shareholders exchange all their stockfor New S shares. Old S then elects tobe a qualified subchapter S subsidiary,which is a disregarded entity for taxpurposes. New S then forms a wholly-owned LLC, which is initially disregarded for tax purposes, and Old S ismerged into the LLC with LLC as thesurviving entity.
The merger is not a taxable eventbecause both Old S and the LLC are disregarded for tax purposes. Furthermore,RIA is now in a new LLCthat can take on institutional investors, plus has theflexibility to create moreinnovative employee incentive plans that are typicalof LLCs.
• Convertible debt. Athird option is to structurethe investment as a convertible loanrather than as equity. Because the convertible feature of the loan does notconstitute equity at the time of the initial transaction, this structure does notviolate the S-corp rules until it is actually exercised.
CHALLENGES AND SOLUTIONS FOR
C-corps also were popular amongRIAs — particularly if they could notqualify as S-corps. If the RIA wantedto limit liability and had any foreignshareholders, for instance, or wished tostructure multiple classes of stock for itsowners, C-corps were often the defaultchoice with key limitations.
Double taxation issues. Among the
most obvious drawbacks of C-corps
is the impact of double taxation: the
RIA’s earnings are taxed at the corpo-
rate level, and shareholders are taxed
again on dividends. Many closely-held
C-corps circumvented this double-
taxation by distributing excess cash-
flow as compensation. However, this
strategy can trigger Internal Revenue
Service scrutiny for tax-avoidance and
does not work for outside investors
who are not employees.
In the strategic planning context,however, the more significant obstacleis the inability to structure an eventual liquidity event as an asset sale without triggering a tax bill; a C-corp istaxed both at the corporate and shareholder levels upon this sale, whereaspass-through entities such as LLCs orS-corporations are only taxed at theshareholder level.
Many times, the choice of an assetdeal is influenced by the acquirer’sdesire to obtain significant tax savingsby stepping up the assets’ basis to thepurchase price (generally referred toas a depreciation tax shield). Becausethese tax savings are measurable, theparties can calculate the net presentvalue of these future cash flows andnegotiate a split of the economics as partof the deal.
What to do?
Even if the principals are not contem-
plating an exit or other liquidity event
in the foreseeable future, the fact is that
value is accruing inside the C-corp in
a tax-inefficient manner. Here are tax
planning alternatives to consider with a
• LLC conversion. One solutionmight be to convert the C-corp to anS-corp ahead of a more tax-efficientasset sale down the road. This solution is not as attractive, though, if theRIA’s ownership mix would violate theS-corp rules described above, or if theshareholders are contemplating a saleof the business in less than five years
(the IRS’s required look-back period).
•Drop-and-freezetransaction. One solution is a “drop and freeze”The value of the overall enterprisethat is subject to double taxation istherefore “frozen” inside the C-corp asof the restructuring date, and any futurevalue created accrues to the LLC, whichis only subject to one-level of taxation.
In addition to preserving long-termvalue, this alternative also facilitatessuccession planning because thefirm’s value overwhelmingly will beat the C-corp level at the time of thetransaction. Therefore, equity in theLLC can be sold to next gen managersat low prices because the equity onlyhas a claim on the future growth ofthe business.
Peter Nesvold is the founder of NesvoldCapital Partners. James Cofer is a partner ofSeward & Kissel.
The biggest drawback to the LLC
drop-down alternative is that
the firm must notify all clients
of the change in ownership
structure. [This may mean]
every client would potentially
need to sign off on the transfer.