Good morning!
Most owners of closely-held businesses look forward
to the day when they deposit the check that
compensates them for their many years of blood,
sweat, and tears and marks the sale of their
company. When this end is near and an offer is on
the table, many such owners are suddenly brought
up short by the prospect of a substantial tax bill that
they might have avoided "if I had only known…"
Beyond the basic tax-saving decision to elect
Sub-chapter S corporate status (see Alligator
Bites,
below), it's usually too late to avoid a big tax bite if
you start to scramble after the term sheet hits the
negotiating table… except when the goodwill is
personal.
Best regards,
Bradlee T. Howe
Financial Managers Trust
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When the Goodwill Is Personal
"I don't understand," said 13-year-old Noah
over breakfast last Sunday. He'd just seen a replay of
one of his favorite Red Sox players,
Manny Ramirez, hitting a two-run homer for the
Los
Angeles Dodgers to spark their Saturday
night victory.
"The Sox just gave him away. They're even
paying his salary for the rest of the season to play for
the Dodgers. And we got nothing from them in
return?"
My grandson cut his teeth learning shrewd Monopoly
trades, but he was totally unprepared for the Boston
Red Sox to break up their three-four hitting combo of
David Ortiz and Manny Ramirez in a three-way deal
involving the Pittsburgh Pirates and several other
players. As far as Noah was concerned, Manny
was The Man.
Heavily into the process of launching his own athletic
career, Noah long ago decided that he didn't have
time for Fantasy Baseball. If he had, there's no
doubt who'd have been his #1 pick. "Who else is a
sure Hall of Fame player on the Sox?" he asked
me, with impeccable logic.
Certainly with Noah (and many other Sox fans),
Ramirez after eight years of home run heroics
had built up such a storehouse of goodwill that
Noah was willing to overlook Manny's "me-first"
attitude toward teamwork. Noah even admitted that
he could probably beat Manny's standard 90-foot jog
to first base on infield grounders, which we regularly
timed at more than 5 seconds,
I paused between my spoonfuls of Wheaties (yup,
even now) to deliver the lesson of the day —
"It just goes to show what happens when one
player thinks that he's bigger than the team. He
won't get away with that with the Dodgers. [Manager]
Joe Torre will just bench him. After all, he's not
costing them any money."
After a lifetime of preaching the value of teamwork to
my kids and their kids, imagine my surprise last
month when I discovered that there occasionally
can be a payoff when one player is bigger than the
rest of the team.
Here are the key ingredients:
- A sale of the assets of the company (as
opposed to a stock sale).
- The Selling Company is a C Corporation,
which is subject to double taxation.
- The Buyer is paying a premium price, above
the book value of the assets being purchased. The
difference between the two is ordinarily accounted for
as corporate "goodwill," and this gain is taxed at
the Selling Company's regular rate (usually 35% for
federal; perhaps another 10% for the state). When
the company is then liquidated and the proceeds
distributed to the owners, each of them is subject to
further personal taxation at capital gains rates (15%
federal; 5.3% in MA).
- If, however, this premium value, or at least part of
it, can be attributed primarily to the capabilities,
experience, connections, and/or technical expertise
of the Selling Company's owner or senior
management team, the concept of "personal
goodwill" applies. The result? —
The whole level of corporate taxation is
bypassed.
My particular example involved a client which was
purchased by a Massachusetts company last month
in a deal structured as a sale of assets for $3MM. The
tangible assets (equipment, accounts receivable,
inventory, furniture and fixtures) totaled about
$1.2MM. The remaining $1.8MM is normally
classified as goodwill on the Acquirer's balance
sheet, and it ordinarily would have been recognized
as income by my client's C Corporation and taxed
at nearly 45%. The remainder would have been
taxed again, at 15% + 5.3%, when the
proceeds were distributed to the two shareholders
(husband and wife). So $1.8MM would have
dwindled to about $790,000, net, to them.
Instead, based on the expert advice of Attorney Tom
Wells, it became clear that what the Buyer was
acquiring was primarily the unique personal talents
and abilities of the Selling Owner. Without him, there
was little premium value that could be attributed to
his company. What's more, because my client never
had entered into a non-compete agreement with his
company or assigned to the company any of his
rights (why would he?), it will be difficult for the IRS to
make the case that the company owned all the
goodwill. Potentially, by avoiding the
corporate-level tax, my client ends up with
$1,435,000, an improvement of some $645,000.
So what's the lesson here? Can star players
on closely-held C Corporation teams go their own
way to the Hall of Fame? Can they avoid a
Non-Disclosure Agreement, retain all of their rights,
and find a good agent to represent them even as they
admire their work while jogging to first base? Not if
they want to stay on the team (you listening,
Manny?).
But when the corporate game is all over, and it's
about adding up the score for yourself vs. the taxing
authorities, don't be modest about giving yourself
a lot of credit, especially when it's your
company. If it comes down to personal goodwill,
you could be a winner. Manny clearly is not.
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Alligator Bites
There are two different types of corporate
structure,
the standard C Corporation and its alternate, the
Sub-chapter S [of the IRS Code] Corporation.
Business owners electing one or the other should
consider the differences carefully: once elected, it
can take as long as ten years to unwind a C-Corp
choice in order to avoid the "double taxation"
assessment.
The key differences:
- The profits of C Corporations are taxed at the
corporate level and, subsequently, its dividends are
taxed as personal investment income. By contrast,
the profits of an "S" flow through to its stockholders in
proportion to their ownership, and they pay taxes on
those profits at their individual tax rates. There is no
tax at the corporate level, so there is no double
taxation as with a "C."
- An S Corporation is limited to 100 shareholders;
C Corporations can have an unlimited number.
- C Corporations may have non-US resident
shareholders; not so, an S Corp.
- S Corporations may be owned by individuals only
(with one or two exceptions); the C Corp can be
owned by another C or S Corporation, an LLC,
partnership, or trust.
- C Corporations may have multiple classes of
stock; the S, only one.
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About Us
Financial Managers helps the managers of smaller
companies and non-profit organizations develop
reliable financial information for operational
decisions.
On an affordable retainer basis, FM serves as
the
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The goal is for the organization
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time FM will take the lead in identifying and hiring the
right full-time financial person for the firm, and effect
a smooth transition to his or her management.
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Financial Managers Trust
781-799-5737 | FAX 781-788-9794
PO Box 2 Lexington MA 02420
PO Box 1527 Fort Myers FL 33902
www.finman.com
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DRAINING
THE SWAMP
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"Upper-incomers are bearing a record share of the
U.S. income tax burden. The top 1% of filers paid
39.9% of all federal income taxes for 2006, up half a
point from 2005. That group reported [earning] 22%
of adjusted gross income. The top 5% of earners paid
60.1%. The lowest-earning 50% paid just 2.99% of
taxes."
— from the Kiplinger Letter, August 1,
2008
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