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Grow + Sell Your Business Part One: Organizational Structures

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The first seminar of a four-part series on growing a business and preparing it for sale led by the co-chair of Kegler Brown's M+A practice, Eric Duffee. Eric partnered with Jeff Tubaugh and Maggie Gilmore of BDO for this presentation, which focused on the fundamentals of entity selection. It detailed different entity types and the related impacts from tax reform affecting them. It also discussed concerns related to outside investors, partnerships, various structural forms and the tax impact of each.

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Grow + Sell Your Business Part One: Organizational Structures

  1. 1. 2 Entity Selection – Fundamentals
  2. 2. 3 »LLCs » Sole owner, SMLLC Single Member LLC » Treated as a DRE “disregarded entity” for federal tax purposes » Business’ taxable income included on sole owner’s individual return » Top individual tax rate 37% » Subject to self-employment taxes (FICA: SS and Medicare) » Multiple members, default tax treatment is partnership » No restrictions on owner type or number of owners » Generally tax-free formation and liquidation » Income allocated to owners and taxed at owner level » Individual owners may be subject to self-employment taxes » Active owners paid via Guaranteed Payment (versus Salary) Legal Entities for Taxation Purposes
  3. 3. 4 »Corporations » C Corporation » Incorporate at the state level; generally incorporation is tax-free » Business’ taxable income taxed at the corporate level at 21% federal rate » Distributions to owners can be taxed as dividends at 15 or 20% » No restrictions on owner type or number of owners » Liquidations to owners generally a taxable event. » S Corporation » Restrictions on owner type or number of owners: no C Corporations, certain trusts, or non-U.S. owners (limited to 100 shareholders) » Income allocated to owners and taxed at owner level » Individual owners involved in the business may take a salary » Liquidations similar to C Corporations Legal Entities for Taxation Purposes
  4. 4. 5 »C Corporations » Advantages » Business’ taxable income taxed at the corporate level at 21% federal rate » No owner restrictions and ease of ownership transferability » Federal, state and local income tax compliance at corporate entity » Disadvantages » Distributions to owners can be taxed as dividends at 15 or 20% » Liquidations to owners generally a taxable event » Sale of assets leaves owners of stock with non-recoverable tax basis in shell company C Corporation v. “Flow-Through”
  5. 5. 6 »Flow-Throughs » Advantages » Business’ taxable income may be offset with Small Business (199A) deduction, lowering individual ETR from top rate of 37% to 29.6% » Distributions to owners tax-free to the extent of tax basis » One layer of taxable gain on sale of entity or assets » Disadvantages » On current business taxable income, higher ETR than C Corporation » More complexity with income tax filings at federal, state, and local level » Partnerships: Self-Employment taxes, complexity of ownership » S Corporations: Liquidations to owners generally a taxable event, owner restrictions which may impact ability to sell to 3rd party C Corporation v. “Flow-Through”
  6. 6. 7 » Corporate tax rate reduced from 35% to 21% » Significant tax changes to entities with international operations » Individual top tax bracket reduced from 39.6% to 37%, with higher income thresholds for higher brackets (through 1/1/2026) » Flow-through entity owners ability to take Small Business 199A deduction, effectively reducing the tax on business income from 37% to 29.6% (through 1/1/2026) » Individual state tax itemized deduction capped at $10,000: this includes taxes due on multi-state business taxable income paid at the owner-level » Was there a mass change of business owners converting from flow-through entity to C corporation to take advantage of lower tax rate? » Short answer: No. Because of the double taxation of corporate profits (at corporate level, and again at distribution), many small business owners opted to keep their businesses structured as flow-through entities. Tax Reform Impacts
  7. 7. 8 Outside Investors
  8. 8. 9 »Preferences? » C Corporation » Private Equity likes an operating C Corp or use of a “Blocker Corp” to protect their investors from receiving flow-through income » Ideal if stock can be sold later @ Capital Gain rates » Partnerships » Write-off of step-up in basis » Preferential waterfalls for preferred investors Outside Investors
  9. 9. 10 »Partnership Investments » Preferred Units » Accrue an annual return » Accrual and capital contributions returned before common owner returned » Gross Income trap (covered later) » Write-off of Step-Up in Basis » Purchase Price Allocation impact » Offset to annual income Outside Investors
  10. 10. 11 »Tax Impact of an Investment » C Corp » Issue of new shares is a non-tax event » Stock basis of investors = cash investment » Partnership » Starting capital = cash investment » Write-off of step-up in basis » Issuing of new units requires additional tax calculations and special allocations » What if we are an S Corp??? » Need to do some pre-transaction restructuring Outside Investors
  11. 11. Pre-Structuring Organization of the Company Op Co Inc. (S Corp) Shareholders
  12. 12. 1313 Shareholders Hold Co Inc (S Corp) Step 1 - Shareholders form Hold Co Inc and contribute shares of Op Co Inc to Hold Co and make QSUB election for Op Co Inc. Shareholders Op Co Inc. (S Corp.) Hold Co Inc (S Corp) Op Co S Corp Shares Op Co Inc. (QSUB) After Hold Co Inc Shares Note 1: Situation #1 of Revenue Ruling 2008-18
  13. 13. 1414 Op Co Inc. (QSUB) Hold Co Inc. (S Corp) Shareholders Step 2 – Op Co, Inc. converts to an LLC Op Co, LLC (LLC) Conversion Note 1: At least one day after Step #1.
