A Case Study in Business Succession Planning

You hear the words “succession planning” often in today’s business world. This part of a company’s strategic planning, which can be critical to its success and sustainability, requires careful consideration. The following case study is an example of a succession plan developed by Isaac Wiles for one of our clients.

The business was a C corporation operating in the construction arena, with some net operating losses (“NOLs”) left over from the last economic downturn.

Over the years, the majority shareholder (the “Founder”) had been selling shares to the next generation (the “Successor”) using the standard method of having the corporation bonus money to the Successor, with the Successor then using those funds to “cross-purchase” some of the Founder’s shares. These bonuses were deductible by the corporation as a business expense, but the Successor was taxed at the highest personal federal income tax rate (plus applicable payroll taxes) on the bonused amounts. This meant that the corporation had to “gross up” the amount bonused to the Successor so that payroll taxes, and the Successor’s income tax on the bonused amounts, could be paid. Thus, for every $1.00 that the Successor paid to the Founder to purchase shares, the corporation had to pay to the Successor approximately $2.00.

From the Founder’s point of view, since his tax basis in his shares was very low, most of his proceeds from selling shares was being taxed at the highest capital gain rate (20%), plus the 3.8% net investment tax. Additionally, the next partial cross-purchase was going to make the Founder a minority shareholder, which was making him somewhat uncomfortable.

Our solution to the puzzle was a multi-step process.

First, rather than cross-purchasing shares (by bonusing money to the Successor), the corporation redeemed some of the Founder’s shares (i.e., purchased shares directly from the Founder). While the amounts paid by a corporation for its own shares are normally not deductible by the corporation as a business expense, the corporation was able to deplete its remaining NOLs to offset the redemption payment. This step alone saved the parties more than $600,000 in federal income tax, since the amounts bonused to the Successor did not have to be “grossed up” to cover the Successor’s taxes (as had been the case with the cross-purchases). And, while the Founder did not get capital gains treatment with respect to the redemption proceeds, because his basis in the shares was very low, and because the amounts received for the redemption were taxed at the qualified dividend rate, his tax “burden” was basically the same as it would have been if his shares had been cross-purchased.

The next step was to have the Successor cross-purchase the Founder’s remaining shares, with the purchase price being paid over several years, pursuant to a promissory note from the Successor to the Founder.

Finally, effective as of the date the Founder ceased being a shareholder, the corporation made an S election, converting it to a pass-through entity for federal tax purposes. This allowed the Successor (now the sole shareholder) to take advantage of the new 20% deduction for pass-through income. Thus, S corporation distributions (rather than bonuses) will be used to provide the cash flow needed to make the installment payments on the note to the Founder, with such distributions being taxed at a greatly reduced effective rate (approximately 29.5% compared to 37%), as well as not being subject to payroll taxes. It is estimated that, with respect to each annual installment payment to the Founder, the tax savings will be at least $150,000. It also should be noted that the corporation could not have made the S election if it had significant NOLs. Thus, using the NOLs for the share redemption solved that problem as well.

As a result, by properly structuring the final transition, the tax savings will almost certainly exceed $1,000,000.

Obviously, this outcome was unique to the facts of this business. The critical point is that creative planning can often result in real savings.

If your business is in the beginning phases of succession planning or you are unsure where to begin, the business lawyers at Isaac Wiles are here to help you through every step of the process. To discuss your company’s succession planning in more detail, contact John Perkinsjperkins@isaacwiles.com, or one of the other business attorneys at Isaac Wiles.