In this episode of Cascade Conversations, Raj Kothari, Cascade Partners Managing Director, and Chris Ballard, Partner at Varnum, LLP, discuss the tax implications of transactions. From stock transactions to asset deals, Chris and Raj share taxation complexities and why you need financial and legal counsel to make the right choices for you and your business.


Video Transcript:

Welcome to Cascade Conversations! Join the team at Cascade Partners and their network of trusted advisers as they work to demystify details terminology and strategies in the world of acquisitions, divestitures and financings.


Raj Kothari – Cascade Founder and Managing Director:
Thanks for joining us for another Cascade Conversations! I’m Raj Kothari, a managing partner and founder of Cascade Partners. And joining me today is Chris Ballard, a partner with Varnum and a friend and colleague in the similar patrol for the last five or six years. Maybe, Chris, share a little bit about your background and experience.


Chris Ballard – Partner at Varnum Attorneys at Law:
Absolutely. So, as Raj mentioned, I am a partner of Varnum, which is a major law firm in Michigan, and I have been practicing in the tax and estate planning arena for more than 30 years now. So, working with a lot of local family businesses and just helping them and their families in their successes.


Raj Kothari: And then, if that’s not enough, Chris currently serves as the wing commander for the State of Michigan for the Civil Air Patrol. So, another way that he’s contributing, giving back to our community. But today we’re going to talk about taxes; everybody’s favorite topic. And taxes, when it look at that transactions and I know, Chris, often when we start having these conversations with shareholders at the fundamental level we’re talking about, is it a stock transaction or is it an asset deal? And maybe you can share just a little bit about what really the tax impact of that.


Chris Ballard: Sure. And so, this is a really fundamental area of any sort of a deal. And it’s something where the buyer and the seller are completely at odds with each other a lot of times. And so, there are incentives going running both directions. And so, if you have a buyer; buyers generally like to have asset deals because when they acquire the assets, they basically get to re-depreciate everything so that there’s a huge tax incentive for them.

And also with an asset deal, a buyer gets to leave any sort of contingent liabilities on the table and they don’t have to worry about those sorts of things. And on the other hand, with a stock deal, those tend to favor the seller. So, especially if the seller is organized as a C corporation, then they don’t have to worry about double taxation on the assets and they get to treat the sale using the more favorable capital gains rates, which is a huge incentive for the seller also.


Raj Kothari: 20 percent today, right?


Chris Ballard: Only 20 percent right now. Yeah so, and otherwise with the asset deal, the cash goes into the corporation and then when they pay it out as a dividends, they’re going to get double taxation. And so, that’s a big problem from the sellers’ perspective. But the buyer, if the buyer buys stock, their stock with whatever liabilities are out there in the company. They might be unknown liabilities at this point. And so, that’s a big risk from the buyer’s perspective to do a stock deal.

But it’s that people are usually able to talk about the pluses and minuses, and work out the differences between each other.


Raj Kothari: Well, I know oftentimes, as you said in the beginning, buyer’s prefer assets and sellers prefer a stock deal. But we also find when it’s an asset-light business, that’s an easier place for the seller to argue it ought to be a stock deal because there isn’t really a lot of tax benefit to the buyer and those dynamics because there’s nothing to write up, right?


Chris Ballard:
That’s right. That’s right. So yes, and every deal is unique and so, it is a matter of if the buyer and the seller are talking through what the important parts of the deal are and emphasizing those and coming to a consensus.


Raj Kothari: Yeah. And often I know, while we’re dealing with the tax consequence on the business side, we’re often worried about, “Well, what does it mean if we do a stock deal? Everything goes in as it is, it’s just a change in who the shareholders are, right? Everything for the business.”

But when you do an asset deal, in many cases you have to go to your customers and get new contracts. You’ve got to go to your employees and get new employment agreements. And that puts a lot of other people in the mix of your transaction having a lot of influence on when the transaction gets done or if the transaction can be done.


Chris Ballard: Yeah. So, there may be provisions with some of the assets, especially if there’s real estate involved, or it could be a very difficult getting those assets.


Raj Kothari: Nothing like landlord consents, right? They’re a lot of fun.


Chris Ballard: Exactly. A lot of times.

And an intellectual property can also be a major deal, especially if the seller doesn’t own the intellectual property outright and just has the rights to the property. That can create additional issues as well.


Raj Kothari: Yeah so, oftentimes it’s like everything, right? The tax issue is rolled up into business issues, and often we’ve gotten past the tax issue by addressing the real practical business side of, “Hey, we can’t go get those contracts all renewed or that exposes the business to risk that we don’t have today.”


