Tax Implicationsof

Exit Strategiesgfor

Corporations Partnerships and Corporations, Partnerships and LLCs

AgendaAgenda

d Introduction

Tax Implications to Buyer

T I li i S ll Tax Implications to Seller

Mitigating tax differences to Seller

E it S l t t d A t S l Equity Sales treated as Asset Sales

Intra-Family Transfers

Why Sellers prefer an Equity Deal Why Sellers prefer an Equity Deal versus Asset Deal

Capital Gain versus Ordinary Income

All liabilities are assumed by Buyer and Seller is relievedf f li bili ifrom future liabilities

Typically eliminates or reduces the necessity for transferringindividual assets and assigning contracts and permitsindividual assets and assigning contracts and permits

Why Buyers Prefer an Asset Deal

b f

versus Equity Deal Step up in bases of assets

Contingent Liabilities

Seller Corp. Balance SheetTax Basis  Fair Value 

Cash $              50,000.00  $              50,000.00 

Accounts Receivable $           200,000.00  $           200,000.00 

Machinery & Equipment $        1,000,000.00  $           600,000.00 

Accumulated Depreciation $         (600,000.00)

Net Machinery & Equipment $           400,000.00  $           600,000.00 

Land and Building $        1,000,000.00  $           800,000.00 

Accumulated Depreciation $         (250,000.00)

Net Building $           750,000.00  $           800,000.00 

Goodwill $        1,200,000.00 

Total Assets $        1,400,000.00  $        2,850,000.00 

Accrued Liabilities $           100,000.00  $           100,000.00 

Accounts Payable $           100,000.00  $           100,000.00 

Long Term Debt $           200,000.00  $           200,000.00 

Total Debt $           400,000.00  $           400,000.00 

Contributed Capital $              50,000.00  $        2,450,000.00 

Undistributed Earnings $           950,000.00 

Sh h ld E it $ 1 000 000 00 $ 2 450 000 00Shareholder Equity $        1,000,000.00  $        2,450,000.00 

Total Shareholder Equity and Debt $        1,400,000.00  $          2,850,000.00

Q tifi ti f L f F t T Quantification of Loss of Future Tax Depreciation/Amortization

If Buyer is a C corporation, the loss of the Step-Up in basisresults in approximately an additional $320 000 NPV of taxresults in, approximately, an additional $320,000 NPV of taxbenefits.

If Buyer is an S corporation, LLC or partnership, the loss ofy p , p p,Step-Up in basis results in, approximately, an additional$370,000 NPV of tax benefits.

Seller’s Tax Consequences ofqAsset Sale

f h h ll b l l f If the entity is a C corporation, there will be two levels of tax– one at the entity level and one at the shareholder level.

If the entity is an S corporation or an LLC/partnership the If the entity is an S corporation or an LLC/partnership, thetax cost is the difference between ordinary and capital gainrates on certain of the assets.

C Corp Shareholder’s Tax Consequences

Stock Deal w/o Adjustment

Stock Deal with Adjustment

for No Step‐Up for No Step‐Up Asset Deal

Proceeds $   2,850,000.00 

Basis $ (1,400,000.00)

Corporate Gain $   1,450,000.00 Co po ate Ga $ , 50,000 00

Tax 34%

Corporate Tax $       493,000.00 

Purchase Price/Distribution $   2,450,000.00  $   2,129,939.85  $   1,957,000.00 

Basis $       (50,000.00) $       (50,000.00) $       (50,000.00)

Shareholder Gain $   2,400,000.00  $   2,079,939.85  $   1,907,000.00 

Shareholder Tax 20% 20% 20%

Shareholder Tax $       480,000.00  $       415,987.97  $       381,400.00 

After Tax Proceeds $   1,970,000.00  $   1,713,951.88  $   1,575,600.00 

Effective Tax Rate 20% 20% 36%

S Corporation Shareholder Tax Consequences

The difference between a stock sale versus an asset sale for anS corporation will be the character differences between

di d i l iordinary and capital gain. 1245 Recapture is taxed at the shareholder’s ordinary income

tax rate 1250 Recapture is taxed at 25%

S Corporation Stock SaleS Corporation – Stock Sale

Proceeds $    2,450,000.00 

Basis $ (1,000,000.00)

Gain $    1,450,000.00 

Tax Rate 20%

$       290,000.00 

Effective Tax Rate 12%

S Corporation Asset SaleS Corporation – Asset SaleProceeds $    2,850,000.00 

Less Basis $ (1,400,000.00)

