The most powerful tax planning strategy available to an entrepreneur is the selection and integration of an entity structure and accounting method that balances personal needs with the overall business model. Tax constraints and limitations make the selection process complicated, but with some careful planning and foresight, you can achieve tax optimization throughout the business life cycle and design your ideal exit strategy.
The process generally starts with an evaluation of your short-and long-term personal goals and business objectives, including mapping alternate options that address the following issues:
There are many tax reasons why a small construction business organized as a limited liability company (LLC) chooses to operate as a flow-through partnership or disregarded entity taxed as a Schedule C filer on Form 1040. What happens, however, if you have successfully operated your construction business as an LLC, but have reached a point in your personal life that you want to achieve maximum liquidity and are willing to share continued success and the potential upside with your employees? Your exit strategy options may be very limited because you are a small construction business with a limited pool of viable potential buyers, if any. This is a common scenario among successful, small construction contractors that primarily depend on new contract awards, making them an unattractive target candidate to larger organizations.
When you peel back the layers of the onion, so to speak, what generally makes an organization an attractive target? Who knows your business best (i.e., real insider information)? Who is the best candidate to acquire your construction business? In today’s tight credit market, you will not be able to secure 100% third party financing and will need to partially self-finance the sale transaction and take the junior lien position to third party lenders.
In consideration of all of these important questions, an owner should strongly consider the possibility of selling its construction business to its employees, including the existing management team. As an inducement to the selling party, the issuance of warrants with an upside (regarding future appreciation rights upon a future sale event) can be attached to the subordinated debt financing. The terms and conditions, however, must be properly structured in order to avoid second class of stock successful determination upon IRS examination, which would entirely and/or severely eliminate all the favorable tax effects of selling to an Employer Stock Ownership Plan (ESOP).
With the proper tax planning, your existing construction business (organized as an LLC and currently taxed as a partnership or disregarded entity) can be converted to an association to successfully consummate a potential future sale to your ESOP in a tax efficient manner. Under the current tax system, an LLC organized under state law and taxed as a partnership or disregarded entity as discussed above cannot participate in or sponsor an ESOP. Moreover, an S Corporation owned 100% by an ESOP stockholder is generally not subject to federal and state income taxes (other than, potentially, built-in gains tax at the S Corporation entity level) upon its conversion from an LLC to S Corporation. Some tax professional describe an S Corporation that is 100% owned by an ESOP as a tax shield (i.e., the ESOP is a tax-exempt entity not subject to federal including most state and local income taxes with respect to pass-through S Corporation taxable income).
There are two basic ways to convert an LLC to an association. One way, if applicable under state law, is for the LLC to undergo a formless conversion process and convert to an association. Alternatively, if the LLC qualifies (i.e., the LLC did not change its default tax classification within the last 60 months), it can file a federal election (IRS Form 8832), under the check-the-box provisions, to be classified as an association for federal and most state taxing provisions. Please note that there are exceptions to the 60-month limitation classification change rule. This latter option requires an additional step to change the legal form of the LLC to an association under state law via an F reorganization (the LLC will be merged into a newly-formed association, with the association being the surviving entity). The check-the-box election option gives you more flexibility since the conversion paperwork election can be filed with the IRS on or before 75 days after the targeted effective date of the conversion.
The next step, after the conversion to an association, would be for the association to elect Subchapter S tax treatment election, which can be effective the same date as the conversion date. Under the check-the-box election, you can use IRS Form 2553 to convert to an association and elect Subchapter S. Furthermore, similar to IRS Form 8832 discussed above, IRS Form 2553 paperwork can be filed with the IRS on or before 75 days after the effective S election date.
In addition to the tax planning required to minimize and mitigate the triggering of built-in gains upon conversion to an S Corporation as mentioned above, there are many other hidden tax traps that should be considered and addressed in advance when incorporating an LLC. This includes any pre-binding buy-sell agreements or other step transaction doctrines that, under certain circumstances beyond the scope of this blog, could entirely negate the tax-free status generally associated with an incorporation of a partnership and make the entire transaction a taxable sale. In addition, because of the conversion mechanics, the converting entity faces complex accounting method matters that require special handling, including the potential filing of a non-automatic accounting method change application and the review and approval of the IRS national office within certain statutory due dates.
Please note that the tax planning option described above might only be ideal for a construction company owner looking for maximum liquidity versus deferral and diversification. Also, stay tuned for future blogs regarding other ESOP sale transactions, including transactions involving a C Corporation and Sec 1042 deferral exchange election treatment, or a combination of sale transactions involving first stage (Sec 1042 deferral) and second stage (electing Subchapter S tax treatment and selling the rest of the ownership). For more information on ESOPs, please visit the website for The National Center for Employee Ownership (NCEO).
Through the end of 2013, investors other than corporations can exclude 100% of the gain on its sale of qualified small business stock (QSBS) from its income, for stock acquired on or after September 28, 2010 and on or before December 31, 2013.
There are several criteria to meet the QSBS designation, two of which are:
Entity choice must be weighed carefully. Choosing to be a C corporation just to