  14. 14. 1515 Hold Co Inc. (S Corporation) Shareholders Step 3 - Buyer buys X% of Op Co LLC from Hold Co Inc Buyer (LLC) Cash Alternative option – Buyer contributions cash to Op Co LLC in exchange for units Op Co LLC (LLC)
  15. 15. 1616 Op Co LLC (LLC) Buyer (LLC) Shareholders Hold Co Inc. (S Corp) Post-Closing Ownership
  16. 16. 17 » The Problem » Complex partnership operating agreements that are more difficult for the common investor to understand » Owners not seeking counsel on the economics of the tax allocations = surprises » Opportunities » Increased cash for growth / possible partial redemption of existing owners » Knowledge of industry » Rapid growth Private Equity / Family Office Investments
  17. 17. 18 » Things to know with tax allocations » Typically new investors hold preferred units with a % annual yield that is paid or accrued » Annual tax allocations are NOT based on a % of units owned » Targeted Capital Accounts & Liquidation Preferences » Income allocated to get investors to their targeted capital amount based on a deemed liquidation at book value (includes use of gross income items) » Preferred Investors will get their yield and oftentimes their investment back before the common unit holders start to receive their investment dollars back » If company value drops over time, the investment of the common owners shifts to preferred with the accrued yield Private Equity / Family Office Investments
  18. 18. 19 » Things to know with tax allocations – An example: » Owners A & B have 50/50 partnership » Private equity firm receives membership units to give it a 1/3 ownership interest for $1 million but holding preferred shares with 8% accrued annual yield » Year 1 scenario – company has $0 net income » Since PE firm accrued an 8% yield (not paid), their target becomes $1,080,000 so they have to receive $80,000 of income » Owners A & B would show $40,000 of loss each to net total allocations to $0 » Result = taxable income to PE Firm and need for tax distributions even though no income was generated Private Equity / Family Office Investments
  19. 19. 20 »Common Structure for Multi-Location Companies Entity Structuring OWNERS STORE 2STORE 1 STORE 3
  20. 20. 21 »Better Structure for Multi-Location Companies Entity Structuring OWNERS HOLDING COMPANY LLC STORE 1 STORE 2 STORE 3
  21. 21. 22 » Every state has its own unique taxes that have to be filed » State income tax » Gross receipts tax » Privilege tax » Payroll tax withholding (state, local, county, school district, etc.) » Sales tax rates (including any add-ons for specific location) » Personal property tax » Food, beverage, liquor privilege – location-specific taxes on restaurants » County taxes » Business & licensing taxes (e.g., liquor license, facility license) » Nexus issues for franchisors (market based vs cost of performance states) M&A Due Diligence Trap - Tax Filing Issues
  22. 22. Contact Information MAGGIE GILMORE, CPA Tax Managing Director mgilmore@bdo.com 614-573-7757 JEFF TUBAUGH, CPA Tax Partner jtubaugh@bdo.com 614-573-7785
  23. 23. 24 » BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through more than 60 offices and over 500 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multi-national clients through a global network of 67,700 people working out of 1,400 offices across 158 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. Material discussed is meant to provide general information and should not be acted on without professional advice tailored to your firm’s individual needs. © 2017 BDO USA, LLP. All rights reserved. www.bdo.com
  24. 24. Selecting the Right Entity: ALTERNATIVES Corporation (Inc.) C-Corporation S-Corporation Limited Liability Company (LLC) Maybe, but probably not:  General partnership  Limited partnership  Limited liability partnership  Limited liability limited partnership  Panamanian bearer corporation
  25. 25. Selecting the Right Entity: CONSIDERATIONS Protections Taxes – including losses Maintenance/ upkeep Flexibility Compensation alternatives Investor expectations/ Preferred equity structures Exit Readiness
  26. 26. Selecting the Right Entity: WHAT STATE? Somewhere else?Ohio Delaware
  27. 27. Selecting the Right Entity: FORMALITIES Proper formation documents Separate bank accounts/books/ records; flow of funds Arm’s length contracts with insiders Clean cap table Know the rules!
