The Ripcord Moment

Minimize Taxes and Maximize Profits When Selling Your Business

June 15, 2022 Joe Seetoo Season 2 Episode 12
The Ripcord Moment
Minimize Taxes and Maximize Profits When Selling Your Business
Show Notes Transcript

“Minimize taxes, maximize profits.” – Scott Gilmore, a Tax Principal at KROST. In this episode, Scott offers his expertise on important tax matters to consider when it comes to succession and exit planning for businesses.

Scott discusses M&A transactions, including what types of businesses meet the qualifications (HINT: You have to be a C-corp), and the tax implications that come with these transactions. 

He talks about purchase price allocation on a sale and how the buyer and seller must come together to agree on a purchase price. He dives into what the goals of the seller should be during this process, including allocating more consideration to capital gain items.

Scott goes over some tax-deferral techniques that can be used during the exit planning process, including the use of the installment sale treatment and rollover equity.

He talks about ways to handle the transfer of real estate and leases during a succession plan. If you already own the property, leasing to the new buyer might provide you with a steady income for the foreseeable future. On the other hand, if you are currently leasing the property, make sure that these leases and contracts will carry over to your buyer before going through with the sale.

Lastly, he shares two action items for business owners:

1.      Prepare ahead of time to save yourself money. Get professionals on your team early. A year or more would be great, but at least 3 to 6 months will give your team enough time to optimize your outcome. 

2.      A change of ownership might be difficult for some of your employees, so before you go through with a sale, talk to your employees to help you pick the right buyer. Find out what the most important things are to them about the business and their work within it. For your business to continue to be successful after a sale, those key employees will need to stick around and be happy under new ownership. 

Disclosure: Information presented herein is for discussion and illustrative purposes only. The views and opinions expressed by the speakers are as of the date of the recording and are subject to change. These views are not intended as a recommendation to buy or sell any securities, and should not be relied on as financial, tax or legal advice. You should consult with your attorney, finance professional or accountant before implementing any transactions and/or strategies concerning your finances.

Joe:

Welcome to The Ripcord Moment. I'm your host, Joe Seetoo. Today we're joined by Scott Gilmore. He's a tax principal at KROST. Scott has over 20 years of professional experience as a tax advisor to his clients. And Scott, I'm so, so fortunate to have you on the podcast today. Looking forward to our conversation. Specifically related to and tapping into your expertise on tax matters that owners need to think through, especially in the sort of COVID environment we've been in, in terms of what they need to think about for a tax perspective before they go through some sort of succession event. So welcome to the podcast. I'm looking forward to our conversation. 

Scott:

Thanks, Joe. Happy to be here. Yeah, the M&A frenzy is going on right now. We're seeing a lot of action there, both COVID related and non-COVID related. So definitely some tax implications for all buyers and sellers from different angles and different problems for different folks. And I'll look forward to discussing what it looks like from each of our standpoints.

Joe:

So let's dig into this, because tax is obviously one of those things that, you know, everyone hates paying. Oftentimes it tends to be sort of a focal point around the mindset of any owner, whether it's in their financial plan, which we're dealing with, or specifically when a when an owner goes to sell their company, how to minimize the taxes. So what are some of the tools in your toolkit that you bring to the table that can help sort of ease the pain when a client goes through a transaction like this? 

Scott:

Sure. So, you know, essentially the key to all of these transactions is being prepared. Right, there's options, there's different ways you can sell, different types of sales, price allocation, depending on what type of company you are, an LLC, an S-corp, a C-corp. So the tool kit can change depending on what kind of company you are, what you're looking to do and what kind of deal your buyer wants to bring to the table. And so you need to be in touch with your attorney, your wealth advisor, your CPA, and make sure that everybody is having their area of expertise heard and explained, before you go through with the transaction. On my angle from the tax side, there are certain things that we have people do depending on the type of company in order for them to maximize the amount of cash that's left in their pocket at the end of the day. Right. That's the goal. There's going to be some taxes. There's rare situations where you're not going to have a tax hit. Sure. But the goal is to make it as small as possible. Right. 

 Joe:

So one of the common ones that we hear about is qualified small business stocks or IRS 1202. And while I'm familiar with it, I'm certainly not an expert in it. But I think this is an area you have a lot of knowledge.Let's talk a little bit about how that might be appropriate for certain clients to explore if they're not familiar with it. 

