Plan now for inside buyouts

Succession planning took a hit in recent years. The financial crisis of 2008 touched off an unnerving chain of events for business owners looking for an exit. Constrained lending diminished the number of able buyers and lowered valuations. Baby Boomers, particularly those close to retirement, were forced to put plans on hold. Now a confluence of financial and political factors—from an improved economy to concerns about a possible sharp rise in tax rates known as the tax cliff—is turning some patient sellers into more eager ones.

For companies that have deferred succession the past few years, there is still time to implement a plan before Jan. 1, when capital gains tax rates are scheduled to increase. CPAs can take an active role by helping business owners pick the best option and showing them why timing matters.

Tax cuts originally passed during the George W. Bush administration relating to capital gains, dividends, and ordinary income are scheduled to expire Jan. 1. Without congressional action, the top rates, now at 15%, will reset to the rates immediately before the reductions, generally 20%. Also, surtaxes imposed by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, (one of the major components of health care reform) could add another 3.8% to those rates, depending on income.

For succession-minded business owners, inside buyouts have been a timeless and reliable exit strategy. Inside buyouts are diverse, applicable to a full range of economic conditions, with a company’s circumstances and the seller’s tax situation driving the choice. For many, the nation’s looming tax cliff could make now the right time to implement an exit strategy. This article discusses different ways to structure an inside buyout and explores the advantages and disadvantages.

INSIDE BUYOUT DEFINED

An inside buyout is the process of transferring ownership of a private company to key managers themselves, key managers in partnership with private equity, employees and employee stock ownership plans (ESOP), or family members.

Inside buyouts have several important advantages when compared to third-party sales, which even in a strong economy can be difficult. The first advantage: Inside buyouts offer control to the seller, including the timing of the sale. Also, the parties in the transaction already know each other. That familiarity can help accelerate the process with the tax cliff looming.

“The transaction due-diligence process is always a rigorous discipline,” said Andrew J. Sherman, mergers and acquisitions partner with international law firm Jones Day. “But when an inside buyout is proposed and the parties are predisposed to a result, the favorable outcome is often significantly accelerated.”

Helping a client properly execute an inside buyout is beneficial for the CPA because it enables the CPA to have an active and strategic role in the company’s future. Also, an inside buyout most likely means a continuation of the business relationship.

TAX CONSIDERATIONS

This article discusses a range of buyout scenarios, and in most cases the tax impact is a material aspect of the eventual transaction structure. So before discussing the different scenarios, it is helpful to think about the tax considerations. Many buyers favor an asset sale to obtain a “step-up” in basis of the assets and to limit their exposure to liabilities of the target corporation. With a stepped-up basis in the assets, the buyer recognizes less gain on the assets’ eventual sale and greater depreciation and amortization while they are owned.

Assuming that exposure to the liabilities of the target corporation can be managed, a buyer may agree to a stock transaction under the provisions of a Sec. 338(h)(10) election. Under this election, the buyer purchases the stock of the seller, but the sale is treated as an asset sale and the buyer still gets a step-up in basis for the assets purchased. The seller pays tax on the (fictional) asset sale instead of on the stock sale and generally demands a higher purchase price in return for its tax cost in agreeing to the Sec. 338(h)(10) election; however, the seller may agree to absorb all or a portion of the additional tax cost for the advantages of having a stock-based transaction. The buyer may find that depreciation or amortization of large asset amounts (such as goodwill) will be a tremendous benefit for which it is worth agreeing to an increased sale price.

If an asset purchase is adopted, there may be considerable issues regarding the allocation of the purchase price under Sec. 1060. Under the rules in Sec. 1060, a taxpayer is required to allocate the purchase price using the residual method in Sec. 338(b)(5). However, if in connection with an applicable asset acquisition, the parties agree in writing on the allocation of the purchase price, or to the fair market value (FMV) of any of the assets, the agreement is binding on both parties for tax purposes unless the IRS determines that the allocation (or FMV) is not appropriate.

