C-Corp: A Business Seller’s Nightmare

April 29, 2008 by creddy.

The Horror of C-Corp Asset Sale

 

“I’m proud of paying taxes. The only thing is–I could be just as proud for half the money.” – Arthur Godfrey 

We recently completed the sale of a healthcare deal where the seller had his business incorporated as a C-Corporation. When we informed him of the downside of a C-Corp in a asset sale, the business owner was stunned. While C-Corp business sale has no disadvantages when it comes to a stock sale, the tax burden on the asset sale of a C-Corp can be onerous to a business owner.

To begin with, C-Corp shareholders suffer from double taxation. All corporate income is taxed at the corporate level and any distributions of the profits to shareholders in the form of dividends are taxed at the shareholders personal level. For most mid-market businesses in California, the gains at the corporate level are taxed at the corporate tax rate of 42.84% (34% federal and 8.84% CA State). Further compounding the problem is the fact that there is no such thing as Capital Gains for C-Corps. All income, including income on properties held on a long term basis, is taxed at the same rate.

Assuming an asset sale, which is the preferred type of sale for most acquirers, and worst case allocations, the seller is looking at a potential tax liability of 42.84% at the corporate level and a further 44.3% tax liability at the personal level (35% Federal and 9.3% CA State) leaving him with an effective tax rate of about 68% of the gains on the transaction price! Ouch!!

The worst case scenario for an S-Corp asset sale is far superior. The seller only needs to pay 1.5% at the Corporate level (0% Federal and 1.5% CA State) and a further 44.3% at the personal level. The difference in sale proceeds from a C-Corp and an S-Corp amounts to 22% of the gains in this worst case allocation scenario. On a $10M transaction gain, that boils down to $2.2M!

This above scenario is the worst case and with more reasonable allocations and with some creativity in deal making, this difference can be narrowed significantly. However, even in highly optimistic allocation scenarios, sellers are looking at about a 15% difference in take home just because they chose a wrong corporate structure!

In the case of our healthcare business owner, we could locate a buyer who was willing to do a stock sale and we were able to put together a dramatically better deal for the seller with a 24.3% tax bite (15% Federal Capital Gains Tax and 9.3% CA State). That’s about a 44% savings on taxes compared to the worst case asset sale scenario! We were pleased with how well we could serve this client, but not all stories end so well.

If you are a business owner with a C-Corp, here are some options to help avoid the nightmare at exit:

1.    Unless there is a compelling reason to remain as a C-Corp, switch to an S-Corp. Note that there is a 10 year recapture period before the conversion is complete. Consult your CPA or M&A advisor for advice on steps that you need to take if you plan to sell the business within the 10 year window.

2.    Consider moving or retaining the ownership of all appreciating assets outside of the C-Corp into a different entity such as an S-Corp or an LLC.

3.    For all future incorporations, avoid a C-Corp structure altogether unless there is a very compelling reason to be a C-Corp (ex: having plans to go public or having a lot of shareholders).

4.    If you have a C-Corp, for all practical purposes, you must aim for a stock sale. Look for an M&A advisor who has the proper licensing and experience in doing stock deals. Anecdotally, about 1% of the small to mid-market business intermediaries have the proper licenses to do stock sales. Surprisingly, most business intermediaries are unaware of the licensing requirements required in stock transactions.

Unfortunately, for the business owner, if an unlicensed intermediary does a stock deal, the acquirer may be able to rescind the transaction for up to 3 years after the close of escrow per the provisions of Section 29 of Securities Exchange Act of 1934. Yet another nightmare scenario! For Information about licensing requirements and the SEC act of 1934, see:

http://www.law.uc.edu/CCL/34Act/sec29.html  http://www.californiachronicle.com/articles/52091

Tax laws are complex and change constantly. This article is only intended to provide an insight into some of the major implications of choosing a particular corporate structure. Contact your CPA for tax advice. For information about the specific tax bracket you are in, see: http://www.smbiz.com/sbrl001.html  

Posted in Exit Planning, M&A, Tax Related | No Comments »

Financing Options For Mid Market Companies

March 10, 2008 by creddy.