Gain $    1,450,000.00 

Rate

1245 Recapture $       200,000.00  39.6% $    79,200.00 

1250 Recapture $          50,000.00  25.0% $    12,500.00 

Goodwill $    1,200,000.00  20.0% $  240,000.00 

Total $    1,450,000.00  $  331,700.00 

Liquidating Distribution $    2,450,000.00 

Beginning Basis $    1,000,000.00 

Gain $    1,450,000.00 

Ending Basis $    2,450,000.00 

Shareholder Level Gain $                         ‐ 20.0% $                   ‐

Total Tax $  331,700.00 

Effective Tax Rate 14%

S Corporation ComparisonSt k S l A t S lStock Sale vs. Asset Sale

Stock Sale Tax $       290,000.00 

Additional Recapture Taxes $         41,700.00 

Asset Sale Tax $       331,700.00 

LLC’s/Partnerships Sec. 751 requires that a transferor member/partner

LLC’s/Partnerships

recharacterize a portion of his gain attributable to the sale ofhis membership/partnership interest to the extent of“unrealized receivables ”unrealized receivables.

“Unrealized receivables” generally include unrealizedaccounts receivable, inventory, Sec. 1245 recapture and Sec.y p1250 recapture.

Mitigating Differences

Use of Tax AttributesUse of Tax Attributes

Without NOL With NOLWithout NOL With NOLProceeds $   2,850,000.00  $   2,850,000.00 Basis $ (1,400,000.00) $ (1,400,000.00)NOL $    (700,000.00)Corporate Gain $   1,450,000.00  $       750,000.00 Tax 34% 34%% %Corporate Tax $       493,000.00  $       255,000.00 

Purchase Price/Distribution $   1,957,000.00  $   2,195,000.00 Basis $       (50,000.00) $       (50,000.00)Shareholder Gain $   1,907,000.00  $   2,145,000.00 Shareholder Tax 20% 20%Shareholder Tax $       381,400.00  $       429,000.00 

After Tax Proceeds $   1,575,600.00  $   1,766,000.00 

Effective Tax Rate 36% 32%

Covenant Not to Compete Allocating a portion to Covenant Not to Compete avoids

corporate level gain but is subject to ordinary income.p g y

Without WithProceeds $    2,450,000.00  $    2,450,000.00 Covenant Not to Compete $ (1,000,000.00)

Basis $ (1 400 000 00) $ (1 400 000 00)Basis $ (1,400,000.00) $ (1,400,000.00)

Corporate Gain $    1,050,000.00  $          50,000.00 Tax 34% 34%

Corporate Tax $       357,000.00  $          17,000.00 

Purchase Price/Distribution $    2,093,000.00  $    1,433,000.00 

Basis $       (50,000.00) $       (50,000.00)Shareholder Gain $    2,043,000.00  $    1,383,000.00 Capital Gain Rate 20% 20%Capital Gain Tax $ 408,600.00 $ 276,600.00Capital Gain Tax $       408,600.00  $       276,600.00 

Covenant Not to Compete $                         ‐ $    1,000,000.00 Ordinary Income Tax Rate 39.6% 39.6%Ordinary Income Tax $                         ‐ $       396,000.00 

f $ $After Tax Proceeds $    1,684,400.00  $    1,760,400.00 

Effective Tax Rate 31% 28%

Personal GoodwillPersonal Goodwill Treats the shareholder’s goodwill as a distinct and separate

asset and not included as a corporate asset.

Martin Ice Cream Co v. C.I.R., 110TC 189.

B ll f h h “P l By allocating a portion of the purchase price to “PersonalGoodwill,” corporate level gain is avoided but the buyer stillpurchases an amortizable 197 asset.p .

Illustration of Personal GoodwillBasis $ (1,400,000.00) $ (1,400,000.00)

Covenant Not to Compete $ (1,000,000.00)Corporate Gain $ 1 050 000 00 $ 50 000 00Corporate Gain $    1,050,000.00  $          50,000.00 Tax 34% 34%Corporate Tax $       357,000.00  $          17,000.00 

Purchase Price/Distribution $    2,093,000.00  $    1,433,000.00 

Basis $ (50 000 00) $ (50 000 00)Basis $       (50,000.00) $       (50,000.00)Shareholder Gain $    2,043,000.00  $    1,383,000.00 Capital Gain Rate 20% 20%Capital Gain Tax $       408,600.00  $       276,600.00 

Covenant Not to Compete $ ‐ $ 1 000 000 00Covenant Not to Compete $                          $    1,000,000.00 Ordinary Income Tax Rate 39.6% 39.6%Ordinary Income Tax $                         ‐ $       396,000.00 

After Tax Proceeds $    1,684,400.00  $    1,760,400.00 

Effective Tax Rate 31% 28%

Deductions arising from SaleDeductions arising from Sale Accrued but not deducted expenses – 461(h) Upon assumption of debt, economic performance is deemed to

occur. Must be included as part of the proceeds from sale Must be included as part of the proceeds from sale.

