In some cases yes!  Congress has long recognized that small businesses investment is an important driver of the U.S. economy.  Back in 1993, to encourage capital investment in small businesses, they created a rule that eliminates federal income tax on some (later revised to all) of the gain on the sale of certain C Corporation stock issued after August 10, 1993. This article introduces the Qualified Small Business Stock (“QSBS”) tax break for business owners who are contemplating a future sale.

QSBS Requirements

To qualify for this tax break, your stock has to be deemed Qualified Small Business Stock per Internal Revenue Code Sec. 1202. Here’s a summary of 1202’s requirements:

1. The business must be a domestic C Corporation
2. Is a small business, defined as assets of less than $50 million
3. The stock was issued after 8/10/1993*
4. The stock was acquired at original issuance
5. The stock has been held for 5 years or more at the time of sale
6. The business is NOT engaged in professional services that are dependent on the reputation or skill of one or more employees, financial services, farming, mining or resource extraction, hotels, restaurants or other similar businesses

*Depending on the issue date of the stock, 50%, 75% or 100% of the gain (up to $10 million) may be excluded from federal income tax. The gain exclusion is 50% (subject to a 7% Alternative Minimum Tax (“AMT”) add-back) for stock acquired between August 11, 1993 and February 17, 2009. Stock acquired between February 18, 2009 and September 27, 2010 is eligible for 75% gain exclusion (subject to 7% AMT add-back), and stock acquired after September 27, 2010 receives a 100% exclusion, without an AMT add-back.

Andersen Tax offers a more complete list of QSBS requirements.

The QSBS tax break was made permanent by the PATH Act (Protecting Americans from Tax Hikes Act) of 2015. In case you’re wondering, the recent Tax Cuts and Jobs Act of 2017 did not alter QSBS rules, but the reduction of the federal corporate tax rate to 21% affects the magnitude of the QSBS benefit relative to a sale of assets. It is my understanding that California’s Franchise Tax Board no longer allows an exclusion on the gain of QSBS.

M&A Perspective

When a C corporation sells its assets rather than its stock, Sec. 1202 doesn’t exclude the gains that occur inside the corporation. So, even if you hold QSBS stock, you may not be able to get off tax free.

Acquirers of private businesses generally prefer to buy assets, not stock. For buyers, buying assets reduces their future tax bills, improves their cash flow, and reduces potential legal liabilities. When asked to buy stock and forgo these benefits, buyers usually expect to negotiate a meaningful price discount. However, given the magnitude of the QSBS tax break, especially when eligible for 100% exclusion, a seller of QSBS could give a buyer a significant price discount and still come out well ahead (relative to selling assets).

Fortunately, the reduction in the corporate tax rate to a flat 21% under the Tax Cuts and Jobs Act of 2017 makes a C Corp asset sale more palatable. The corporation will have to pay 21% on the gains, but the shareholder, when they receive the remaining sale proceeds through a liquidating dividend, can use Sec. 1202 to avoid tax on that cash. The overall tax effect is closer to that of an asset sale by an S Corp or LLC.

Do you have QSBS?

The prospect of selling qualified small business stock is compelling; however determining whether your C-Corp stock qualifies as QSBS and claiming this benefit can be tricky.  Work with a CPA or tax advisor who is well-versed in QSBS requirements and who can calculate and compare your after tax proceeds under various deal structures. For another slick C-Corp tax maneuver, see my blog on personal goodwill.

If you intend to sell your business some day, please be aware that tax minimization strategies can have a big impact on how much money goes into your pocket. Some strategies can take 5 years to implement, so get your M&A and tax advisor involved early on.

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Exit Strategies Group’s M&A advisors are dedicated to staying abreast of tax minimization strategies for our business sale, merger and acquisition clients.  Al Statz, founder and CEO of Exit Strategies Group, is based in Sonoma County California and works with lower middle market companies throughout the U.S.  For further information on this subject or to discuss selling a company, contact Al at alstatz@exitstrategiesgroup.com or 707-781-8580.

The concept of goodwill in a business sale is familiar to most business owners. The more the better, right? Personal goodwill (versus enterprise goodwill) on the other hand is less familiar, and trickier to deal with. If your company is structured as a C-Corporation, you should know about personal goodwill and how its existence could put more money in your pocket when it’s time to sell. Here’s how this works.

The C-Corp Dilemma

Sellers of C-Corps prefer to sell the stock of their companies because it is more tax efficient than selling assets; yet the reality is that most business sales are structured as asset transactions. Why? Because, for buyers, buying assets reduces their tax bill, improves their cash flow, and reduces potential legal liabilities. Astute buyers that are asked to forgo these important benefits (i.e. when they are asked to buy stock) will expect a substantial price discount. Some will just walk away.

With an S-Corp on the other hand, which is a pass-through entity, selling assets (vs. stock) usually isn’t a much of problem from a tax perspective. In some cases, selling assets can even be to a seller’s advantage.

