires a nuanced understanding of tax laws and strategic financial planning. By employing a combination of discounts, deferred compensation, optimal entity structuring, and buy-sell agreements, business exit planners can effectively reduce tax burdens and facilitate a smoother transition of ownership. These strategies not only ensure compliance and financial efficiency, they also maintain the integrity and continuity of the business during the transition phase. Effective planning and expert advice are indispensable, highlighting the value of skilled business exit planners in achieving successful business exits. Whenever selling or buying a company, it is beneficial to seek a professional’s guidance.
2024-173897 Exp 05/26