A closely held enterprise is one with a limited number of owners who often have some direct involvement with the business. Even though their ownership interests are not publicly traded, privately owned enterprises often find their ownership roll growing as years pass. This can occur for a number of reasons:
- Parents distribute interest in the business to their children, some of whom may have no involvement in managing the business.
- Employees may be awarded equity interests—or the option to purchase them—as an incentive.
- Board members or key service providers sometimes are granted equity interests as compensation for their services.
- Acquisitions of competitors may be financed by issuing equity interests as payment.
Regardless of the circumstances, many companies eventually have a large number of minority equity holders, which can create a complex, cumbersome and downright expensive situation. Companies that establish a pattern of paying regular dividends or distributions may find that equity holders who aren’t directly involved with the business come to expect—or even depend upon—regular cash distributions. As ownership becomes more diverse, executives may spend more time educating minority shareholders about the business or explaining and justifying business decisions or policies. Transactions that may be beneficial for the business as a whole or for the majority owners could be viewed negatively by minority owners, who may threaten litigation or otherwise attempt to interfere. Family politics may be more amicably resolved if kept outside the boardroom.
For these reasons and others, privately owned businesses often look to limit the dispersion of ownership interests or reduce the number of equity holders.
Stopping the Spread
As the saying goes, “An ounce of prevention is worth a pound of cure.” It can be effective to first put measures into place to slow or halt the further dispersion of a company’s equity, positioning the company to reacquire outstanding interests over time. Here are a few steps to consider.
Buy/Sell Agreement – A buy/sell agreement is almost always a desirable arrangement for a private company to have in place and, if appropriately tailored for your company’s situation, can be a great tool to help stop proliferation of ownership. While there are a number of common provisions that may be included in such an agreement, a well-written buy/sell agreement may provide a range of benefits to the company and its owners:
- A predetermined process for an owner who wishes to sell to obtain liquidity
- Protection for owners who wish to remain involved in the business
- A cross-purchase provision that can give existing business owners right of first refusal to acquire business interests that another owner wishes to sell
- A redemption provision, or entity-purchase provision, that can offer the company an option to reacquire the interest that must be waived before the interest could be sold to an outside party
- Specific provisions dictating how the value of the company’s equity interest will be determined—whether through third-party valuation or a formula—or allowing the selling shareholder to obtain a firm offer from another third party to fix the price
Replace Stock Options or Grants with Other Incentives – Stock ownership plans, e.g., stock options or restricted stock grants, can provide a cash-deferred way to provide meaningful incentive to key groups of employees. However, because this turns employees into owners, the true “soft” cost of these plans may not be apparent until after the options are exercised. If structured properly, incentive stock options can be tax-advantageous. Because of alternative minimum tax and other considerations, employees who exercise stock options that are in the money—where the stock value has grown to exceed the cost to exercise the option—frequently find they need to sell some of the stock they’ve just acquired to pay their taxes in the year they exercise the options. If that stock isn’t publicly traded, they may have difficulty finding a buyer or getting a fair price for their shares.
As a result of these issues, companies with stock that’s not regularly traded may wish to consider alternative incentive structures that offer many of the benefits of stock options or grants without some of these drawbacks. Examples of such arrangements include phantom stock plans, stock appreciation rights or other deferred compensation plans. A previous BKD article offers more information on some of these arrangements.
Be Cautious About Using Equity as Currency – When negotiating a merger or acquisition, one approach has been to provide selling shareholders or key management of the acquired business with carryover equity in the acquiring company. This can be used to bridge a perceived value gap when negotiating a deal, as the seller often is more optimistic than the buyer about the profits its business would generate. While paying with equity doesn’t require cash, it ultimately can prove to be more expensive than anticipated when those interests are eventually repurchased. In addition, lenders sometimes may ask for stock warrants as an additional cost of financing, especially for a large, heavily leveraged transaction. As with compensating employees, there are alternatives to providing equity interest or warrants that companies may wish to consider:
- Earn-out agreements measure the revenue, earnings or cash flow of the business’s acquired elements and allow for calculation of additional contingent purchase price to be paid later—often one to three years after the purchase of the business closes
- Similar arrangements can be crafted with lenders allowing them additional finance fees or interest if the company meets certain performance targets; this can offer the upside associated with warrants without the legal complications of potentially having the lender become an owner of the business
Buying It Back
You also may have heard the phrase, “The best defense is a good offense.” When planning to reacquire equity interests in the hands of owners, there are a variety of methods to employ. Below are some common approaches to reacquiring equity interests.
Equity-Holder Purchase – The simplest approach may be for one owner to purchase equity interests from another. This may work for small ownership groups; however, issues can arise if the purchase shifts the balance of power, i.e., if a new shareholder or shareholder group acquires a majority interest. A cross-purchase provision in a buy/sell arrangement can be put in place in advance to structure how such a transaction may occur.
Company Tender Offer for Repurchase – This approach is common with public companies and can be quite useful for closely held enterprises. The company itself can offer to redeem equity interests from owners. This offer may take a number of forms; it’s a good idea to consult with legal counsel when determining how a corporation should structure such redemptions.
Reducing the total number of outstanding equity interests increases the relative ownership percentage for owners who don’t redeem their interests. While it reduces the company’s assets—cash or other assets are transferred out to owners to reacquire the interests—this can actually have a beneficial impact on the company’s performance ratios, e.g., return on equity or total assets, earnings per share or price-to-earnings ratio.