Scott:

Sure. So 1202 is a huge windfall for the right client. Right. 1202 small business stock offers you at this point in time the way the law is written, a 100% gain exclusion equal to either the greater of $10 million or ten times your basis. So if your basis is a million it's 10 million capped. If your basis is 10 million it's $100 million of gain you could exclude. That means you're not paying tax on that money. It's rare to see a situation where you have that type of benefit come your way. Now, this doesn't necessarily apply to the state depending on what state you're operating in, but that's a federal exclusion from taxable income and can double, triple the amount of money in your pocket if done correctly. The issue with 1202 is not everybody qualifies. It's really kind of honed in on a certain segment of people and types of companies that qualify. In kind of high level, I can walk you through some of those requirements. 

Joe:

So certainly our audience is going to know, well, do I qualify? Right. Who does qualify for this?It sounds like a tremendous opportunity for, again, the right clients. So who are those right clients? 

Scott:

Correct. And you want to know it as you're setting up your company to as thinking about in the back of your head if you maybe a company like this. So the first thing I think there's about six or seven different qualification standards and I think the first one, the easiest one to talk about is type event. This only applies to C-corps. So S-corps and LLCs, which in my practice I see a ton of, closely held businesses are oftentimes organized as what's called flow through taxation, which are your S-corps and your LLCs. C-corps have double taxation, but only C-corps could qualify for this benefit.Taking that even a step further, only certain types of businesses qualify for this benefit. Well, the way the code is written, they say these don't qualify and these are the ones that do. And so in the don't qualify section, I have a list here. Health, law, engineering, accounting, basically anything where the principle asset of the company is name or reputation or skill of a person or employee. Right. So they're trying to say, hey, professional service providers, you really are not going to be included in that. Secondarily, financial institutions, banking, insurance, investments, those don't qualify. Farming doesn't qualify. Oil and gas doesn't qualify. Real estate and hotels don't qualify. So all of these investment type opportunities are out. And so it leaves you with mainly manufacturers, distributors, wholesalers, those types of businesses that are heavier on the employment side, they've got a leader associated with them, and they are manufacturing or distributing some type of product. It's not service based. 

Joe:

It's capital oriented, generally speaking. Yes. For a rule of thumb. 

Scott: 

Yes. So for example, and there's other qualifications, but that takes out a good chunk of closely held businesses. But there's also your family. Your family owned Merrill Machinery Company. That's on its third generation, and maybe they're ready to sell that company at some point.

Joe:

So let me propose a hypothetical here to you. So let's say, you know, we're working with a manufacturing company that's out there, and they are contemplating at some point likely thinking about some sort of exit, not a family succession event, potentially to a third party or whatever it might be. They start off as an S-corp. They hear about this. What's the sort of analysis that you would put them through or consider? Does it make sense to convert from an S-corp to a C-corp, given the fact that you mentioned, there's double taxation on the C-corp, but there's a potential capital gain exclusion benefit. Is there sort of a rough outline that you could help sort of walk us through to think through or at least think through what might make sense for that type of client?

 

Scott:

Yeah, I think really the only way to do this is to model it out. You pick a time frame, call it ten years, and you look at the differences and what it's going to cost you from an operational standpoint over those ten years in taxes by being a C-corp. What does double tax look like to get the same dollars in your pocket? You see what that dollar amount is, and then you compare that to the potential gain exclusion you could be looking at. It's tough because you don't know what you're going to get purchased for or when you're going to get purchased. And so essentially there's this you have to take a risk when you look at it from that perspective. But it's worth looking at because this benefit is so huge. 

Joe:

Right. Okay. Well, this is a good cursory or good deep dive on the 1202. Is there anything else you think will be good for our audience to cover on 1202 or should we move on to other tools in your toolkit?

Scott:

 I think it's worth exploring. There's a couple other qualifications that you need to go through, and I think that people would like to know about that. Number one, you got to hold the stock for five years, right? You can't form a company, a start up in two years. Here comes Amazon and they're going to buy you that would not qualify for a small business. So you got to hold it for five years. Another one that's important is called the original issuance of stock, which means you have to get your stock from the company itself. If Joe has stock, I can't come buy it off you and qualify for 1202. I need to get the stock direct from the company in exchange for cash or for services.