Most middle-market entities have made an S corporation election (rather than remaining a C corporation). Private-equity resources often favor C corporation status because it allows for greater flexibility in crafting equity incentives for management and permitting various levels of investment by partners. While it is technically possible for corporations to migrate between C and S status, making changes must be accomplished in light of complex tax regulations. For example, making an S election after many years as a C corporation exposes the shareholders to possible built-in gain taxes if the assets of the company are subsequently sold before completion of the lookback period (five, seven, or 10 years, depending on the circumstances). The point of this discussion is that a consideration of applicable taxes merits a thorough review by professionals to ensure that transaction costs are minimized.

MANAGEMENT BUYOUT

Often a sentimental favorite, this strategy is frequently dismissed because of the perception the key employees do not have the financial resources to acquire the business. While the economics of the proposed transaction places many firms beyond the reach of key employees, there are strategies to consider. It is important to begin succession planning early to allow key employees to use future company cash flows for the acquisition. Even if the acquisition-related payments are received in succeeding years, the transaction can be structured to be taxable under today’s federal tax rates by opting out of installment-sale treatment of the gain and paying the tax in the current year.

The ideal circumstances for an internal transition occur when the seller and buyers have worked well together for years. The seller often is willing to help finance the transaction but expects key employees to make a substantial financial commitment. Key employees still must raise some of the money themselves—from family, home mortgage, savings, etc.; guarantee buyout-related debt (from a bank and the seller); and discuss with their “team” (family, other investors, etc.) the risk involved. This commitment is appropriate because the potential financial gain is the greatest for key employees once the acquisition obligations are repaid.

The buying group should appoint a leader responsible for completing the transaction and for other roles. Leadership includes discussion with the owner on succession planning and often sensitive contingency plans for events such as failing health.

The decision to embark on a management buyout can be reached quickly, which means tax plans can be created to reduce or eliminate exposure to higher rates. However, the execution of the buying group’s plan—from employee buy-in, raising capital, and repaying the obligation—takes time.

Valuation of the business today includes a firm’s intrinsic value and is a big part of the negotiation. For business valuation experts, the intrinsic value standard is close to an income approach using discounted cash flow, similar but not identical to FMV. FMV assumes the purchase price is for cash, but negotiated transactions can include a range of options, including financial earnouts, management consulting agreements, deferred compensation, and financial-aid packages—often with incentives such as warrants.

As discussed above, the most tax-efficient structure for the seller often is a stock sale, yet the buyer typically prefers an asset acquisition because the subject property may be depreciated or amortized as appropriate, and unknown liabilities stay with the seller. The eventual transaction will consider the objectives of buyer and seller, but it has to make sense from a cash flow standpoint. Often, asset sales (or deemed-asset sales) are combined with other elements such as bank assistance, balanced financing package regarding seller notes, deferred compensation to the seller, and an earnout based on an easily verified variable (such as sales).
 
MANAGEMENT AND PRIVATE-EQUITY BUYOUTS

When the transaction is beyond the means of key employees or beyond the economic comfort level of the owner for seller financing, the spirit of an inside buyout can be accomplished with the introduction of a private-equity (PE) resource. Banks are often limited by the amount of debt financing they will accept, so if a company is valued at, say, $10 million, tapping into PE can be useful.

Though many PE resources exist, it is difficult to play the financial match game and find a financial partner who shares the vision and interests of the buyer and seller. Locating the PE firm with the right industry acumen, commitment to management, appropriate investment time horizon, and access to buyout capital is a challenge. Key managers might not have the time or expertise to effectively evaluate PE candidates. After all, they have a company to run. CPAs should take an active role in the selection, or, if they lack that expertise, contact another CPA or other professional contact with knowledge of PE.

“For objectives to be realized, it is essential to locate the best private-equity resource for the particular company,” said Dennis Roberts, CPA/ABV, chairman of investment banking firm The McLean Group. “Positive chemistry between the principals is integral to success. With so many firms to consider, retaining an experienced investment banker to expedite the selection and closing the transaction is a worthwhile option to consider.”

One major advantage to PE is its ability to offer a substantial percentage of the purchase price in cash (at least 80%) at closing. Management will attempt to negotiate the most favorable percentage of equity participation. That amount depends on several factors. Do the key managers have the skills and customer contacts essential to the business’s success? What role will those managers play in the future?

