Selecting the most appropriate entity structure is a decision that impacts every stage of a business owner’s journey. There are a variety of options available, each offering a unique series of benefits and drawbacks in addition to distinct tax considerations.
Business owners should consider their exit plan when weighing the type of entity structure they’d like to adopt. By beginning with this end goal in mind, entrepreneurs give themselves the best possible operating conditions while also laying the groundwork to dispose of their equity in a tax-efficient way.
Tax implications are far from the only consideration when it comes to selecting an entity. Various other factors drive this decision, from limiting personal liability to the expectations of investors and financing partners.
From a tax perspective, two key factors are critical drivers of the optimal entity structure: estate planning and income tax planning. In this overview, we outline the ramifications of different entity structures and explore which types of entity structures are best suited to different scenarios.
When an entrepreneur starts a new business, it’s unlikely their exit strategy is at the forefront of their mind. Fortunately, as the business evolves, it’s possible to change course and embrace a more thorough succession planning approach.
Mark E. Abrams, Partner, Smith + Howard Advisory LLC, comments:
“For entrepreneurs who have built something self-sustaining, creating an internal and/or external succession plan is a prudent and healthy activity. Many entrepreneurs may think they’re too busy for this type of thinking. On the contrary, if done right, making an investment in the company’s future through strategic planning, internal team building and key partnerships will create more time for even the most overtasked entrepreneur.”
Beginning the succession planning process as early as possible unlocks an increased menu of options for entrepreneurs. The sale of your business typically dwarfs other large transactions such as the sale of your home or vehicles. With such high stakes, the last thing any business owner wants is to be forced into a fire sale, or to reach their target retirement age with no clear strategy in place.
Investing in the business’s ability to operate without the daily supervision of the entrepreneur is an important driver of value, but so is the tax structure that the business owner chooses for the business. This decision can have major implications, and it’s important that business owners proactively consider it as a key component of the succession planning process.
As noted, various factors drive which entity structure makes the most sense for a given business. Perhaps one of the most important, at least from a tax perspective, is the business owner’s long-term plan for the business.
Some entrepreneurs might aim to cash out and sell their business to a strategic buyer. Others might want to pass their business down to the next generation, whether that’s to family members or the business’s employees. And the most ambitious entrepreneurs might aim to raise capital, scale their business quickly, and then sell their business to private equity or a strategic acquirer. All of these are valid goals, but each presents unique tax challenges and opportunities.
Business owners must take a dual focused approach to the tax implications of the entity structure of their business. One element to consider is how the profits the business produces through its lifecycle will be taxed; the other is the business owner’s exit strategy. The choice of entity structures drives the terms on which exits can occur and also has major ramifications on the income tax strategy of the business’s owners.
Below, we provide a brief overview of each of the most common tax structures used for succession planning. It’s important to note that this is a high-level overview. Every entrepreneur’s situation is unique and it’s important to consult with qualified financial advisors and tax planning professionals.
Flow-through entities, including partnerships and S Corporations, offer a series of attractive benefits, although there are some limitations to bear in mind. They are an appealing option for profitable businesses that want to distribute profits to their owners each year.
Generally speaking, these profits will be taxed at a lower rate through a partnership than they would through a C Corporation. The business’s profits are only taxed once, at the partner’s effective tax rate. That’s in contrast to a C Corporation, where profits are taxed at the corporate level and, if after tax profits are distributed to owners, they are taxed again at the individual level as dividend income. For corporations that do not distribute after tax profits, the 2nd level of tax can be deferred until a liquidity event in the future.
Under current law, combined individual and corporate tax rate generates a higher effective tax rate. Structuring a business as a flow-through entity therefore offers entrepreneurs a tax arbitrage opportunity. However, business owners should consult their tax planners concerning built-in capital gain taxes and excess net passive investment income taxes, as these can offset the potential advantages of this approach.
Partnerships can also be favorable for certain types of succession plans. For internal succession plans, the issuance of profits interests can be a tax efficient way for employees to participate in profits and become a partner with less tax burden. However, the best internal succession plans create “skin in the game” for employees but it may cost more for an employee to “purchase” an interest this way. For high cash flow businesses, employees may finance their acquisition with their share of company cash flow. In an external succession plan, a buyer may get a more depreciable basis than they would in a stock purchase transaction.