Debt Capital, Equity Capital & Convertible Debt

 

There are three basic types of funding options for mid market companies: debt, equity and convertible debt. In this article, we will discuss the trade offs of each of these funding options in the context of a mid-market company.

Debt Capital

Debt capital is money raised for a company that must be repaid over a period of time with interest. Debt financing can be either short-term or long-term. Unsecured debt is rare and lenders typically secure debt with assets of the company. This also means that service, technology, and other asset-lite companies have a hard time raising debt capital.

Common debt financers include banks, credit unions, finance companies, and credit card companies.

Advantages of debt capital

Ø  Raising debt capital, for profitable asset intensive companies, can be faster than raising equity capital.

Ø  Debt capital is typically cheaper than equity capital because the financing companies pick only the lowest credit risk companies and further secure their loan with assets.

Ø  The lender does not gain an ownership interest in the business and this allows the business owner to remain in the driver’s seat of the company without being answerable to investors.

Disadvantages of debt capital

Ø  The loan amount and the interest payments can saddle the balance sheet and income statement of the company.

Ø  Any downturn in the business or unexpected capital needs can make it difficult to make the interest payments and send the company into a debt induced downward spiral.

Ø  For some debt instruments, the terms can be complex and may onerously burden the business.

Ø  If the debt is personally guaranteed, liability will extend to non-business assets.

Ø  If the company gets into trouble, the debt financier could become adversarial.

Equity Capital

Equity capital is money raised by a business in exchange for a share of ownership in the company. Equity financing allows a business to obtain funds without incurring debt and without having the burden of associated interest/principal payments. For a growing company with cash needs and for companies with an erratic earnings stream, it can be a big advantage to not have to repay a specific amount of money at a particular time.

Equity capital can be public or private. Public equity capital is only available for large companies (revenues over a hundred million dollars). Two key sources of private equity capital for mid market businesses are Private Equity Groups (PEGs) and corporate investors. Other forms of private capital such as angel capital and venture capital, are typically not available to mid-market companies. Angel investors and venture capitalists provide funding to young, nascent private companies.

Equity investors can be passive or active. Passive investors are willing to give you capital but will play little or no part in running the company, while active investors expect to be heavily involved in the company’s operations. Investing in a company’s equity over a long term without any security collateral is inherently high risk. As a result of that, this form of capital typically comes with an active participation from the investors.

Passive or active, equity investors are typically patient, long term investors. These investors seek to add value in an effort to help the company grow and achieve a greater return on the investment. In return for their risk and participation, private equity investors usually look for a 25% or more return on investment, and put a number of checks and balances on the company’s operations to achieve their goals.

Advantage of Equity Capital

Ø  Lack of recurring principle/interest payments makes the business more able to cope with the ebb and flow of the business and increases the margin of safety

Ø  Corporation’s risk is shared with investors

Ø  Right investors can add significant value

Ø  Smooth transition option for business owners looking to ease out of the business

Ø  May be the only possible type of capital for rapidly growing and asset-lite companies

Ø  Equity investor is committed to the company until exit. If the company gets into trouble, the equity investor is likely to help with the turnaround

Disadvantages of Equity Capital

Ø  Owner answerable to investors and some loss of control

Ø  Can be more expensive than debt capital (albeit at a lower risk)

Ø  It typically takes longer to raise equity capital than debt capital

Ø  Deal terms can be complex. Without good deal making support, the company may unknowingly allow the investor to undervalue the company and take a disproportionately higher percentage of the company compared to the value of the investment made.

Convertible Debt

Convertible debt is a hybrid of debt capital and equity capital. Convertible debt typically involves favorable interest rates and other terms on the loan in return for the option to convert some or all of the debt into equity at predetermined price levels. Convertible debt instruments are complex and require a substantial amount of work on the part of the deal makers. There are many different variations of convertible debt available depending on the needed trade-off between debt and equity.

