Page 25 - Investment Advisor May 2021

shareholders exchange all their stock again on dividends. Many closely-held a tax-inefficient manner. Here are tax
for New S shares. Old S then elects to C-corps circumvented this double- planning alternatives to consider with a
be a qualified subchapter S subsidiary, taxation by distributing excess cash- legacy C-corp.
which is a disregarded entity for tax flow as compensation. However, this • LLC conversion. One solution
purposes. New S then forms a wholly- strategy can trigger Internal Revenue might be to convert the C-corp to an
owned LLC, which is initially disre- Service scrutiny for tax-avoidance and S-corp ahead of a more tax-efficient
garded for tax purposes, and Old S is does not work for outside investors asset sale down the road. This solu-
merged into the LLC with LLC as the who are not employees. tion is not as attractive, though, if the
surviving entity. In the strategic planning context, RIA’s ownership mix would violate the
The merger is not a taxable event however, the more significant obstacle S-corp rules described above, or if the
because both Old S and the LLC are dis- is the inability to structure an even- shareholders are contemplating a sale
regarded for tax purposes. Furthermore, tual liquidity event as an asset sale with- of the business in less than five years
depending on the applica- (the IRS’s required look-
ble state laws, Old S’s busi- The biggest drawback to the LLC back period).
ness interests may transfer •Dr op -and- fr eeze
to the LLC with limited, drop-down alternative is that transaction. One solu-
if any, third-party consents tion is a “drop and freeze”
required. Moreover, the the firm must notify all clients transaction through which
RIA is now in a new LLC the C-corp is dropped into
that can take on institution- of the change in ownership a newly formed LLC. The
al investors, plus has the C-corp shareholders take
flexibility to create more structure. [This may mean] back a preferred interest
innovative employee incen- every client would potentially in the LLC (with little to
tive plans that are typical no upside potential) and
of LLCs. need to sign off on the transfer. the junior or common
• Convertible debt. A equity in the LLC is sold or
third option is to structure distributed to those stake-
the investment as a convertible loan out triggering a tax bill; a C-corp is holders who the parties wish to par-
rather than as equity. Because the con- taxed both at the corporate and share- ticipate in the upside of future growth
vertible feature of the loan does not holder levels upon this sale, whereas of the business.
constitute equity at the time of the ini- pass-through entities such as LLCs or The value of the overall enterprise
tial transaction, this structure does not S-corporations are only taxed at the that is subject to double taxation is
violate the S-corp rules until it is actu- shareholder level. therefore “frozen” inside the C-corp as
ally exercised. Many times, the choice of an asset of the restructuring date, and any future
deal is influenced by the acquirer’s value created accrues to the LLC, which
CHALLENGES AND SOLUTIONS FOR desire to obtain significant tax savings is only subject to one-level of taxation.
C-CORPS by stepping up the assets’ basis to the In addition to preserving long-term
C-corps also were popular among purchase price (generally referred to value, this alternative also facilitates
RIAs — particularly if they could not as a depreciation tax shield). Because succession planning because the
qualify as S-corps. If the RIA wanted these tax savings are measurable, the firm’s value overwhelmingly will be
to limit liability and had any foreign parties can calculate the net present at the C-corp level at the time of the
shareholders, for instance, or wished to value of these future cash flows and transaction. Therefore, equity in the
structure multiple classes of stock for its negotiate a split of the economics as part LLC can be sold to next gen managers
owners, C-corps were often the default of the deal. at low prices because the equity only
choice with key limitations. has a claim on the future growth of
Double taxation issues. Among the What to do? the business.
most obvious drawbacks of C-corps Even if the principals are not contem-
Adobe Stock RIA’s earnings are taxed at the corpo- in the foreseeable future, the fact is that Peter Nesvold is the founder of Nesvold
plating an exit or other liquidity event
is the impact of double taxation: the
Capital Partners. James Cofer is a partner of
value is accruing inside the C-corp in
rate level, and shareholders are taxed
Seward & Kissel.
MAY 2021 INVESTMENT ADVISOR 23