Chris Ballard: Right, right.


Raj Kothari: So, while we’re talking about kind of transaction tax; many times, what we find is shareholders aren’t thinking about their personal estate tax issues. And until the very, very last minute—and you’ve said to me often, “Hey, it’s important to start that process early.” Why think about that differently and why start that earlier when I’m thinking about, as a shareholder, the state impact when I’m when I’m selling my business?


Chris Ballard: Yeah, so there’s a couple of reasons for trying to dive into the personal estate planning side of things earlier rather than later. One of the more fundamental parts is that basically, once you have a letter of intention (LOI) signed, that cuts everything off. And at that point, things are frozen from an estate planning standpoint. And you can’t, then at that point, decide, “Oh, I’m going to be giving the assets or a stock away to my kids and then my kids will sell it and get a lower tax rate. “The IRS will treat that as if you sold the property and recognized all those gains and then transferred the money to the kids. And so, it’s a lose-lose situation if you wait until that point.

The other side of it is that if you know that you want to sell a business—if you start planning, like, years in advance—you can basically take advantage of…It’s almost like compounding, in a financial sense, where you can kind of layer transactions on top of each other and make a series of smaller gifts that add up to really, really big gifts down the road.

So, if you get an early start on things, it’s not even necessarily giving up any sort of control early on. It’s just structuring things, setting up trusts so that, down the road when you do sell the property, all of the gains that are basically flowing through—a big chunk of those will go to your children or descendants rather than to you. And so, that can have the effect of shifting assets down generations. And right now the estate taxes at 40 percent of all the assets, and so, every dollar you can get with your kids that you don’t need is saving you know $0.40 in tax down the road.


Raj Kothari: Right. So, that $0.40 or that 40 percent tax rate is on top of what you may have paid as a capital gains or ordinary income through the transaction. So, what you’re really saying is, “Hey, if I plan far enough ahead and start thinking about it today, even though I’m not going to think about selling my business five or six years from now, I can still maintain control, but I can lower what estate taxes might happen because I’m going to move it at a lower valuation to my kids or my family. Is that right?


Chris Ballard: Right.


Raj Kothari: And I know that’s one of the big things, right? When you get a letter of intent that sets the valuation, you can’t use a lower or discounted valuation as a privately held business, an internal minority or all those dynamics that would impact.


Chris Ballard: And you can even take advantage of some techniques such as grantor-related retained annuity trusts, where you can actually give assets away to your children or grandchildren without paying any taxes at all. But those have to be done in a very structured long-term way in order to be effective.


Raj Kothari: Right. So, often we’ve said, when preparing for an exit, is that planning process starts very, very early. And one of those is not just building out the team, but it’s the tax elements and thinking about that tax element, and working with tax counsel to figure out how to structure that or put that in place so you can retain control, but you can get the advantage of it.


Chris Ballard: Yeah, but there are a lot of non-business considerations also. And so it’s, I don’t know, you specialize in dealing with those sorts of things.


Raj Kothari: Yeah, I mean a lot of times the tax elements are one driver, but the tax consequences of, “Okay, well who’s signing off on the transaction? Who has to be bought in?” because many times through a transaction we find our clients saying, “Well, I want to reward people on my team. And so, I want to give them a big bonus.” Yeah, well that has big tax implications to them, but it also has an impact on the on the buyer because if I pay the employees a ton of cash at closing, how excited are they staying on? And sometimes we’ve gotten clients to understand, “Well, if you pay a portion of it now and let the buyer pay a portion of it later, the employees are still getting the same dollars.

It’s creating a better incentive to make sure there’s a good smooth transition, which is what every buyer wants and needs. And sometimes you can structure those in a more tax efficient way than that. And we’ve also seen that particularly when there’s rollover equity. So, when the seller is going to own a piece of the company going forward, but he wants “one of my key team members, now, to have some of that equity,” we have to be very thoughtful about how you give that equity away because, if I just give it to them, they got stock, and now they have a tax bill and they don’t have any cash to pay.


Chris Ballard: That’s right. And that that can especially be an issue, like in LLC transactions also where they can have phantom income and can create huge problems for people that think they’re getting a windfall; but it’s all like a future realization for them.


Raj Kothari: Right. I mean, a shareholder thinks they’re trying to do something good. And is good, it just has a cash impact. So, we’ve helped kind of work through some structures that I know we’ve used in the past to help do that. But it’s an important part of thinking about, “Hey, how do I reward my team? How do I think about the business impact and the tax implications that has to those people on a team that aren’t even necessarily part of the transaction?”