  28. 28. Capitalization Debt Secured vs. unsecured Senior vs. mezzanine vs. subordinated Straight debt vs. convertible debt Bank vs. other lenders Equity Common Preferred: preferred yield/coupons, “liquidation” preferences, anti-dilution, protective provisions, participating vs. non-participating “Sweat Equity”
  29. 29. Bringing on “PARTNERS” Know the value your “partners” bring to the company Prepare for the potential “business divorce” with a “business pre-nup” Transfer restrictions and buy-sell agreements Valuation + funding
  30. 30. QUESTION 1 Who owns this company? No. Shareholder Shares Issued Date Issued Date Cancelled 1 Dr. Heinz Doofenshmirtz 70 7/12/03 2 Roger Doofenshmirtz 20 7/12/03 8/1/19 3 Perry the Platypus 10 7/12/03 SHARE LEDGER for DOOFENSHMIRTZ EVIL, INC Authorized 100 Common Shares Without Par Value
  31. 31. QUESTION 2 Math! Luke, Han, and Leia start a company called Rebel Industries, LLC. Luke owns 50%, Han owns 37.5% and Leia owns 12.5%. In order to finance growth and operations, they agree to take on a preferred equity investment from Jabba. Jabba provides Rebel with $1 million for 20% fully-participating preferred equity with a 7% accruing preferred yield. 10 years later, they sell to Evil Galactic Empire, Inc. for $10 million. Which of the four owners gets most of the sales proceeds?
  32. 32. Pre-Issuance Shares Pre-Issuance Percentage Post-Issuance Shares Post-Issuance Percentage Preferred Return Waterfall for Remainder Total Luke 400 50% 400 40% - $3,320,000 $3,320,000 Han 300 37.5% 300 30% - $2,490,000 $2,490,000 Leia 100 12.5% 100 10% - $830,000 $830,000 Jabba 0 0% 200 20% $1,700,000 $1,660,000 $3,360,000 800 100% 1000 100% $1,700,000 $8,300,000 $10,000,00 0
  33. 33. QUESTION 3 Tax Math! Mr. Krabs owns Krusty Krab, Inc. Krusty Krab is a C- corporation. He lives in a state with no state or local income taxes. He receives two offers to purchase the company as follows. Assuming the only assets are goodwill/intangible assets with no tax basis, which one will produce the most after-tax proceeds for Mr. Krabs? Offer 1: Stock purchase for $10 million Offer 2: Asset purchase for $12 million
  34. 34. QUESTION 4 Can they do this? Harry, Ron and Hermione form an S-Corp called Hogwarts US, Inc. They’re looking to take on outside investment from Snape Investment Funds, LLC. They negotiate a deal to give Snape 10% preferred equity and a 5% accruing preferred return on its initial investment. Hogwarts US is generating significant tax losses and will likely do so for the foreseeable future. It’s important to everyone to continue passing these losses through to the owners after Snape’s investment.
  35. 35. Eric D. Duffee Kegler Brown Hill + Ritter eduffee@keglerbrown.com keglerbrown.com/duffee 614-462-5433