Tax Cuts Could Cut Into Selling by Closely Held Firms: New Rules Offer Big Payoffs for Holders Whose Stock Is Redeemed by Their Companies

The new federal law slashing the tax rate on dividends to 15% could dampen the supply of entrepreneurial firms for sale in the m&a market. According to analysts, the act, known as the Jobs and Growth Tax Relief and Reconciliation Act (JGTRRA), makes it easier for large stockholders of private concerns to sell their shares back to the company and take only a modest tax hit. In many cases, they suggest that could be a preferable alternative to seeking liquidity through a complete sale of the company. However, tax experts also spot a potential kicker for increased m&a dealmaking in another feature of the law, which cut the long-term capital gains tax rate to 15% from 20% through the end of 2008. In effect, the act signed on May 28 by President Bush at least temporarily puts a 15% tax bite on the private stockholder’s proceeds in most cases, regardless of the cash-out option. Which of the two tax carrots will prove to be sweeter for entrepreneurs facing liquidity choices over the next few years depends on myriad circumstances and individual business situations. But analysts emphasize that the enhanced attractiveness of the private company stock repurchase – also known as a redemption or a partial liquidation – has emerged as a more formidable rival to m&a as a cash-out mechanism. Robert Willens, a managing director and tax expert at Lehman Brothers, says that the warmer environment for tax-advantaged repurchases has the potential to constrict the sell side of the m&a market. “This is a major, major change,” he said. Key revisions that enhance the redemption route include: * Equalization of the tax on dividends and capital gains at 15%; * Erasure, for practical purposes, of technical differences in the form of the repurchase; and * Allowing the shareholder to remain active in the business after selling the stock back to the company. Willens explained how the new ground rules work in a recent edition of his Tax & Accounting analysis series. There are two classifications for stock redemptions in calculating the tax bite on the proceeds. If the deal is an “exchange,” it qualifies for the capital gains rate. But if the resale is a “distribution,” the proceeds are classified as dividends. Formerly, a distribution required the seller to pay ordinary income taxes – currently 35% at the top, down from the prior 38.6%. But under JGTRRA, the tax on dividends falls to 15% To win exchange treatment, the seller had to cut all ties with the company for a 10-year period and also had to sell any shares held by members of his family – the so-called “family attribution” factor. Technically, those requirements still exist. But because the bite on dividends and capital gains has been equalized, the seller suffers no tax penalty if he or she decides to stay on board and members of his or her family hang on to their shares. Tom Ochenschlager, a tax partner at Grant Thornton, noted in a recent web cast on the tax changes that a founder or other large shareholder can have the best of both worlds from a tax perspective. He sketched a common scenario in which the founder of a company that employs his grandchildren wanted to liquefy his assets but remain with the company. “Grandpa, who founded the company, wants to be redeemed and get some cash out, but nevertheless wants to be active enough to guide the younger generation in the management of the company,” he said. “If you redeem him out, he still can remain active. Formerly, the redemption proceeds would be taxed at a 38.6% rate. Under the new rules, the tax would be only at a 15% rate as if it were a dividend. There is no incentive under the new rules for grandpa not to remain active in the company and there is no need to qualify for the family attribution rules.” However, both Willens and Ochenschlager noted that exchange treatment still might appeal to sellers who are looking to squeeze the tax bite down to an absolute minimum. Under distribution treatment, the 15% tax hammers the entire proceeds. With an exchange, the 15% falls only on the difference between the shareholder’s basis, i.e., original cost, in the stock and the proceeds. “This will almost always reduce the total tax liability from a sale of stock below the amount due if a fully taxable dividend were paid instead,” noted a PricewaterhouseCoopers analysis. Stock repurchases under the new tax umbrella could be especially appealing to family owned and operated companies in which second, third, or even later generations have come on board and don’t want to see a change in control of the business. Redemptions could avoid rupturing the family, provide for continuity in management and ownership, and bypass an m&a process that many business people consider complex and disruptive. The new tax climate also offers a mechanism for selling control shares to employees of the business, in effect serving as a performance incentive tool. A straight sale in the m&a market would be more attractive if multiple family members or non-relative insiders want to sell at the same time or if the company lacks the funds or can’t borrow to pay off the key holders. In those cases, the 15% capital gains rate might be the more compelling tax lure. PricewaterhouseCoopers, for one, sees the reduced levy as a major selling spur for private companies facing a virtual win-win decision under JGTRRA. “As the government cracks down more and more heavily on so-called abusive tax shelters, business owners may be persuaded to take advantage of a fully sanctioned tax shelter: Sell now before rates go back up,” said a recent Deal Flash prepared by partners Michael Kliegman, Mark Boyer, and Jonathan Davies. “If you think a five-point reduction in tax rates is not enough to influence the behavior of owners and investors, think again. From our experience, it is almost impossible to overestimate the desire to minimize taxes. This mind-set could create win-win opportunities for owners as well as private equity firms.” (For the impact of JTGRRA on the private equity market, see LBO Signposts on page 18.) Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com