Determining the most optimal tax structure to operate your current business enterprise depends on many factors such as the current life cycle of your business model, outside investor requirements, licensing issues, tax matters, financial constraints, bankruptcy considerations, and your exit strategy.
If asked to rank the importance of the listed factors, your exit strategy and tax matters should be considered in conjunction with each other and should be at the top of the list unless there are financial investor pre-requisite requirements. Generally, the correct analysis of these two factors tend to alleviate much of the inherit tension stemming from the other cited factors.
For example, if you are a successful technology company or government contractor, your exit strategy will most likely entail a sale of your business to a private equity investment group or perhaps to a public company. To sweeten the pot and maximize your after tax consideration, the ability to consummate a deemed asset sale treatment election for tax reporting purposes would be critical.
Purely from a seller party tax perspective, as a target, you ideally want to be operating as a pass-through entity (i.e., partnership or an S corporation) with no tainted assets subject to built-in gains tax implications (e.g., subject to potential double taxation) prior to consummating an asset sale transaction. However, this perfect world scenario might not be available to you because of evolving facts and circumstances and/or factors beyond your control such as previous ownership composition or perhaps financing structure involving third party investors requiring preferred equity participation.
Supposing that your future target corporation currently operates as a standalone C corporation or as a subsidiary of a consolidated tax filing group, should you consider restructuring to achieve pass-through tax status? The answer might be “no” because the most likely scenario for your particular exit strategy planning might simply be to sell the target corporation to a private equity investment group or a large public company and agree to make a Sec 338(h)(10) or Sec 336(e) election to account for the stock sales transaction as a deemed asset sale for tax reporting purposes (that would be generally tax favorable to the purchaser because of stepped-up and amortization of intangibles over 15 years). Note that, under the current regulation construct provisions, you can generally restructure without negative tax implications a standalone C corporation into a consolidated group filing tax structure in order to qualify for Sec 338(h)(10) and/or Sec 336(e) election provisions prior to consummating a qualified sales stock transaction.
Now, suppose you started a government contracting business a couple of years ago and you received tax advice that it would be beneficial for you to operate your business model as a C corporation because of the partial gain exclusion provisions under Sec 1202 available to a qualifying C corporation, small business stock upon future sale (i.e., provided the stock was originally issued to you and it was held for more than 5 years). Depending on your exit strategy timetable, economic climate and trends, market niche (including the current positioning of your business), technological advantage, and other factors beyond your control, the suggested tax structure might be quite ideal for you. However, a taxpayer’s ability to retain the use of a favorable accounting method that is generally available to large pass-through entities engaged in providing services (i.e., business model for which material and supplies is not a significant producing income items), such as cash basis, should be also be heavily factored into the overall decision making process. (See previous article: “Exploring Cash Basis for a Competitive Edge”)
If you would like to explore your tax operating structure options with regards to your particular set of facts and circumstances, please contact your Aronson LLC tax advisor or Jorge Rodriguez, CPA, Tax Director, at 301.222.8220.
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