But for C-Corps, selling assets is a big disadvantage. Here’s a simple example. Assume that the combined federal and state C-Corp income tax rate is 29%, and that the combined individual capital gain tax rate is 28%. In an asset sale, for every $1.00 of transaction price (above book value of assets), C-Corp shareholders net only 51¢. Could this happen to you?

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Exit Planning Tip:  

If you own a C-Corp and your expected holding period is 5 years or more, talk to your CPA about electing S-Corp status so that you can avoid the possibility of being double taxed when you sell.

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Does the Goodwill Go Home at Night?

Goodwill value is that portion of a business purchase price that exceeds net tangible asset value. Personal goodwill (“PGW” for short) differs from enterprise goodwill in that PGW represents the value of an owner’s personal service to that enterprise, and is considered an asset owned by that person, not the business. PGW value is usually the result of an individual’s outstanding reputation and close personal relationships with customers or suppliers, or exceptional rainmaking or technical mastery, and other unique abilities that produce economic benefit for the business.

When PGW is present, the success and value of a business are largely dependent upon one or two individuals, usually the owner(s) in a small business. Without the key individual(s), the business may have little value. In other words, the goodwill goes home at night.

Personal Goodwill Presents a Tax Savings Opportunity

In asset sales of small owner-operated corporations, there can often be two sellers: (a) the business entity, and (b) an individual selling his or her personal goodwill. Selling PGW creates a tax savings opportunity for C-Corp owner-operators.

Using the same tax rates as above, for every $1 of purchase price that can be allocated to personal goodwill, the seller’s tax savings is 21¢. This is because the $1 allocated to PGW does not get taxed at the C-Corp level (is not “double taxed”). Suppose that in a $2 million transaction, $800K can be allocated to personal goodwill. This reallocation puts $168K more in the seller’s pocket.

NOT an Afterthought

Allocating part of the purchase price to personal goodwill has been an arrow in our quiver for the past decade or so; however, it cannot simply be a post-closing purchase price allocation. Rulings in multiple tax court cases demonstrate that PGW is under attack by the IRS.

When a C-Corp seller is considering allocating a portion of a purchase price to personal goodwill, these are some of the norms for supporting the existence of PGW apart from enterprise goodwill, and making it hold up to IRS scrutiny:

1. There should be a separately negotiated PGW purchase agreement. As brokers, we plan for this with the seller and buyer, before an offer is made, and coordinate with the parties’ attorneys, CPA’s and lenders.
2. The amount allocated to PGW should be based in economic reality. An independent personal goodwill valuation should be obtained to finalize the amount. This could cost $6-10k.
3. There should be a significant and separately paid for covenant not to compete with the seller personally.
4. The buyer should have a written employment/consulting agreement with the seller, for an extended term (say 18-24 months) with reasonable compensation. Otherwise, how could the seller’s PGW be transferred?

Selling any business with high personal goodwill is challenging. When goodwill goes home at night, valuation and marketability are generally reduced. Having a C-Corp structure adds yet another layer of difficulty and expense because of double taxation. Working with an experienced M&A broker, transaction attorney and CPA is extremely helpful when buying or selling this type of business.

Exit Strategies Group’s professionals dedicate themselves to staying abreast of tax strategies and potential pitfalls for private business owners as they plan and carry out business sale, merger and acquisition transactions. Don’t hesitate to call — the earlier we are involved the more impact we can have.

Al Statz is founder and President of Exit Strategies and is based in Sonoma County California. He can be reached at alstatz@exitstrategiesgroup.com or 707-781-8580.

Employee Stock Ownership Plans (ESOPs) have compelling competitive, financial and legacy benefits. For business owners weighing their exit options, a leveraged ESOP may be feasible if the owner, company and employees possess certain attributes:

Owner Attributes

1. Owns 30% or more of corporate stock
2. Has a low basis in the stock
3. Looking to reduce involvement in the company long term (5+ years) or shorter term if successor(s) are in place to take over
4. Concerned with employee welfare and wants to reward them by transferring an interest in company stock to them
5. Wants to sell shares on a tax-deferred basis
6. Willing to sell for fair market value and forgo the possibility of obtaining a price premium through an M&A sale process

Company / Employee Attributes

1. Mature, non-cyclical business with strong operating performance (revenue and net margins), past and projected
2. A balance sheet strong enough to absorb ESOP acquisition debt
3. Adequate cash flow from operations to cover capital spending needs and debt service for ESOP acquisition and other borrowings
4. Adequate payroll, say $1,000,000 or more per year
5. 20+ employees
6. A participatory management culture, and open and effective communications between employees and management
7. Strong executive leadership and management bench to succeed long term

ESOPs are costly to set up and comply with IRS and DOL regulations. They are not for everyone. ESOP is a complex area that is not well understood by most CFO’s, attorneys, CPAs and M&A advisors. Be sure to work with specialists.

Use these rules of thumb if you are considering transferring ownership of your company through an Employee Stock Ownership Plan. To find help determining the feasibility of an ESOP for your California company, feel free to contact Al Statz at 707-781-8580 or alstatz@exitstrategiesgroup.com.