Leveraged ESOP – Rather than selling to owners or to the company itself, a third option may be to establish an employee stock ownership plan (ESOP). Unlike stock options or grants, the stock in such a plan is held in a trust and not actually distributed to or directly owned by employees. While employees get a retirement benefit derived from the growth in value of the company’s stock over time, they don’t directly participate in the governance of the sponsor company the way they would as actual stockholders. A leveraged ESOP can provide a cash-deferred incentive to employees as well as a current source of liquidity for stockholders who want to sell some or all of their stock without resulting in a change of control over the company. Depending on how it’s structured, an ESOP also may provide tax benefits to the company in the form of additional deductions as well as potential benefits to shareholders selling their stock to the ESOP. However, an ESOP is a U.S. Department of Labor-regulated employee benefit plan that can be complex to establish and brings ongoing annual costs that can include valuation of the company’s stock, administration of the plan and, potentially, an annual plan audit.
Each of the alternatives described above brings a number of financial, legal and tax issues that should be considered. From a tax perspective, it’s important to understand how both the corporation and the shareholders will be taxed when a stock transaction occurs.
Sales/Purchases Among Stockholders – The sale of stock from one shareholder to another is not taxable at the corporate level. At the individual shareholder level, the selling shareholder is taxed at preferential capital gains rates on the excess of the proceeds received over the amount paid for the stock, assuming the stock was held for more than 12 months prior to the sale. If the stock is sold at a loss, the loss will be disallowed if the stock is sold to a related person or entity.
While the corporation itself pays no tax related to the transfer of shares among shareholders, stock ownership changes could produce significant negative consequences at the corporate level in certain situations. If there is greater than 50 percent shift in corporation ownership, the rules of Internal Revenue Code (IRC) Section 382 will substantially restrict the corporation’s use of tax attributes, such as net operating losses, on a go-forward basis.
Redeeming Corporate Stock – At the corporate level, no deduction is allowed for any amount paid by the corporation to reacquire its own stock. However, interest and other fees related to debt incurred to finance the redemption are deductible. The Section 382 limitations described above also apply to redemptions.
The redeeming shareholder’s tax treatment depends on the type of redemption and the shareholder’s relationship to other corporate owners. In general, redemption payments are taxable to the shareholder as if they were dividends, unless an exception is met. While dividends also are eligible for preferential rates, dividend treatment may not be the best tax answer as shareholders cannot reduce their dividend income by their stock basis (amount paid to acquire the stock) or offset other sources of capital losses. Therefore, it’s often desirable to structure redemption payments to qualify for one of the exceptions described below.
When a redemption qualifies for an exception to dividend treatment, the redemption is treated as a payment in exchange for stock and the shareholder can offset the redemption proceeds with stock basis, thereby paying tax on only the gain (excess of redemption payment over cost of acquiring the shares). Assuming the shareholder owned the stock for more 12 months, this gain will qualify for preferential long-term capital gains rates. While the IRC provides several exceptions to avoid dividend treatment, the two most common exceptions are substantially disproportionate redemption and complete termination of interest. Structuring a redemption to qualify as either of these two exceptions can be difficult for closely held businesses, due to the family attribution rules (discussed later).
- Substantially Disproportionate Redemption – To qualify as substantially disproportionate, the shareholder’s interest after the redemption must be less than 80 percent of his/her interest before the redemption and the shareholder must possess less than 50 percent of the voting power after the redemption.
- Complete Termination of Interest – In a complete termination of interest, the shareholder surrenders 100 percent of his/her interest in the corporation.
Family Attribution Rules – The family attribution rules attempt to restrict a shareholder’s ability to easily manipulate stock ownership requirements by transferring shares among family members. To curb this perceived abuse, the family attribution rules consider a shareholder’s stock ownership to include the shares held by certain members of his/her family. For corporate shareholders, “family” means spouse, parents, children and grandchildren. Note that grandparents, siblings and in-laws are not “family” in this context.
For example, assume father, son and grandson collectively own 100 percent of a corporation’s stock; each individual owns 33.3 percent. After applying family attribution rules, grandfather is deemed to own 100 percent of the stock (his own plus his son and grandson). Son also is deemed to own 100 percent (his own plus his parent and son). However, grandson is only deemed to own 66.6 percent (his own plus his father’s).
The deemed ownership resulting from application of the family attribution rules must be used to determine whether a redemption qualifies as substantially disproportionate or as a complete liquidation. In addition, stock owned through other entities by or for the shareholder will be considered owned by the shareholder. Also, if a shareholder holds options, he or she is deemed to own the stock to which the options relate.
There’s an important exception to note with respect to the family attribution rules: In a complete termination of interest, the family attribution rules will not apply if, immediately after the redemption, the shareholder has no interest in the corporation as a shareholder, officer, director or employee and doesn’t acquire such an interest for 10 years after the redemption. In addition, a waiver of family attribution rules and notification must be filed with the IRS. This exception does not apply to substantially disproportionate redemptions.
Selling to an ESOP – ESOPs can provide major tax benefits to a company in the right situation. It’s possible for a 100 percent S corporation-owned ESOP to be exempt from federal and most state income tax, regardless of profitability. More in-depth discussion of ESOP tax strategies and benefits is available on BKD’s website.
Equity interest decisions can be difficult and complex, leading some to table them for a later time. However, if your company is facing these challenges—or would like to avoid them—you should consider taking some carefully planned steps today to avoid jumping through hoops tomorrow. Whether you’re considering implementing an “ounce of prevention” or a “good offense” to remain closely held, BKD advisors stand ready to help.