 

Joe:

So it sounds like both of those, just to jump in here, if I'm sort of interpreting between it, it's they don't want someone speculating from an investment standpoint and they don't want second hand, an acquirer, benefiting from sort of the founder or the original owners intent it's really meant to benefit longevity, growing an enterprise of a business that's employing people for certain hopefully a long number of years and then rewarding them for their, you know, their sort of growth of that company and supporting the economy.

 

Scott:

Yeah. This is a founder benefit, this is an entrepreneur benefit. And this is meant to have people incentivized to create their own companies and for founders to have an exit that has tax advantages for them. There's also a size limitation that I think is important. You have to be $50 million or less in tax basis. And the way they measure that is they measure that after the issuance of the stock and every time you issued stock. So if you were to start a company with let's just say $2 million, your basis is obviously under 50, you're fine. But if you go into the company issued stock to somebody else for, let's say, $50 million, and so after that transaction, you're a $52 million company. You would be ineligible for a 1202. So that $50 million price point or asset base is a very important thing to keep in mind because you can be right there on the cusp and that could be the difference between qualifying and not qualifying.

 

Joe:

So it sounds like again this is really meant for the smaller entrepreneurs. They didn't want this to benefit sort of companies that have blown up or that are really large in nature.

Scott:

And the last requirement that I think is important to think about is, it's got to be an active business. And I think that kind of goes hand-in-hand. It's not for, you know, investing in other companies or owning stocks and bonds. It's for operating business that you put your blood, sweat and tears and built up to something that the third party is interested in acquiring. 

Joe:

Okay. Great, Scott, thank you for the education on 1202. Maybe we can move the conversation along. Maybe another tool in the toolkit one that I've commonly heard about, which is purchase price allocation. Talk to us a little bit about how you work your magic there and what that means for a seller. 

Scott:

Sure. So at the end of the day, your tax ramifications are very much tied into your purchase price allocation. And I'd be remiss if I didn't mention there's two basic types of sales: a stock sale and an asset sale. Most of the time you have an asset sale. And so when we talk about purchase price allocation that's essentially tied in to an asset sale and allocating that purchase price over the type of assets that you're receiving. Right. There are two types of income that you run into when you normally and of course, when you sell a business: ordinary income and capital gains. The goal here is obviously to get as much capital gain income as you possibly can. Your tax favorite rates, top rate for ordinary is 37% federal, top rate for capital gain is 20%. So right there you have a 17% spread you can take advantage of. When you do a purchase price allocation the buyer and the seller have to agree on it. Oftentimes what's advantageous tax wise for one is not for the other. And so this is a point of negotiation when you're doing a deal right. The things that I would want people to walk away with is ordinary income comes from a few common things. And these are things that as a seller, you don't want price allocated to. The first one is your inventory, right? Your inventory, if your allocation to it is above market value or above purchase cost, you have ordinary income. Same thing if you have receivables that you've written down and you sell them for full value, those also give rise to ordinary income. The main thing to really think about is most deals involve some type of handcuff, covenant not to compete, solicitation agreements, things that kind of lock you in. Those agreements are ordinary income as they are compensation. And so when you're negotiating the deal as a seller, you want as low of a price as possible allocated to your covenants, so that you have less ordinary income. Goodwill is a very good place for an allocation because that's capital gain. 

Joe:

I mean, this might sound like a silly question but are most attorneys well versed in this, or does it typically require coordination among the tax professional like yourself with the attorneys typically negotiating deal, perhaps with the investment banker in these transactions. Talk to us a little bit about that.

 

Scott:

Yeah, I do believe that most attorneys and bankers are well versed in the basics of it, there could be more nuance in more complicated deals where they may need a little assistance from an expert on the tax side. But, you know, most attorneys and bankers and brokers that are doing these deals have done enough of them that they know what the common pitfalls are. They know what the seller's looking for. I believe that they are negotiating with these thoughts in their head.

Joe:

Is there anything else you want to cover on purchase price allocation? You think we've fully covered it there? 

Scott:

I think the most important thing is it's not something you want to take lightly. There's a form called 8594. It goes with your tax return. But the buyer and the seller have to attach it. And if you have a mismatch on that, you disagree on the price your chances of, you know, that are going to go up. And so I would just like to remind people that this gets issued and this gets recorded with the IRS. They know what you're doing. And so don't take don't overlook the importance of your allocation.

Joe:

Got it. Don't take it lightly. Great tidbit, Scott. So we talked a little bit about 1202 and purchase price allocation, what other techniques should sellers contemplate or think through as they're thinking about structuring their deal, that again is going to help them not avoid taxes but manage the tax bite?