PE typically directs the structure of the transaction and arranges financing. Key managers often do not have to make the same level of financial commitment as required in a management buyout without PE because they lack control and their financial upside is limited. In many cases the key managers will likely be able to negotiate 10% to 20% of the final amount as their long-term financial incentive, subject to the attainment of mutually agreed goals.

When PE is involved in a buyout, optimal tax efficiency is achieved through a stock sale. The decision to acquire stock or assets is negotiable depending on the circumstances. If there are no material contingent liabilities associated with the company and the PE resource is likely to resell the business within five years, a stock sale often is considered. An asset purchase could be desirable to the PE firm if unknown liabilities are potentially material and there are significant high-turnover company assets (receivables and inventory) and rapidly depreciating items such as equipment.

ESOPs: THE TAX-EFFICIENT OPTION

ESOPs are qualified defined contribution plans that allow employees to own the company’s stock. They offer a wide range of tax incentives and favorable attributes (see “The ESOP Exit Strategy,” JofA, March 2010, page 32). The sale to an ESOP is always a stock transaction subject to favorable capital gain tax treatment (and, in certain cases, the full amount of the tax related to the transaction can be deferred if stock in a C corporation is sold to an ESOP).

The selling owner may like the tax advantages of the ESOP, and management may like that new outside owners are not coming in, but research shows that ESOPs (and employee ownership), when combined with effective communications, also result in companies that financially outperform non-employee-owned counterparts significantly (Shared Capitalism at Work, edited by Douglas L. Kruse, Richard B. Freeman, and Joseph R. Blasi; University of Chicago Press, Chicago, 2010). Data compiled by the National Center for Employee Ownership and published in September 2010 showed that the debt default rate of companies with ESOPs was less than 2%. This is a worthwhile observation in challenging economic times.

ESOPs are not for all companies, especially ones that cannot demonstrate reasonably consistent and predictable cash flow. Sellers and buyers should engage knowledgeable professionals with employee ownership expertise—potentially a lawyer, an independent transaction trustee, and a CPA. Experts can help set realistic expectations and help the buyer realize the full range of benefits.

One highly visible and well-publicized management buyout using an ESOP involved Springfield ReManufacturing Corp. (SRC). SRC was acquired from a publicly held parent corporation in 1983 by its key managers and an ESOP. Over time the ownership interests of the key managers were redeemed by the ESOP, and today SRC is 100% employee-owned and thriving. Jack Stack, former president of SRC, has described the buyout journey in two highly readable books: The Great Game of Business, Doubleday, 1994; and A Stake in the Outcome, Doubleday, 2003.

EMPLOYEE COOPERATIVES

Often overlooked, an employee cooperative may be an option for smaller companies where an ESOP is too expensive or the regulatory environment is too complex. Employee cooperatives receive special federal tax treatment but require favorable state legislation for some of the tax benefits.

“Many private companies, particularly in more rural areas, are naturally attracted to ESOPs, but the installation costs and ERISA compliance issues make them impractical for smaller firms,” said Bill McIntyre, CPA, program coordinator with the Ohio Employee Ownership Center (OEOC) at Kent State University. “Where statutes permit, forming an employee cooperative may be a cost-effective option for the owner and the employees to consider.”

FAMILY BUYOUTS

When the succession plans for a privately owned company involve transferring ownership to family members, one frequently embraced strategy is giving stock to those members. Gifting is often combined with more traditional methods, such as earnouts, deferred compensation, and even the purchase of company stock by family members. Gifting can be the most tax-efficient method of transferring wealth to the next generation. The topic of gifting and the use of common estate planning vehicles including trusts are well-documented in other AICPA resources. There is an outstanding opportunity for families to facilitate the significant transfer of wealth through gifting before Jan. 1.

Congress enacted extensions of the gift tax provisions as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, beginning on Jan. 1, 2011. The expanded gift tax provisions are for the 24-month window ending Dec. 31, 2012.

