By Layne T. Smith & Niels A. Bybee
Business owners who are looking to successfully exit from their business through a merger or sale transaction face many important decisions that can affect the tax treatment of gains from an exit transaction. Decisions that impact the potential tax burden can be made at many stages of the business lifecycle, including (i) when the business is formed, (ii) prior to commencing a sale process, (iii) when structuring the sale transaction and (iv) after the closing of the transaction.
Qualified Small Business Stock
First, when the business is formed the owner must decide what type of entity to utilize, including whether to form a C corporation, an S corporation or a limited liability company. While each type of entity has varying tax advantages (and disadvantages) that tax advisors can help navigate, one benefit of using a C corporation is that upon an exit, if certain conditions are met, the owners can exclude gain on the greater of $10 million or 10 times the adjusted basis of the owner’s investment in the business. This exclusion, known as the “Qualified Small Business Stock” exclusion, is possible under Section 1202 of the Internal Revenue Code to shareholders of C corporation stock, provided that the owner has owned the stock for at least five years and the corporation’s assets have a tax basis of less than $50 million immediately after issuance of the stock. The Qualified Small Business Stock exclusion is a planning method commonly employed by startups and venturebacked businesses, and it can also be an option for existing LLCs that are willing to convert to a C Corporation.
Charitable Transfers
Second, prior to entering into an exit transaction the owners should consider whether to transfer a portion of their equity in the business to a charity or a donor advised fund. Generally the transfer should be completed prior to signing a binding letter of intent or a purchase agreement. If the transfer is made too late, the IRS may ignore the charitable contribution and cause the donor to recognize a taxable gain on the donated equity. Upon transfer, the owner can take an immediate tax deduction for the value of the transferred equity, and upon closing, the owner generally will avoid capital gain recognition on the donated assets. In addition, if a donor advised fund is used, the donation can grow tax-free, and the owner has the benefit of recommending grants from the donor advised fund to any IRS-qualified charity. Section 170 of the Internal Revenue Code requires that the owner obtain a qualified valuation for the contributed assets, which must be filed with the owner’s tax return. This planning technique is one we often see our seller clients choose to adopt in advance of a sale.
Structuring the Sale
Third, when structuring a merger or acquisition, the owners should consult with their tax and legal advisors about the proper deal structure. Good tax advice on structural questions can save sellers millions of dollars in taxes. Tax advisors will consult owners on matters such as stock or asset sales, tax-free reorganizations, efficiently rolling equity, and many other nuances of a deal. The value of competent tax planning in an exit cannot be overstated.
Qualified Opportunity Zone Funds
Fourth, after an exit transaction closes, owners may consider rolling the sale proceeds into a qualified opportunity zone fund (QOF). The tax regulations creating these funds were authorized under the 2017 Tax Cuts and Jobs Act, and final regulations were released by the IRS in December of 2019. Congress created this planning vehicle to stimulate economic development and job creation by incentivizing long-term investments into over 8,700 neighborhoods, or “opportunity zones,” in the U.S. and in five U.S. territories.
The tax code allows for significant tax benefits if an owner re-invests proceeds of a sale that would otherwise be taxed at capital gains rates into a QOF within 180 days of the sale. The benefits of rolling sale proceeds into a QOF include (1) deferral of the capital gain from the sale until the earlier of the date on which the investment in fund is sold or exchanged or until December 31, 2026, (2) a 10% step-up in tax basis, if interest in the QOF has been held for at least five years, (3) no tax on the appreciation on the investment in the QOF if the interest in the QOF is held for at least ten years and (4) no depreciation recapture (in most cases).
The above are high-level descriptions of a few examples of strategies that can be used at different stages of the business lifecycle to minimize the tax impact of a sale. Each of these decisions, and many others in the business lifecycle, should be made with the active involvement of your tax and legal advisors.
About Layne T. Smith
Layne T. Smith is a partner in Dorsey & Whitney’s corporate group. His practice focuses on mergers and acquisitions, joint ventures and outside general counsel work. He is co-chair of Dorsey & Whitney’s international Mergers and Acquisitions practice group. He regularly works with private equity sponsors, strategic acquirers and sellers.
About Niels A. Bybee
Niels A. Bybeeis an associate in Dorsey & Whitney’s corporate group. He helps clients with mergers & acquisitions, corporate restructurings, and debt and equity financings.