 

Scott:

Sure. So one thing we always do in tax planning in general is looking for deferral techniques. There's very few exclusion techniques out there where you don't pay taxes, but there's a lot more techniques out there that work as deferrals, deferrals of tax down the road, the time value of money type situations where you can hold onto your cash. And one of the most basic ones, and they're common with deals is to do an installment sale. And what I mean by that is you strike a deal with a buyer and through that, you don't receive all the cash upfront you receive it over a period of time. There could be a payment in six months, 12 months, a second payment in 24 months. Depending on the business, there's a lot of different times that those remaining payments may come in effect. With the tax code, if you're receiving payments over time, you can defer the tax until such time as you receive the cash, kind of a matching principle. One thing I want to mention about that is this only works with capital gains. Any ordinary income components, must be recognized year one, whether or not you get the cash. 

Joe:

Really. I got to just jump in, but I got to imagine this is exactly why that purchase price allocation that we talked about a few minutes ago, you got to be really cognizant of what that's like, especially in an installment sale. Otherwise, might really back yourself in a corner or have an unfavorable tax liability sooner than you might have anticipated. 

Scott:

You may. Now, oftentimes the lion's share of the deal is cap gain through a goodwill allocation. So you're okay, but it certainly is something you got to think about because there could be a certain company that has a large covenant associated with it, but a payment that doesn't necessarily match the tax liability, and then you're stuck having to find where the cash is going to come from. So most deals do involve some installment sale with an earnout clause or some type of payment that comes down the road based on performance. 

Joe:

But actually I also want to take this to a level in terms of us as financial planners where I think the communication style, and you and I share a number of clients, we work very closely together, where the communication between the advisors, in this case, the financial advisor and the tax professional and the client, if they're in a situation where there's this sort of installment sale structure, right. That that is really thoughtfully put into their financial plan and that their cash flow model accurately reflects the transaction so that the client really is not caught off guard on making those tax payments or on sort of what cash they have because after the sale, they may want to go buy that second home or pay off their mortgage or whatever it is buy that boat or yacht they've been dreaming about. But that's importance of, you know, coordination between professionals and how it overflows into what we do as financial planners. 

Scott:

Well said. Because oftentimes we know when the tax payments are going to come due and you come up with an investment strategy and an allocation strategy from a financial standpoint where you can maximize your earnings to help you pay your tax bill, knowing that that cash is going to be due in 6 months, 12 months, and investing in short term or long term asset classes that help you accomplish those goals. So the coordination is key. 

Joe:

Maybe we could pivot the conversation to an area I think you have a lot of expertise in and passion, and that's in real estate. And so oftentimes we see right owners, many of them acquire the real estate that's associated with their operation. Talk to the audience a little bit about some just thoughtful tax planning that needs to occur, whether or not they sell the real estate as part of the package with the business or if they're separate.

 

Scott:

You know, most of the time in the deals that I've been in, the real estate is something that the seller wants to hold on to. So oftentimes they want to keep the real estate they see it as a family asset, but the buyer wants to maintain use of that facility to run the business out. So you have two components that come into play there. One is usually there's a sweetheart lease that goes on between common on businesses. You own the real estate. Your company is out of there. They probably have a pretty nice lease payment, things happen there. One is when your buyer comes in and does due diligence, you're having a more favorable EBIDTA because your lease payments less than maybe market value. And so I don't think you're going to advertise that, but that's probably something that's going to come out to the buyer. They're going to look at that number and decide, well, what's the lease payment going to be when I'm now the owner? Now, on the flip side of that, because you own both sides, you can probably mark up your rent to fair market value. And so the amount of income and essentially cash flow you can get in real estate, it's great because you get cash, you use depreciation to pay less taxes so you can up that rental payment now that a third party is leasing from you and use that to supplement your cash flow. Maybe you're not getting your salary from the business anymore, but now you have increased cash flow from the rental property and that's helping you to live your lifestyle. Things to think about when you're deciding, do I sell the real estate, do I not? Not to mention that appreciation in California, especially over time on real estate as averaged, what, north of 5% on a bad market per se? Yeah, it's been pretty good. It's usually a pretty good asset to be associated with. 

Joe:

As we move into the last few minutes here of our time together, talk to us a little bit about as we approach the transaction itself. And maybe the quality of the earnings of the business, what are some of the financial and other things you encourage an owner to wrap up and do as part of getting prepped for due diligence on a sale? 

