IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family businesses. The following blog article has been provided by Joseph Hollcraft of IBA (https://ibainc.com/):
The Hunt for Low Taxation in a M&A Transaction
In 1990, Paramount Pictures et. al., released The Hunt For Red October. Rooted in the secret and tumult of the Cold War, The Hunt For Red October brings up questions about responsibility to country, to duty, and to all of humanity – which do you choose when all three are on the line? Ultimately Sean Connery’s character is found to be doing “the right thing” by putting humanity over his obligation to Russia and to his decades of military service.
Separately but in the same vein, here is Peter Drucker on corporate social responsibility:
Business exists to supply goods and services to customers, rather than to supply jobs to workers and managers, or even dividends to shareholders. The hospital does not exist for the sake of doctors and nurses, but for the sake of patients whose one and only desire is to leave the hospital cured and never come back. Psychologically, geographically, culturally, and socially, institutions must be part of the community.
Here at IBA we serve the business community. It is important to each member of the IBA team to be a part of, and participate in, our local and regional business organizations. Whether it’s IBA’s sponsorship of CCIM, our relationship with the philanthropy of The Master Builders of Washington, or our aid in youth outreach within the Washington Hospitality Association and Oregon Restaurant and Lodging Association’s efforts, we believe in the lifting up of business, business owners, entrepreneurs, and by extension our local, state, national, and international economies. To each of these groups we demonstrate an obligation of care.
I’d like to tell you the story of my own hunt, where my goals and values were put in conflict, and the path I found, eventually, to a resolution.
3 years ago I was put in touch with one of the owners of a privately held company, we’ll call them Acme, operating inside Oregon. My contact was the SBA and Business Development offices of Wells Fargo Bank under the guidance of Jessica Beck and Katie Schroedl. When I first met Acme’s ownership they didn’t believe their business was worth much more than a couple million dollars for the machinery. After a build up and expansion of business operations in preparation for a sale I valued Acme at $10.2MM.
The most exciting thing about this company is that it’s a C-Corp, its assets are less than $50MM, and current ownership has held the stock exclusively since Acme’s inception. Some of you readers already know what I’m driving at – Acme’s owners qualified for a Section 1202 qualified small business stock gain exclusion. Or so we thought…
A Section 1202 gain exclusion, or QSBS as it’s more commonly known, is a way the original owners of a C-Corp can sell their stock with zero tax liability. Just take the money and thoughtfully enter their next chapter. Section 1202 was written into the tax code in 1993. As it turns out, Acme was founded in 1989. They opened too early. There was no way to know in 1989 what would happen in 1993 but that didn’t affect the outcome. The tax bill on their distribution of sale proceeds would be calculated at the standard capital gains rate for their bracket after the revenue for the sale of assets was taxed at the corporate level and further compounded by depreciation recapture. They were going to be on the hook for a tax bill approaching 80%. Or so we thought…
The primary issues with an asset sale, or asset sale treatment in a stock sale (which we needed to assume a worthy buyer would insist on), were that remaining depreciation was ~$900K on ~$13MM of assets, they only had 1 customer (though the customer everyone wanted), and they had $2MM in the bank. Inspired by the kindness of the owners and my own system of values, I dove in deeper and invented a plan: what if, after locating a buyer, we sold the assets of Acme into a holding company at an appropriate price? Acme’s ownership would pay the taxes on the sale of assets but leave the proceeds in a corporate bank account. Then, 6 months later, sold the stock to the purchasing entity at a price to include the cash in the bank and the annual net revenue to ownership, adjusted by an appropriate multiplier, generated by the business? This would allow ownership to sell Acme’s assets and cash holdings and let them exit without the first layer of taxation or a marginal tax rate on their distribution of final sale revenue.
Without knowing if this tactic was in bounds from the IRS’s perspective, I began reaching out to referral partner after referral partner. I spoke to 6 CPAs and 3 tax attorneys at exceptional legal and CPA firms such as Aaron Dawson, CEO of Opsahl Dawson, Mary Hull, a partner at Stoel Rives, Jason Imhof, a shareholder and exceptionally knowledgable CPA at Geffen Mesher, finally culminating in a conversation with Justin Hobson at Miller Nash wherein he told me there was specific IRS guidance against this idea. My hunt was at a dead stop. Or so we thought…
In my exploration of potential buyers I found a brilliant, socially responsible entrepreneur that wanted to purchase companies and turn them over to the employees via an Employee Stock Ownership Program, commonly known as an ESOP. The idea was interesting to me and to the ownership of Acme. “What if,” I thought “there is special tax treatment in an ESOP?” I investigated. Enter the 1042 Exchange.
A 1042 Exchange is when a business owner sells their company via an ESOP and immediately invests some or all the proceeds into stock or securities issued by American companies. This was a 100% tax free election. The idea was that the owners of Acme would sell via an ESOP, invest the money, then live off the gains of their investment. It was a good plan. It served the owners of Acme very, very well. But business brokers aren’t allowed to participate in ESOPs. This we were certain of.
If Acme went to market and was sold in an asset sale or was subject to asset sale based taxation in a stock sale, the net proceeds to ownership at a $10.2MM sale price would be around $2MM after they paid off equipment loan debt. In an ESOP, proceeds, though likely delayed at least 3 years, would be the entire shebang. No tax at all on any money they invested under the 1042 Exchange guidelines. Further, ownership doesn’t pay depreciation recapture or outstanding debt in an ESOP sale. I was presented with a choice: make an incredible amount of money on a single sale or do the right thing.
Per my advice and the guidance of their team of advisors, today the owners of Acme are contemplating an ESOP. They are unsure of the correct path forward and I have been at their side, going now on 4 years, advising and guiding them with the thorough and superior knowledge IBA brokers are known for. This is one of my favorite things about being a part of IBA – I have brilliant colleagues. Each of us kind, each of our clients mattering equally, each of us acting with the highest degree of care. I walked away from a potential commission of about $450,000 because that’s what the situation, when approached care forward, demanded. I haven’t regretted it for a moment.
This past Christmas I received a package. The owners of Acme take annual vacations to recharge. Owning and operating a manufacturing company is not an unstressful task. The package was a box of Hawaiian sugar cookies, one of the owners’ favorite. This gift, the relationship I’d developed, and the endorsement of my years of learning under the guidance of Gregory Kovsky, was the best thanks I would get. It was appreciated. It was enough.
IBA engages in its practices under the rules and regulations of each state’s Real Estate licensure. In each and every state, part of this license is an obligation to confidentiality, an obligation of skill, and the obligation to do right by a client. Honestly, you’ll find these attributes in the culture of just about every business brokerage. But care, kindness, guidance, education of our clients, in these IBA stands tall and, mostly, alone. These things we pride ourselves on. These things are the IBA difference.
If you have questions relating to the content of this article or the process associated with selling or buying a business, Joseph Hollcraft would welcome the opportunity to talk with you. Mr. Hollcraft can be reached at (503) 739-4880 or [email protected].
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing best practices.