In general, business buyers aim to structure transactions in a way that enables them to depreciate their purchase. Buyers and sellers can both benefit from a flowthrough structure in a taxable sale. With the proliferation of LLCs which can be taxed as a C Corporation, S Corporation or a partnership depending on the business owners’ election, buyers and sellers may elect to treat a membership purchase as an asset purchase.
If done properly, buyers may get basis for depreciable assets, thereby allowing buyers to recover their basis more quickly than they would otherwise in a traditional stock/membership interest purchase. Sellers still maintain mostly capital gain, but will have to give up some higher effective rates on a portion of their gain to accomplish this. These higher taxes can be a bargaining chip for sellers to leverage more consideration in a transaction in order to accommodate buyer’s desire to get higher depreciation deductions.
Additionally, flow-through entities tend to be attractive to private equity investors that target assets that produce ordinary losses and capital gains.
As noted, however, there are some situations where flow-through entity structures may not be the best fit. Flow-through entities are not eligible for the Qualified Small Business Stock (QSBS) exclusion, which allows owners of qualified small businesses to receive favorable capital gains treatment when the business is sold.
For entrepreneurs planning an internal succession through an Employee Stock Ownership Plan (ESOP), flow-through entities are also limited. If the business owner sells stock to an ESOP, their ability to defer their taxable gains is limited.
Finally, under current laws, partnership structures may offer greater discount planning opportunities for estate planning purposes than an S Corporations. This primarily has to do with the limitations on classes of ownership and control known as the S Corporation single class of stock rule. You may have one class with voting and nonvoting shares which is not a deal breaker. For intra-family transfers, business owners typically like to retain control by holding voting shares and gifting away non voting shares.
A sale and gift to an estate planning vehicle like an Intentionally Defective Grantor Trust or a Spousal Lifetime Access Trust often is often involved with the transfer of non-controlling interest of family owned businesses. This is a popular “estate freeze” technique that makes use of the historically high lifetime exemption that is set to sunset in 2026.
For ambitious business owners planning to reinvest earnings into further growth, a taxable corporation may represent a better fit. Taxable corporations are eligible for the QSBS exclusion, enabling business owners to achieve favorable capital gains tax treatment upon the sale of their interest in the business provided the business meets the Qualified Small Business (QSB) criteria.
Because of a lower annual tax rate inside a C Corporation (flat 21% rate and no Alternative Minimum Tax), C Corporations offer a unique opportunity to accumulate earnings for future acquisition at a lower annual effective rate. This contrasts with a higher marginal federal rate for owners of flow-through entities. These may reach as high as 37% for service businesses, although reduced rates apply to qualified flow-through businesses through 2025. A C Corporation is favorable for business owners who want to continually re-invest profits in the business to fuel future growth.
QSBs are also an attractive option for entrepreneurs aiming to sell their business to an ESOP and pass ownership to their management and employees. Upon the sale of stock to the ESOP, the seller may reinvest their proceeds in qualified replacement securities such as publicly traded securities and bonds. This essentially defers capital gains tax on the sale of the business and affords sellers the opportunity to invest in publicly traded securities at a lower basis.
The decision to structure a business entity in a particular way is an extremely complex matter, and it’s important entrepreneurs seek qualified professional help. In many instances, the key determinant of the optimal strategy for any given business is the long-term goals of the business’s owners.
“It all boils down to your objectives as a business owner. Some owners want to take the profits their business generates each year and invest it elsewhere. Others want to reinvest it in their company to generate even more growth. Understanding your priorities today, as well as the legacy you hope to build, is key to selecting the right entity structure.”
–– Mark Abrams, Partner, Smith + Howard Advisory, LLC
Consulting with experienced financial advisors and estate planning professionals to understand the options available is an invaluable first step. At Smith + Howard Wealth Management, our experienced team works closely with the tax professionals at Smith + Howard Advisory, LLC, to help business owners determine the optimal succession planning strategy.
To learn more, contact a Smith + Howard Wealth Management professional today.
Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.
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