Scott:

Sure. So first things first. You may be hit with an unsolicited offer, that's a great thing, or you may take your company to market with a broker looking for sale, either which way have your financial house in order. Somebody who's going to buy your company is going to have a due diligence period and they're going to come in there and their job during due diligence is to find out what's wrong, not what's right, but what's wrong, and where they can say, wait, wait, wait, your EBITDA's lower, I should pay you less money. That's essentially what they're trying to do. These sellers are getting consultants. They're hiring consultants to come in there. They're doing their own quality of earnings study on your company. They're looking at your financials. You're giving them your ledgers with all your books and records. Oftentimes you have personal expenses running through there. You want to make sure that you have worked with your professional team: your accountant, your wealth advisor, your attorney, and you've cleaned that up, and the package that you're handing to the buyer is clean, is concise, is usable, and doesn't lead to more questions that you may or may not want to answer. Not to mention that it gives them confidence, and what they're looking at is truthfully what's going on. Now most of the time that's the case, but isn't everything. What's behind door two, what's behind door three? Clean up ahead of time, have the best possible package you can hand to any potential buyer.

 

Joe:

Now, that's really helpful. It's you know, you're trying to promote confidence, right? That the reporting reflects accurately the reality of the business. If they're not in alignment, if you're making verbal representations about your clients, your revenues, your margins, and they don't match to the financial statements well, that plants a seed of doubt in the potential buyer's mind and all of a sudden the risk goes really up around the consistency and the quality of those earnings. 

Scott:

They'll want to dig in a little deeper at that point. And the other thing I would say is figure out who's going to coordinate with that other team. Oftentimes it shouldn't be the owner, it should be your accountant, it should be your attorney, who's answering those questions because that person is more in the weeds in terms of what those numbers mean, not operationally speaking, but how they are represented in the financials.

Joe:

I mean, the owner should be running the business, right? Not necessarily in the weeds like you're saying. Well, Scott, you know, we call this the ripcord moment. I'm a firm believer that when an owner goes to sell or transition, have a succession event, that they've got to have their parachute ready to go. Their ripcord can't fail. And for many owners, it's a once in a lifetime opportunity. They have a lot of emotions going on. So I always ask our guests, our professionals to share 2 action items that owners should consider sooner than later to ensure the viability and the resilience of their business. So what would those two items be from your perspective? 

Scott:

Well, the first one is going to be a bit repetitive, but I can't say enough. Prepare ahead of time. Make sure that you don't call your accountant hey, I just sold my company, our escrows closing tomorrow, and you leave an opportunity, a planning opportunity for a type of entity, change opportunity on the table that could have saved you money. Get the right professionals that are trained in their specific areas of expertise on your team. It will save you more than it costs you nine and a half times out of ten. 

Joe:

So real quick on that, you know, from a tax standpoint and a financial reporting standpoint, in general, what's a decent rule of thumb for someone like you and your team, the longer the better, but what's at least a reasonable number? 

Scott:

Three to six months would be nice.

 

Joe:

It doesn't seem like too much of an ask. 

Scott:

No, I mean, a year's great. But you know, three months is enough time to do a lot of things. It just depends on how big of a lift that might look like. 

Joe:

Understood. Thank you. And then the second one?

Scott:

The second one and I've seen this from personal experience, is oftentimes these are closely held businesses. You've had employees with you for years, maybe even generationally speaking. The change you control, the change of ownership is difficult for them. It's massive. Yes, massive, and you don't know where their pain points might be either on the buyer side or on the employee side. So my advice to people is talk to your employees, figure out what's important about the company to them, what things you're doing that make it work. Because oftentimes for the business to succeed for the next owner, those key employees need to be around and they need to be happy. So you've got to figure out how big of a change it's going to be, what their plans are, and talk to the buyer and pick the right buyer, who's going to be able to retain your key staff, because chances are you have an earnout that's tied to it and you want to realize that money. 

Joe:

Now, I think that's sound advice, Scott. Those are good pearls of wisdom. So let's go ahead and wrap it up. Scott, thank you again for your time today, your expertise. It's always great to connect with you. Well, and for everyone in our audience, thank you for listening. This is Joe Seetoo to signing off from The Ripcord Moment and we'll see you next time. 

Scott:

Thanks, guys. 

Joe:

Thanks, Scott.