Planning with the End in Mind: Tax Considerations Before Selling Your Pest Management Business
The pest control industry tends to have a high volume of mergers and acquisitions, perhaps because these companies offer an attractive feature to buyers—the recurring revenue stream. As a result, it’s more likely your exit from the business will be through a sale to a large competitor such as Terminix, Orkin, or Anticimix, rather than through management buyout or family transition.
Many pest control operators (PCO) start out with the goal of selling in mind, but then the daily operations and management of the business crowd out strategic planning until deal day dawns. It’s usually at this time that our firm receives a call from the business owner requesting a valuation and tax advice. While consulting an expert is certainly highly recommended, we would shout from the rooftops that PCOs should consult the relevant advisors earlier in the process to help enhance value.
Even if the sale of the company is not currently in your strategic plan, a significant portion of your net worth is most likely tied up in the business, so measuring the risk and return of your investment is time well spent.
Two important factors to consider now, rather than later, are the gap between current value and desired value and tax structure of the entity.
Measure the Gap
Many business owners do not consider how they are using the funds received from a transaction until the deal is complete. In other words, they negotiate blindly. Regardless of whether you plan to roll the funds into a new venture or sail off into retirement, it’s critical to know what value you need out of the business transaction before agreeing upon a sales price.
In coordination with a financial advisor, walk backward and determine how much after-tax proceeds you need to fund retirement or the next investment goal. This desired value should then be compared to the current value of your business to determine if there is a gap. A valuation expert can measure the current value and walk you through the asset and income approaches. A good valuation specialist is also a great resource to weigh in on how to build value and close the gap. For example, if your earnings before interest, taxes, depreciation, and amortization (EBITDA) is higher in the termite service line than in bed bugs, consider funneling more marketing dollars toward the termite service line.
By evaluating your company’s entity structure now, rather than at the deal table, you’ll have more options available to help increase after-tax proceeds. The sale of a business is typically structured as the sale of either the individual assets or the stock of the company. The deal structure determines the tax consequences and whether the proceeds will be taxed at the current preferential capital gains rates or the individual’s ordinary income tax rates.
With the current legislative proposal including an increase in the top capital gains rates from 20 percent to 25 percent, the value of advance tax planning is increasing.
For example, there are significant benefits available for qualified small business stock (QSBS). Section 1202 of the Internal Revenue Code was created to encourage investment in certain small businesses by allowing investors to avoid tax on some or all of their gain from the sale of QSBS if held for at least five years. To qualify as QSBS, the stock must be:
- Issued by a domestic C corporation with aggregate gross assets that do not exceed $50 million; the entity can be converted to a C corp prior to the transaction and qualify if the holding period and aggregate asset threshold are met
- Issued after August 10, 1993
- Acquired by a taxpayer directly from the company in exchange for money, property, or services
If eligible, each stockholder can avoid paying federal tax on gains up to the greater of $10 million or 10 times their tax basis. Please see planning opportunities for QSBS in this recent BKD Thoughtware® article. Note, current legislation also includes a proposal that would limit the benefit of Section 1202 for taxpayers with adjusted gross incomes of $400,000 or more, or any estate or trust.
Tax Deferral or Gain Exclusion
In addition to considerations such as entity design, asset versus stock structure, electing in- or out-of-installment sale treatment, and allocation of purchase price, there are other strategies to defer or decrease the tax cost of a transaction.
Investing the sale proceeds in an Opportunity Zone (OZ) business, property, or fund allows for deferral of tax payment on the gain and even partial exclusion of the gain. An OZ is an economically distressed area, as defined on this map. There are multiple tax benefits of investing in an OZ business, piece of property, or fund, e.g., the deferral of capital gain recognition until the earlier of: date of sale of the OZ investment or December 31, 2026, as well as the exclusion of up to 15 percent of the original deferred gain, if held for more than seven years, and permanent exclusion of tax on gains resulting from post-investment appreciation, if held more than 10 years. Keep in mind, the benefit of capital gain recognition deferral could be offset by the higher top capital gains rate as contemplated under proposed legislation.
For the charitably inclined, there are many opportunities available, ranging from gifting appreciated stock to the more sophisticated vehicles, such as a charitable remainder trust. The proceeds can be donated to a charitable remainder trust, generating a tax deduction and stream of annual revenue for the donor during their lifetime, while the remainder of the trust goes to the designated charity at death.
Depending on the amount of proceeds received, an owner may also need to consider estate and gift planning. Currently, an individual can give away during life or at death up to $11,700,000 without incurring estate or gift tax at the 40 percent rate. However, the current legislative proposal on the table would drop the exemption to an inflation-adjusted $5 million per person. Working with a competent estate planner can help you sustain a successful transfer of wealth from one generation to the next.
Planning with the end in mind brings to light several considerations that may be foreign, uncomfortable, and even surprising to a PCO who may only enter an exit strategy once in a career. BKD’s team of professional advisors considers the business succession, transaction, and personal tax considerations, along with estate and wealth planning. We help guide our clients through the process from beginning to end and provide our experience and technical knowledge to help business owners develop appropriate goals, avoid pitfalls, and land gracefully.
For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below. To learn more about how we can help your pest control company, check out our outsourced accounting and tax services.