Convertible debt is more likely to be seen in distressed or high risk companies, and some investors specialize in distressed convertible debt. However, the flexibility of convertible debt makes it an attractive option in a wide variety of situations. This option gives the management maximum flexibility and is worth considering for larger mid-market companies.

Posted in Valuation, Tax Related, Deal Structure, Finance | No Comments »

The Limitations of Using EBITDA for Mid Market Companies

February 20, 2008 by creddy.

Looking behind the numbers

 

“Does management think the tooth fairy pays for capital expenditures?” – Warren Buffett 

EBITDA, follow-on to EBIT, was created by investment bankers to find out the true operating profitability of the company. EBITDA is a great tool to measure the profitability of companies with expensive assets that get depreciated over an extended period of time. Financiers look at EBITDA to measure the debt carrying capacity of the company. It is common to measure mid-market company profitability and cash flow using EBITDA and use EBITDA as the exclusive indicator of the business performance.

Each business has its own unique set of strengths, weaknesses, opportunities and threats, none of which can be captured by EBITDA or any other single metric. Intelligent business acquirers must consider the amount, the growth rate, and the variability of cash flow generated by the operations. EBITDA, when used properly, can be a helpful starting point in this regard. However, as you will see from the discussion below, EBITDA has several limitations when it is used for measuring cash flow.

To arrive at EBITDA for a business, acquirers add back Interest, Taxes, Depreciation, and Amortization to the Net Income of the company. Let’s look at each of the items in EBITDA to understand the rationale and limitation of these add backs:

v  Earnings

The most common mistake seen in EBITDA calculations is the inclusion of non-operational earnings in the earnings number. To start off the process, it is imperative that all non operating profits have been factored out of the earnings. Are one time real estate or other asset sales factored into the earnings calculations? How about warranty cost reserves and bad debt allowances? The earnings data needs to be scrubbed to make sure that the earnings number used in EBITDA reflects operating earnings.

v  Interest

Interest payments of a business are primarily a function of the company’s financing strategy and vary widely depending on the debt to equity ratio preferred by the ownership. The resulting leverage factor can artificially inflate or deflate the net income. While adding back interest makes sense in terms of identifying operating profitability, it does not make sense to add interest back in terms of cash flow. Interest payments are certainly a burden on the cash flow! To get a more meaningful measure of cash flow, it would be necessary to subtract from EBITDA the anticipated cost of financing under the new regime.

v  Taxes

Taxes are accounting and owner dependent and a pre tax view of the profits would be a better indicator of the operating profit stream. However, like interest payments, taxes are a real expense and estimated taxes under the new financing and operational structure should be factored into calculating the expected cash flow.

v  Depreciation

Depreciation is an accounting construct that provides for an indirect and backward looking measure of capital expenses. Depreciation expense can be a highly misleading indicator. The accounting treatment of depreciation for many businesses is substantially different from real world depreciation. For equipment intensive businesses, adjustments to EBITDA are almost always necessary to get a true picture of the earnings.

Since depreciation is a non cash expense, it makes sense to add the line item back for cash flow calculations. However, keep in mind that some of the depreciated items need to be replaced over time and new equipment needs to be added in. Any cash flow calculation should factor in the cost of the replacement equipment.

v  Amortization

Amortization is similar to depreciation except that what is being depreciated are intangible assets such as goodwill of the business – very likely from a past acquisition or startup costs. Barring a few rare exceptions, amortization can be fully added back for profitability and cash flow calculations.

In addition to the above, there are some other limitations to EBITDA. It is important to understand that EBITDA only accounts for two non-cash items - Depreciation and Amortization. There is no provision in EBITDA to adjust for some very important non-cash items such as stock grants, stock option grants, inventory value adjustments, bad debt allowances, and gift certificate redemption credits.