Deferred Compensation

Write-off of specific assetsWrite off of specific assets

Purchase Price AllocationPurchase Price Allocation By allocating the purchase price away from items which

generate ordinary income to capital gain assets, thedifference between a stock transaction and an assettransaction for sales of S corporation stock will betransaction for sales of S corporation stock will bereduced/eliminated.

Buyers should be willing to allocate away from land andy g ybuilding to goodwill.

Allocations between parties with differing interests willll b dgenerally be accepted.

TAX DEFERRED REORGANIZATIONS

§ 368(a)(1)(A) - Merger

Shareholders

St k/$Stock/$

Target Acquiring Corp.Merger

ll

Merger Sub

§ 368(a)(2)(D) – Forward Triangular Merger

§ 368(a)(1)(B) – Share Exchange

ShareholdersAcquiring Stock

Target StockAcquiring Corp.

Ill>

Target Merger Sub

lll

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - >

g g

§ 368(a)(2)(E) – Reverse Triangular Merger

§ 368(a)(1)(C) – Stock for Assets§ 368(a)(1)(C) Stock for Assets

Shareholder

Acquiring Stock

Target Acquiring

Assets/Liabilities

g q g

Acquiring Stock

Equity Sales Treatedasas

Asset Sales for Tax Purposes

Corporate ElectionsCorporate Elections 338(g) Elections

338 (h)(10) Acquire 80% or more of stock;

B b i d Buyer must be a corporation; and Target must be an S corporation or member of an affiliated

groupg p

Failed “A” Reorganization (Rev. Rul. 69-6) All cash merger; Cross entity merger

336(e) Election

LLC/Partnership ElectionLLC/Partnership Election

l 754 Election 734 Redemption 743 Cross Purchase 743 Cross Purchase

Intra-Family Transfers

Compensation GrantCompensation GrantPursuant to Sec. 83, a grant of equity is income to the recipientand an expense to the entity.

Child P tChild Parent

Value of Grant $    400,000.00  $ (400,000.00)

Cash Bonus $    262,251.66  $ (262,251.66)

T t l $ 662 251 66 $ (662 251 66)Total $    662,251.66  $ (662,251.66)

Income Tax $ (262,251.66) $    262,251.66 

Total Cash $ ‐ $ ‐Total Cash  $                 $              

GiftGift By gifting the stock to the next generation, all appreciation

after the gift escapes gift/estate tax consequences.

Drawbacks L f t i b i d Loss of step up in basis; and Transferor may still need income.

Value of GiftValue of Gift

C U R RE N T

V A

Amount that Escapes Estate Tax

A L U E

T O D A Y

Gift

+ 20 year

Sale to IDGTSale to IDGT “IDGT” is an Intentionally Defective GrantorTrust

For income tax purposes, certain trust provisions areincluded so that the transferor is deemed to be the owner ofthe trust’s assets for income tax purposesthe trust s assets for income tax purposes

Because the trust is an IDGT, the sale does not generate anygaing

Transferor must pay tax on all income generated from theIDGT’s assets and these payments are not treated asadditional gifts

For gift/estate tax purposes, it is a completed transfer

Sale to IDGTNote

Payment

Shareholder IDGTStock

N tNote(no gain on sale)

“Corp” Distribution

Benefit of Sale to IDGTBenefit of Sale to IDGT No gain is recognized on sale Eligible to be an “S” corporate shareholder Ideal for use to transfer “S” corporation and

LLCs/partnershipsLLCs/partnerships Tax distributions made to trust can be used to pay down debt Note payments can be used to pay transferor’s taxes

Only “seed” gift is subject to gift/GST consequences Future payments of tax is an economic gift to beneficiaries but

not a taxable gift.g

QUESTIONS?

John D. Gatti, JD, CPAM bMember

Kerr Russell Contact Info:

E il j i@k llE-mail: jgatti@kerr-russell.comPhone: 313-961-0200Fax: 313-961-0388

Mr. Gatti is a member of the State Bar of Michigan, American BarAssociation Michigan Association of Certified Public AccountantsAssociation, Michigan Association of Certified Public Accountants,American Institute of Certified Public Accountants and variousselections of these associations. Currently, Mr. Gatti is Vice-Chairman of the M&A Task Force of the MACPA.

Mr. Gatti is a cum laude graduate of Wayne State University LawSchool (Order of the Coif) and a graduate of the University ofMi hi h h i d hi d i E i ith Hi hMichigan where he received his degree in Economics with HighHonors.