Jim Boom owns a small funeral home. The business is a “C” corporation. The corporation has a “triple net” lease on the real estate which is owned by a separate Limited Liability Corporation (LLC). Based on EBITDA the business AND real estate combined are worth about $550,000
Fortunately for Jim, the real estate is worth $700,000 if used for other purposes. One of his competitors has offered him $200,000 for the corporate name, goodwill, files, and phone number. He now expects to reap $900,000 at the closing. But has he considered the tax cost of the sale. It’s not what you get…it’s what you keep!
ANY exit strategy, MUST include an assessment of tax implications and plans for their minimization. Preferably this has been part of planning all along. Unfortunately for many small business owners it is an afterthought and they are very disappointed to learn that they are going to keep far less than they thought. All their years of hard work growing and managing a successful business often seems to evaporate.
Let’s take a few minutes to review Jim’s deal:
Fortunately, the real estate is owned outside the Corporation in an LLC. Unfortunately, Jim’s business entity is a “C” Corporation.
The LLC: In the world of taxation, an LLC is known as a pass – through entity. That means that the tax will be paid at the individual shareholder level based on the gain at the federal capital gains rate at the personal level.
The “C” Corporation. You may have heard the term “double taxation’. For Federal income tax purposes, a “C” Corporation is recognized as a separate tax paying entity. Corporations are completely separate from their shareholders/owners, thus they are also taxed separately. “C” Corporations do not enjoy the benefit of the lower capital gains rates.
Here is where a “C” corporation becomes problematic for Jim. For liability reasons alone buyers are rarely willing to purchase the shares of a small corporation. They prefer to buy assets including good will. This means that Jim’s buyer will buy the assets directly from his “C” corporation and any gain on that sale will be taxed at regular corporate tax rates. Whatever is left and distributed to Jim will be taxed AGAIN as ordinary qualified dividends. Since virtually all of the assets being purchased are goodwill, it is almost all taxable to the corporation.
There are some things Jim could do now to reduce his tax impact as well as strategies that would potentially have reduced it further had he taken action much earlier.
Starting with reality:
If Jim sells the assets of the corporation to the buyer for $200,000 the corporation will pay the following in federal taxes PLUS whatever his state requires.
The deal as initially structured:
Tax Strategy Scenario 1: Tweaking the deal
Let’s assume that:
Jim speaks to his tax advisor who suggests that a better way to structure the sale might be to have the buyer pay a lesser amount for the assets of the business and the balance of the purchase price in a non – compete. (Please note that the allocation of purchase price is reported to the IRS on Form 8594. The allocation must have some economic basis and must be reasonable.)
Instead of selling the assets of the “C” corporation for $200,000, Jim’s tax advisor suggests that they be sold for $10,000 (which an independent expert says is a reasonable value). Jim then enters into a 5 year non – compete payable at $38,000 per year for a cumulative total of $190,000.
How would his tax situation change?
Some Good News
However, in addition to the proceeds Jim receives in year 1, in years 2-5, Jim will continue to receive $38,000 annually for his non-compete agreement. Assuming an effective tax rate of 20%, Jim will receive another $121,600 after taxes, bringing the total of what he gets to keep to $768,234, almost $50,000 more than his initial strategy.
Yes, we realize that Jim should consider the present value of that future cash stream. But even then he is receiving more cash than he would have with the original deal. But let’s not complicate things. At the end of 5 years he will have gotten more cash than he would in the original deal.
The Moral of the Story
You have worked hard all your life. You have planned and orchestrated a successful business. Why not take the time to orchestrate a successful and abundant retirement?
“ Janice has been a practicing Certified Public Accountant since 1980 when she graduated from Adelphi University and began her career working for Deloitte LLP. Her experience is extensive and varied, serving both the public and corporate sector for over 30 years. Janice established her practice in 1990. She has served privately owned businesses in many different industries; but a full 1/3rd of her practice includes independent funeral homes. She offers proactive strategic advice, in addition to assisting with acquisitions, sales, expansions, financing, and tax planning. Janice is a member of the AICPA and the New York State Society of CPAs.”