EBITDA also ignores the impact of changes in working capital. Increases in working capital consume cash and a business could have great EBITDA numbers but terrible cash flow numbers and could be on the verge of going out of business. To have a meaningful picture of the cash flow, acquirers need to review working capital changes to see if there are growth related issues or other working capital changes of significance and adjust cash flows accordingly.

In summary, acquirers should not rely exclusively on EBITDA or any other single metric to measure the performance of a business. To the extent EBITDA is used, acquirers should replace the removed interest, taxes, depreciation, and amortization from their earnings calculations with their own expected operating numbers to get a better picture of anticipated profitability and cash flow and the variability to the cash flow. This can be accomplished by:

- Substituting the Interest costs with expected capital costs under the anticipated capital structure

- Substituting the Tax items with their own tax-rate calculations under the new capital structure.

- Substituting Depreciation expense with an estimate of future capital expenditures.

- Amortization can be kept at zero unless there are extraordinary items that need to be factored in.

- Reviewing working capital changes and adjusting cash flows accordingly.

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Taxes & Valuation: Can You Have Your Cake And Eat It Too?

January 28, 2008 by creddy.

What Every Business Owner Needs To Know About Taxes & Valuation

 

Inevitably, one day the time will come for a business owner to move on. The reason for the exit may be anything from retirement, health problems, burnout, or just taking some chips off the table.

Planning this exit can have a significant impact on how much the business owner takes home from the event. Maximizing the take home requires the business owner to present the business, especially the financial aspect, in the best possible light. Here is where paying attention to accounting details makes a difference.

Businesses typically spend an inordinate amount of time setting up and using accounting practices that reduce the owner’s tax liabilities. CPAs use various business ownership structures and techniques to defer/reduce the revenues or accelerate/inflate the expenses to help business reduce its tax burden. The unforeseen side effect of this exercise is that, to a potential acquirer, the profitability of the business may appear much smaller than what it really is. There may also be other after-sale tax consequences attributable to corporate structure and to depreciation. Business intermediaries “add-back” non-business, non-cash expenses and “recast” the financial statements to get a better picture of the finances, but in most cases this is more of a band-aid than a real solution.

Since most businesses trade in multiples of the business’s cash flow, the practices utilized to save the business a lot of money may result in an artificially low valuation when the business sells. Does this mean that business owners have to give up all of their tax benefits? Not really!

When it comes to taxes and valuation, there may be ways in which business owners can have their cake and eat it too. With advanced planning, a competent M&A advisor can help mitigate potential adverse affects at sale time. Some aspects of accounting that need to be revisited in preparation for an exit include:

-      Business ownership structure

-      Aggressive revenue deferrals or expense accelerations

-      Burdening the business with personal, family and other unrelated expenses

-      Commingling revenues/expenses of related businesses

-      Wasteful spending

-      Inaccurate inventory statements & inventory write downs

-      CapEx budgets

-      Off-the-record transactions

-      Accrued assets and liabilities

-      Nonperforming or underperforming assets on the balance sheet

-      Appreciated, overstated or understated assets on the balance sheet

-      Deciding on Compiled, Reviewed or Audited financial statements

Ideally a business owner planning his/her exit three to five years prior to the actual sale has the best opportunity to do the proper financial planning and make the financial records accurate and presentable.

However, it is never too late to plan for a sale and even a year’s worth of planning is better than no planning at all. Be aware that generally the more time the owner works the problem, the better the results will be.

Posted in M&A, Valuation, Tax Related, Miscellaneous, Finance | No Comments »

2008: Exit Planning For The Year Ahead

January 17, 2008 by creddy.

2007 is over! That is a welcome relief for many business owners.  After several years of solid growth, 2007 has been a harsh year for business executives. Empirical evidence suggests that a vast majority of businesses have seen their revenues stagnate or decline in 2007.

