Part 5 of the "Process-Oriented Approach to Family Business Succession Planning" Blog Series
Taxes. According to the old adage, taxes are one of only two things certain in this life. As we continue to focus on understanding and setting the goals which will drive the succession planning process, the notion of taxes will likely occupy a most prominent position. We have previously discussed the importance of clear vision relating to ownership and management succession, as well as the financial needs of the owner. And while the owner and the successors may be able to succinctly describe how they envision the implementation of the transaction from a practical perspective, the application of income and gift taxes to a transaction does not necessarily follow the same logical progression. So before any contemplated transition moves forward, it is imperative to engage the assistance of experienced tax professionals to avoid the possibility of unintended tax consequences derailing the transition, or worse yet, generating unanticipated costs that operate to frustrate the cash flow and financial benefits the owner expected.
It is critically important to understand that any accession to, or disposition of, wealth carries a potential tax consequence. Will the transition involve a sale, or put another way, an exchange of consideration between the parties? For instance, if shares or assets are exchanged at fair market value, the transaction will be respected as a sale between the parties. The selling party will recognize a capital gain based on the difference between his or her adjusted tax basis in the property sold and the amount realized on the sale. The best case scenario for most sellers might involve the sale of company stock since it would generate a capital gain taxed at a favorable rate. Most purchasers, however, are not interested in assuming the liabilities of the company that come with a stock sale, and would prefer to purchase assets so that they may achieve the tax benefit of the depreciation deduction attributable to those assets.
Consider further that the capital gains rate could actually range between 0%, 10%, 15%, 20% or 23.8% if it is a long term gain. But if any part of the gain is short term, or is susceptible to depreciation recapture, the tax could be as high as 43.4%, which is the current maximum rate on ordinary income. And depending on the jurisdiction involved, the rate of tax is likely to soar even higher from state taxes. So when all is said and done, the selling party may end up putting far less in his or her pocket after accounting for the tax bite.
In addition to structuring a transaction around favorable rates, taxes may also weigh heavily on the negotiations between the parties related to whether payments made are tax deductible or not. As mentioned above, a seller may want to receive as much as possible for stock to take advantage of the favorable capital gains tax rate. A purchaser, however, may prefer to structure the deal to involve payment for stock, as well as to include a payment for a non-compete clause, or a payment for consulting services. Consider the fact that a purchaser is using after tax dollars to fund the acquisition of stock, but is using tax deductible dollars to fund non-compete or consulting payments.
And what if the transaction between the parties does not occur at fair market value? For instance, in an intra-family transaction, the senior generation may conclude that they simply want to transfer ownership by way of gift, or perhaps at a discounted price, which would be treated as part sale, part gift. Depending on the value of the gift, the owner may face exhausting his or her lifetime gift tax exemption to shelter the gift from tax. And if the value exceeds the available lifetime exemption, gift tax must be paid. A similar result could ensue if the transferee is not a family member. However in a business context between unrelated individuals, what may have been intended to be a gift could actually be treated as compensatory in nature, generating an income tax consequence to the person receiving the interest in the business.
The tax consequences in a business transition will be significant, and it is critically important to carefully structure the transaction since the net cash received or paid after taxes could differ dramatically.
Read other posts in our "Process-Oriented Approach to Family Business Succession Planning" Blog Series:
Part 1: Effective Business Succession Planning: A Call to Action
Part 2: 18 Must Answer Questions for Family Owned Business
Part 3: Balancing Family Relations with Family Business
Part 4: Identifying the Business Owner's Goals - Cash Flow and Financial Planning
Part 6: Business Succession Planning: Keeping Your Buy-Sell Agreement Relevant
Part 7: Business Succession: Who Are the Stakeholders and How Can You Satisfy Them?
Part 8: Don't Let the Failure to Communicate be Your Business Succession Plan's Downfall