Chris Ballard: Right. So on the flip side, sometimes owners can be more generous than they thought they were being, and that can also create some problems. And so, I’ve had people that create phantom stock lines for their employees and think like, “Oh, I’m just giving them 1 percent of a deal.” But that that ends up being like $4 million, $10 million down the road, and it’s like, “Whoa, whoa!” And so, that can create some friction also. So, just again, that gets back to the long-term planning, like where you’re trying to put the incentives and what sort of incentive you’re trying to provide.


Raj Kothari: Right. Once you give that, you can’t take it back very easily.


Chris Ballard: Exactly. Yeah.


Raj Kothari: So, while we’re talking about all of the things, sometimes people don’t realize that, besides your business activities, if you do this planning right and upfront, you can actually do a lot towards your philanthropic initiatives or desires or, in some cases, you may not have had that because you didn’t want to lose those dollars. But I know you’ve talked to us about ways that they can do that—they can reward a charity without taking anything away from a family. Can you maybe share a little bit about that?


Chris Ballard: Yeah. So, there are a lot of different charitable options available, but again, these do require advanced planning because once that LOI is signed, the charitable deals are off the table. And so, families can take a look at it at a bunch of different options. One of the more common options is something called a Charitable Remainder Trust, where they transfer some of the ownership of the company to a trust that the family sets up, and the trust is then designed to pay an annuity amount out to designated family members for their lifetime.

And so, it’s a way of how you can actually sort of see it as a pension of some sorts. And in some ways, you can structure those to not actually start paying out until later on. So, there’s really a tremendous amount of flexibility there in terms of how those are structured. And they come under different names. You’ll see “Charitable Gift Annuities” or “Charitable Remainder Trusts” sorts of things. The neat thing about those is that those trusts are all tax exempt. And so, when the business is sold, the trust doesn’t pay any tax on things. As the distributions are made out to the family members, the family members will then pay tax on that, but it’s something where you’re able to stretch out the tact impact on a big sale over somebody’s lifetime while providing them with an income stream.

And then, when the trust eventually terminates—usually when the recipient dies—at that point, assets go to the charitable organization. And so, it ends up being a win-win because the trust can invest the assets on a tax-free basis and the assets keep on growing and, so, the charity ends up with a windfall at the backend.


Raj Kothari: Yeah. So, you’re able to meet your transfer of wealth to your family that you’ve been trying to achieve and also serving a charitable cause, and not really taking away from either pocket, as I understand it. And I know insurance is part of that, and a number of things are part of that. But all those things you said in the beginning require a lot of advance work.


Chris Ballard: Yes. And so, especially on the charitable side because—as we mentioned—once you have the LOI at that point, things are cut off. And so, if you try to set up a charitable gift after the LOI, the IRS will collapse the transaction and treat it as if you sold the stock and then contributed to the charity.

And so, all of that tax you were hoping to avoid by transferring everything to the charity, you’re stuck with. And so, the plan can still go forward with the charitable organization. So, it’s not a complete loss, but you lose a big part of the incentive by being able to sidestep some of the capital gains on the sale.


Raj Kothari: Okay, so really the message is: If I start planning ahead, it’s going to give me more options and flexibility because, at the end of the day, some of those things I can unwind if it doesn’t go down the path I want. But you can’t put it back in the place if it’s too far into the transaction process. And really, if you do it right upfront, you can take care of what your family needs, what you’ve been working to build and maybe have an impact on the greater community through charitable work.

But, no matter what, if you don’t start that tax planning and think through your personal issues, the business impact and the tax impacts, you’re going to miss an opportunity.


Chris Ballard: Yes. So, another tremendous opportunity on the charitable side is that families can look at setting up a Family Foundation. So, if you’ve got a large enough deal, you can transfer some of the ownership to a Family Foundation. And again, the foundation is itself tax exempt, and so you avoid taxes there. And once the deal takes place, family members can come in and work for the foundation.

And so, they can create a smaller income stream for the people working at the foundation while achieving the family’s charitable goals at the same time. But it can also be a way of bringing family members together to work together on philanthropic activities. And so, if you’ve got kids scattered all over the country, you’re having a family foundation where a family gets together and works together to decide on how they’re going to be distributing things. It can be a great way of keeping families together and working together.


Raj Kothari: Well, Chris, thanks for sharing your insights and perspective. I think this focus on tax is an important one. It’s one that we’re often asked about and, unfortunately, sometimes the conversations happen far too late in the transaction process.

Again, thank you for joining us for a Cascade Conversations. I’m Raj Kothari, with Cascade Partners, with Chris Ballard, a partner at Varnum.