For Business owners who were planning to retire or cash out of their business for other reasons, 2007 was tough. Business was soft, long term interest rates were near 5 year highs, credit was hard to come by, and liquidity levels were low. All of these translated into a very negative environment for deal making especially in the housing, construction and retail industries. Business owners who had their businesses on the market saw less than stellar business valuations and, in several cases, found that their deals did not close as planned. Several other business owners who were planning on exiting held back - unwilling to face a reduced valuation and hoping things would be a bit better in the not so distant future.

As we look into 2008, it appears that we have not seen the bottom in the economy. Does this mean business owners should delay their exit/recapitalization decisions until late 2008 or 2009? Not necessarily!

When evaluating the consequences of environmental trends on the business sale/recapitalization process, it is useful to keep in mind that the business sale/recapitalization process for a mid market business can take about 12 months. Most acquirers/investors look carefully at business performance as they navigate through the deal process and positive trends along the way can be helpful in closing a deal and in getting the terms sought by the shareholders.

Here are some key factors business owners need to take into account while planning exit/recapitalization strategies this year:

Ø  Economy: While we have not seen the bottom in the economy, some segments of the market are starting to pick up. Most construction related businesses continue to be in the doldrums, but the prognosis for several other business categories is getting positive. Based on the commentary we are hearing from industry sources, it seems likely that most businesses will end 2008 with more positive trends than what they are seeing now. These positive trends can be beneficial to companies and shareholders with near term plans to exit or to recapitalize their businesses.

Ø  Interest Rates and Liquidity: Long term interest rates are inching downwards and credit is expected to get better as the year progresses. Twenty out of twenty top economists in a recent national poll forecasted interest rates to go down in the near term. Lower interest rates not only improve liquidity, but also have an effect of making valuations higher. Acquirers are likely to find a higher valuation more acceptable in a lower interest rate regime when they can finance the deal and still meet the cash flow metrics needed. Lower interest rates, coupled with improved liquidity, make the chances of putting together winning deals a lot more likely.

Ø  Taxes: Unfortunately, selling a business with a gain means that a business owner has to pay capital gains tax or ordinary income tax on the gain. Since capital gains are taxed at a lower rate than ordinary income, a competent business M&A specialist attempts to structure much of the gains from the sale of the business as capital gains. In the last few years, business owners have been beneficiaries of a historically low 15% Federal Capital Gains Tax Rate.  With an impending new administration in the White House in 2009, most tax experts believe that the low 15% Capital Gains Tax rate is unlikely to stay at that level and there is a substantial risk of the rate being changed to something higher. The prospect of increased Capital Gains Tax should be carefully thought through in the context of the business exit/recapitalization process.

Ø  Deal Making Opportunities: Acquirers are a lot more likely to buy a business in a flat to upwards trending market than in a downward trending market. Deal making opportunities should become more abundant as the economic trends reverse through the year. Deal making opportunities are also likely to be aplenty if the business is in a growth oriented segment, or if the business is of a type that can be desirable to foreign companies. With the US Dollar being extremely weak, foreign entities are actively looking to make synergistic acquisitions. It is unclear how long the weak dollar will last but the prognosis is for the dollar to continue to be weak for the near term.

All things considered, early 2008 would be an excellent time for business owners to review their exit or recapitalization strategies and determine how to approach the business sale/capitalization process for optimum financial return.

Posted in Valuation, M&A, Tax Related, Deal Structure, Miscellaneous, Marketing, Finance | No Comments »

Buyers Approach To A Stock Sale

January 17, 2008 by creddy.

Steps that acquirers need to take in a stock sale

 

In most small to mid market situations, it is advantageous for acquirers to structure the business acquisition transaction as an Asset sale. However, in some cases there may be significant advantage to going the Stock sale route. Also, asset sales may not be practical in some cases for contractual or other reasons. In such cases, acquirers need to pay special attention to three key factors:

v  Indemnification Agreement: Acquirer should get a bulletproof indemnification from the seller for any potential liabilities that may have occurred before the transaction closes but only surface after you close the deal. A stock sale without a proper indemnification agreement exposes buyers to potentially damaging legal and financial risk.

v  Seller Carry: Acquirer should get a significant amount of financing from seller as part of the deal. It is best to have this spread out over a period of few years so that you will have leverage in the event a claim materializes. The seller carry can come in handy if there is a lawsuit and the seller balks at keeping his end of the bargain.

v  Corporate Structure: The structure of the corporation being acquired may have significant impact on the tax status of the acquirer. If the acquirer owns one or more corporations prior to the sale, some post acquisition structural alternatives could significantly enhance the acquisition benefits.  These alternatives need to be reviewed carefully before the close for maximum leverage.

