Structuring Transition Payouts

William J. Killory, CPA, Partner (Feb, 2014)

This is the last in the series on the transition process.  The first article discussed beginning the process and having the right entity structure.  The second article discussed the value of the closely held business.  This article will focus on how that value is structured in the sale or transition process.

The sale to an unrelated third party is all subject to negotiation.  The seller wants the most cash in his pocket at the end of the day and the buyer wants to get a good value and the ability to deduct the purchase price, the quicker the better.  In the ideal world the seller would like to sell stock and have it entirely treated as capital gain.  The buyer does not want to assume any prior liabilities of the corporation and will be reluctant to buy stock and will prefer to pay it in a consulting or similar agreement that he can write off as it gets paid out.  Somewhere in between is where most deals are made.

The typical transaction is the sale of assets by the company to the buyer.  Depending on what is purchased, a variety of tax results can occur.  The sale of fixed assets will create both ordinary income from depreciation recapture and capital gain on appreciated assets.  The goodwill value is capital gain in the hands of the seller and is amortizable by the buyer over a fifteen year period.  The sale of corporate assets is calculated at the corporate level and if it is a C Corporation a corporate tax is levied before any distributions to the owners can be made.  Any subsequent distributions to the owners will be taxed again at the individual level either as dividends or capital gains in the event the company liquidates upon sale.  The goodwill component is capital gain income, but in a C Corporation capital gains are taxed at the same rate as ordinary income.

If it is an S Corporation or LLC then the gain is allocated to the shareholders and is subject to tax on their individual returns only. Any subsequent distributions will only reduce your basis in the entity and generally are not subject to additional tax. The nature of the income retains its character on the personal return so the goodwill value will be taxed as capital gain and the ordinary income will be subject to tax similar to wages.

The buyer in an unrelated purchase will want to subject the seller to a non-compete agreement for the very practical reason that they do not want them to go out and start a new business or go work for the competition.  Non-compete agreements are ordinary income to the seller.  While these agreements generally span three to five years, they are amortized by the buyer over fifteen years for tax purposes.  Non-compete agreements generally are not corporate assets as the individual is the one subject to the limitation.

In our first article, we stressed planning for the right structure primarily to avoid a corporate level tax for the C Corporation owner.  We can mitigate the impact of double taxation with the non-compete agreements and consulting agreements.  The issue of personal goodwill will sometime arise in the buy-sell negotiations.  The Internal Revenue Service takes a rather dim view of this and has successfully challenged this idea a number of times in Tax Court.  There are a few very fact specific cases that have allowed goodwill to the individual apart from the corporation.  There cannot be an employment agreement that has non-compete language and the individual has to be identified and prove that he or she has developed their own good will apart from the company.

Once the asset allocation agreement has been established and agreed to amongst unrelated parties to a purchase–sale agreement then the IRS has little room to challenge the amount and nature of the agreement.  The parties themselves have established the fair market value of the company in the agreement.  Both parties will attach the asset allocation agreement to their respective returns and are pretty well bound by the results of it.

The purchase and sale among related parties involve a lot of the same negotiating and planning, but as they are related the IRS will view the transaction with a high degree of suspicion and will curtail some of the benefits available to unrelated parties.  First, related parties as defined by the Internal Revenue Code are lineal descendants (parents-children) and brothers and sisters.  The IRS will always suspect a gift element and a gift tax return that contains a qualified business valuation is the only way to overcome this suspicion.  Typically a family member will want to redeem his or her stock and cash out.  Related party rules dictate that if that person continues to work or have any relationship other than that as a debt holder then the redemption will be considered a dividend rather than a capital gain transaction.  A direct sale of stock to a related party will be treated as capital gain if it is at fair market value.  If you sell your stock at a loss to a related party then you are not allowed the capital loss.   Any transaction that can be depreciated or amortized by the seller (i.e. goodwill) will be treated as ordinary income in the hands of the related party seller even though it is still amortized over fifteen years by the buyer.

The related party rules can get tricky and getting the most cash into the hands of the seller while preserving cash in the company can get tricky.  By planning in advance of the transition a deferred compensation program can be beneficial in transitioning the company.  This non-qualified retirement plan is generally not taxable to the recipient until received.  It is subject to employment taxes when earned so you do have to be careful on setting this up and reporting this to our taxing authorities.  It is subject to ordinary rates by the recipient when received and deductible by the company when paid so there is some tax equilibrium in the payments.

The transition process can be very complicated.  The sale to an unrelated party is a question of having the right corporate structure, negotiating the best deal and structuring the nature of the payout.  Related party transitions can get complicated as there are many more traps for the unaware.  Combining the sensitivities of the family issues with the complexities of the Internal Revenue Code is not for the faint of heart.  Transition takes a lot of careful, thoughtful planning and there is no one right way of structuring it.  Having your trusted legal and financial advisors involved at an early stage will prevent a lot of tax trouble in the long run.  As always, your Dermody, Burke and Brown tax advisors are here to help you through this process.

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