The lifetime gift exclusion limit for 2012 is $5.12 million for an individual or $10.24 million for a married couple. Starting Jan. 1, 2013, the limits drop to $1 million for an individual and $2 million for a couple. Assuming the privately held company owner is comfortable giving a substantial amount of company wealth to family members, these current limits suggest that the value of most middle-market companies could pass to the next generation with no taxes. The reality is often more complicated than this because of how gift taxes interact with estate taxes.

A few months remain for families to consider and complete a major gift this calendar year. The value of private companies may be depressed after a deep recession and sluggish recovery, so the value of the gift is amplified because conservative valuations are more likely. A gift of this magnitude must be accompanied by a gift tax valuation prepared by a qualified appraiser. Valuations take time to complete and require thorough documentation. If gifting is an option, a best practice is to begin well before the end of the year.

EXECUTIVE SUMMARY

Inside buyouts are often an attractive option for business owners looking to sell. The owners know and trust the buying group and have control over the process, including the timing of the transaction, specific percentage of the sale, and its terms. These attributes often make buyouts preferable to selling to a third party.

An inside buyout is the process of transferring ownership of a private company to key managers themselves, key managers in partnership with private equity, employees and employee stock ownership plans (ESOPs), or family members.

Timing is especially important, with the potential consequences of the tax cliff. Through various buyout types, sellers can avoid a possible sharp increase in capital gains taxes by executing the sale before Jan. 1, 2013.

CPAs can take an active role by helping business owners determine their best option. Inside buyouts are attractive to CPA firms because of the expanded opportunity to provide strategic and tax planning assistance and the likelihood of retaining the client long term.

Inside buyouts can take on several forms. Management buyouts transfer control to a few key employees. Management sometimes works with private equity to help finance the transaction.

Employee cooperatives or ESOPs spread ownership among a larger portion of the company and can have several tax advantages for the seller. Strategic and well-timed transfers to family members have the potential to take advantage of the current large unified estate and gift tax exclusion.

Depending on the complexity of the transaction, CPAs might need to enlist the help of outside experts. Valuation is one critical part of the buyout, and an independent voice is needed if experience in that area is lacking.

CPAs in industry are attracted to inside buyouts because, as key financial executives, they have an opportunity for equity participation in the future of their employer. Depending on the skills demonstrated to the company, industry members could negotiate an attractive package of participation.

Scott D. Miller (smiller@esi-enterprise.com) is president of Wisconsin-based Enterprise Services Inc.

To comment on this article or to suggest an idea for another article, contact Neil Amato, senior editor, at namato@aicpa.org or 919-402-2187.

AICPA RESOURCES

JofA articles

• “Evaluate Your BV Skills,” Oct. 2012, page 16
• “Family Business Transition Planning,” Nov. 2011, page 22
• “The ESOP Exit Strategy,” March 2010, page 32

The Tax Adviser articles

• “Recent Developments in Estate Planning: Part I,” Sept. 2012, page 600
• “Now Is the Time: Converting a C Corporation to an S Corporation or LLC,” Aug. 2012, page 534

Publications

• The Adviser’s Guide to Mergers, Acquisitions, and Sales of Closely Held Businesses: Advanced Case Analysis (#PC091027)
• CPA Client Bulletin (#CB_FI12, #CB_FN12)
• CPA Client Tax Letter (#CTLFI12, #CTLFN12)
• ESOPs: Savvy Strategy for Tax Management, Succession, and Continuity (#PMA1205P, paperback; #PMA1205E, ebook)

CPE self-study

• Buying and Selling Businesses: The CPA’s Role (#733754)
• LLC and Partnership Taxation: Beyond the Basics (#732320)

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.

OTHER RESOURCES

Publication

Buyouts: Success for Owners, Management, PEGs, Families, ESOPs, and Mergers and Acquisitions, Scott D. Miller, Wiley & Sons, 2012

Websites

• The ESOP Association: Advocacy, communications, conferences, and national network of state and regional chapters, esopassociation.org
• IRS Frequently Asked Questions on Gift Taxes
• National Center for Employee Ownership: Communications, conferences, and education, nceo.org
• Ohio Employee Ownership Center: Advocacy as well as resources on employee cooperatives, requirements, tax benefits, and more, oeockent.org