It is essential for acquirers to incorporate these key factors in any stock sale.

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Stock Sale Vs. Asset Sale

January 17, 2008 by creddy.

An Overview of Tradeoffs

 

There are two primary ways of structuring the sale of sale of mid-market companies: Stock Sale and Asset Sale. This document compared the trade offs involved with each of these approaches. Acquirers should keep in mind that regardless of the tradeoffs shown below, asset sales may not be practical in some cases for contractual or other reasons. In such cases, stock sale is the only way to go.

Stock

Sale Vs. Asset

Sale Table

	Asset Sale	Stock Sale
Legal Risk	No legal liability for the corporation prior to the purchase	Legal liability for the corporation prior to the purchase can be mitigated if seller is willing to sign an indemnification agreement
Cash Flow	Most of the assets purchased will be depreciable over 3-30 years with the average being approximately 10 years. This means that you may write off approximately a tenth of the purchase price every year. When you sell, you typically pay back the government for all the deductions you took.Advantage: Time value of money	Low depreciable asset base means you do not get benefits of the excess depreciation you can take. On the upside, there is no depreciation recapture tax at the time of sale.
Governmental	Administrative work to the extent you need to files Corporation, tax & employment application before the close of escrow.	Corporation, tax & employment numbers & documentation in place – any changes can be done at a convenient time at your own pace.
Other Taxes	Sales Tax on FF&E	No Sales Tax
Employees	Rehire employees – administrative hassle with hiring, benefits, payroll processing, etc. before the close of escrow	Employee contracts continue. Any changes can me made at a convenient time and pace.
Workers Comp	Workers comp rate could potentially be higher – sometimes significantly – you need to determine the impact and the net cost.	Workers comp rates lower than yours? If so, you benefit from the lower cost and you may even be able to move some of your staff under this umbrella if it makes sense.
Customers	May need to renew or renegotiate contracts	Customer contracts likely to continue with minimum hassle
Vendors / Suppliers	Re-establish contracts – negotiate transfer of leases and contracts – at the minimum you have administrative hassles and in some cases you may need to come up additional money for deposits.	Vendor contracts continue. If any of the vendors offer superior services at better rates, you may move some of your existing business under the same umbrella.
Bulk Sale	Need to conduct bulk sale in most cases – costs approximately $600 at current rates and takes about 20-25 days – this process delays the transaction.	No need to do bulk sale – which means you close the transaction faster, cheaper and thus enjoying the benefits of the cash flow sooner. None of the creditors are aware of the transaction unless you choose to tell them.
Other	Could consolidate book keeping, tax, and other regulatory filings with current entity to simplify operations.	Need to continue the book keeping, tax, and other regulatory filings necessary to keep the entity in compliance.

 

Sellers and acquirers need to be aware that while several of these elements can be structured to the mutual benefit of both parties, some of the elements have less favorable impact to one of the parties and negations are necessary to structure a win-win deal.

Where it applies:

The intent behind establishing a type of sale (stock vs. asset) is to pick the most beneficial way to structure the transaction.

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Structuring An Exit

January 17, 2008 by creddy.

An Overview of Tax Beneficial Strategies

 

There are several possible ways to structure a deal to suit the needs of a seller. This document summarizes some commonly used strategies and the associated trade offs:

Installment

Sale

Installment sale is a simple strategy where a part of the sale price is deferred. The deferred amount is paid to the seller in several installments over a period of time.

