Business Owners: Exit Planning Strategy Considerations
An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money from the business. This requires planning well in advance of the transition. Here are the most common exit options:
Buy-sell agreements. When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other benefits, a well-drafted agreement:
- Provides a ready market for the departing owner’s shares,
- Sets a price for the shares, and
- Allows business continuity by preventing disagreements caused by new, unwanted owners.
A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax and nontax issues and opportunities.
One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions, however, so be sure to consult your tax advisor.
Succession within the family. You can pass your business on to family members by giving them interests, selling them interests or doing some of each. Be sure to consider your income needs, how family members will feel about your choice, and the gift and estate tax consequences.
Now may be a particularly good time to transfer ownership interests through gifting. If your business is worth less than it was several years ago or if you’re anticipating meaningful growth, you’ll be able to transfer a greater number of shares now without exceeding your $14,000 gift tax annual exclusion amount. Valuation discounts may further reduce the taxable value And, with the lifetime gift tax exemption at a record-high $5.34 million for 2014, this may be a great year to give away more than just your annual exclusion amounts.
Management buyout. If family members aren’t interested in or capable of taking over your business, one option is a management buyout. This may provide for a smooth transition because there may be little learning curve for the new owners. Plus you avoid the time and expense of finding an outside buyer.
ESOP. If you want rank and file employees to become owners as well, an employee stock ownership plan (ESOP) may be the ticket. An ESOP is a qualified retirement plan created primarily to purchase your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or wanting to supplement an employee benefit program, an ESOP can offer many advantages.
Selling to an outsider. If you can find the right buyer, you may be able to sell the business at a premium. Putting your business into a sale-ready state can help you get the best price. This generally means transparent operations, assets in good working condition and minimal reliance on key people.
Sale or acquisition
Whether you’re selling your business as part of your exit strategy or acquiring another company to help grow it, the tax consequences can have a major impact on the transaction’s success or failure. Here are a few key tax considerations:
Asset vs. stock sale. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. Buyers generally want an asset sale to maximize future depreciation write-offs.
Taxable sale vs. tax-deferred transfer. A transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization. But the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are some advantages to a taxable sale:
- The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred transfer.
- The buyer benefits by receiving a stepped-up basis in its acquisition’s assets and not having to deal with the seller as a continuing equity owner, as it would in a tax-deferred transfer.
- The parties don’t have to meet the technical requirements of a tax-deferred transfer.
Installment sale. A taxable sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business’s performance. An installment sale also may make sense if the seller wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT or the 20% long-term capital gains rate.
But an installment sale can backfire on the seller. For example, depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives. And, if tax rates increase, the overall tax could wind up being more. Of course, tax consequences are only one of many important considerations when planning a merger or acquisition.
Incentive stock options
If you’re an executive with a larger company, you may receive incentive stock options (ISOs). ISOs receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value (FMV) at the date of the grant.
Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods. Here are the key tax consequences:
- You owe no tax when the ISOs are granted.
- You owe no regular tax when you exercise the ISOs.
- If you sell the stock after holding the shares at least one year from the date of exercise and two years from the date the ISOs were granted, you pay tax on the sale at your long-term capital gains rate.
- If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates.
- If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or hold them. Waiting to exercise ISOs until just before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) and holding on to the stock long enough to garner long-term capital gains treatment often is beneficial. But there’s also market risk to consider.
Plus, in several situations, acting earlier can be advantageous:
- Exercise early to start your holding period so you can sell and receive long-term capital gains treatment sooner.
- Exercise when the bargain element is small or when the market price is close to bottoming out to reduce or eliminate AMT liability.
- Exercise annually so you can buy only the number of shares that will achieve a breakeven point between the AMT and regular tax and thereby incur no additional tax.
- Sell in a disqualifying disposition and pay the higher ordinary-income rate to avoid the AMT on potentially disappearing appreciation.
On the negative side, exercising early accelerates the need for funds to buy the stock, exposes you to a loss if the shares’ value drops below your exercise cost, and may create a tax cost if the preference item from the exercise generates an AMT liability.
The timing of ISO exercises could also positively or negatively affect your liability for the 39.6% ordinary-income tax rate, the 20% long-term capital gains rate or the NIIT. With your tax advisor, evaluate the risks and crunch the numbers using various assumptions to determine the best strategy for you.
Nonqualified stock options
The tax treatment of nonqualified stock options (NQSOs) is different from that of ISOs: NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but they don’t create an AMT preference item.
You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise. Keep in mind that an exercise could trigger or increase exposure to top tax rates, the additional 0.9% Medicare tax and the NIIT.
Restricted stock is stock that’s granted subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject to that risk or you sell it. You then pay taxes based on the stock’s fair market value when the restriction lapses and at your ordinary-income rate.
But, under Section 83(b), you can elect to instead recognize ordinary income when you receive the stock. This election, which you must make within 30 days after receiving the stock, can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. Why? Because the election allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold.
There are some disadvantages of a Sec. 83(b) election: First, you must prepay tax in the current year — and you could trigger or increase your exposure to the 39.6% ordinary-income tax rate or the additional 0.9% Medicare tax. But if a company is in the earlier stages of development, the income recognized may be small. Second, any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or you sell it at a decreased value. But you’d have a capital loss when you forfeited or sold the stock.
Work with your tax advisor to map out whether the Sec. 83(b) election is appropriate for you in each particular situation.
RSUs are contractual rights to receive stock (or its cash value) after the award has vested. Unlike restricted stock, RSUs aren’t eligible for the Sec. 83(b) election. So there’s no opportunity to convert ordinary income into capital gains.
But they do offer a limited ability to defer income taxes: Unlike restricted stock, which becomes taxable immediately upon vesting, RSUs aren’t taxable until the employee actually receives the stock. So rather than having the stock delivered immediately upon vesting, you may be able to arrange with your employer to delay delivery. This will defer income tax and may allow you to reduce or avoid exposure to the additional 0.9% Medicare tax (because the RSUs are treated as FICA income).
However, any income deferral must satisfy the strict requirements of Internal Revenue Code (IRC) Section 409A.
Nonqualified deferred compensation plans pay executives in the future for services to be currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, unlike 401(k) plans, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from the employer’s creditors.
One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture — even though compensation may not be paid or recognized for income tax purposes until much later. So your employer may withhold your portion of the payroll taxes from your salary or ask you to write a check for the liability. Or it may pay your portion, in which case you’ll have additional taxable income. Warning: The additional 0.9% Medicare tax could also apply.
Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues.
As you can see, exit strategies are complex and require detailled planning well in advance of a transition. Please call us to discuss the possible implications on your investment plan before taking any action.