Some variants:

v  Standard Installment

Sale: Payments are spread evenly over a period of time.

v  Performance Based: Payment stream is tied to metrics agreed on by the buyers & sellers

v  Self Canceling Note: Payments are spread until the seller dies.

Benefits:

v  Smart way to structure a sale in special situations (ex: concentrated customer base)

v  Capital gains are deferred as payments are received

v  Self Canceling Notes pull the future interest of the asset outside of the estate

Downsides:

v  Risk of future payments

v  Capital gains rates may rise in future

Where it applies:

v  Seller has confidence in buyer to deliver on future payments

v  Buyer requires the structure due to economic uncertainties

v  Seller has captured most of the value in the upfront payments and does not mind risking the incremental money stream

Structured

Sale

Structured sale is similar to an installment sale except that the payment stream is guaranteed by a third party

Benefits:

v  Capital gains are deferred as payments are received

v  Secured payment stream

v  Payment stream can be structured in a very flexible way

Downsides:

v  Capital gains rates may rise in future

v  Time consuming and expensive for buyer to setup

Where it applies:

v  Seller may need to substantially increase take-home dollars to make the sale happen. This tax advantageous method requires a motivated buyer to setup this plan.

1031 Exchange

Allows for a seller to roll equity and debt into a new property and defer the capital gains tax until some future sale

Benefits:

v  Capital gains deferral

v  Can move tax deferred dollars from active management to passive management

Downsides:

v  Limited time: 45 day to identify replacement property and 180 days to close

v  May not be able to find a desirable property

v  Capital gains rates may rise in future

Where it applies:

Excellent technique to defer capital gains assuming availability of good investment options

1042 Exchange

Complex exit strategy where privately owned stock can be exchanged for publicly traded stock. If a highly appreciated asset is owned by a corporate entity, shares of that entity can be sold and exchanged for shares of a listed stock.

Benefits:

v  Defer Capital gains tax. Exchange can be made with dividend producing Blue-Chip stocks

Downsides:  

v  Capital gains rates may increase in the future

Where it applies:     

v  Might be applicable for business-owned assets that have appreciated in value

Charitable Trusts

v  This method is only applicable if the sellers have determined what they will leave to charity at death. It is possible to make a future gift to a charity in exchange for an income stream. This method allows for an income stream comparable to what is possible with direct sale of business. It is also possible to gift the income payments to charity and have the asset revert to the estate at death.

Benefits:

v  Charitable Organizations do not pay capital gains tax

v  Tax deduction that is some proportion of the value of the gifted property or asset

v  Asset is removed from the estate for purposes of estate tax

v  Asset and income stream are protected from judgments, liens and bankruptcy claims

Downsides:

v  The asset reverts to charity at death of the grantor(s)

Where it applies:     

v  When the seller has already decided on the amount of the estate that goes to a charity

Private Annuity Trust / Deferred Sales Trust

The capital gains benefits available with a Private Annuity Trust may be discontinued. In this method: Grantor(s) establish a trust, sells the asset to the trust and the trust sells the asset to the buyer. Trust makes installment-like payments to the grantor(s) over their lifetimes. Capital gains taxes are due as installment payments are made to grantor(s). At death of grantor(s), asset passes to beneficiaries.

Benefits:

v  Capital gains taxes are deferred and interest is earned on taxes not paid to government

v  Trust assets can be invested in almost anything. Grantor(s) have the ability to borrow money form the trust. Trust assets can be fully withdrawn as long as capital gains taxes are paid at time of withdrawal

v  Trust is held outside of the estate for purposes of estate tax and assets in trust are protected from judgments, liens and bankruptcy claims

Downsides:  

v  The trust needs to have a third party trustee

v  Capital gains may rise in future, but the trust can be liquated as needed

Where it applies:

The intent behind establishing a PAT should be to exchange an asset for a lifetime income, to defer capital gains taxes or to avoid estate taxes or any combination

Posted in M&A, Valuation, Tax Related, Deal Structure, Finance | 1 Comment »