business divorce: planning for when businesses come … · 2012. 6. 8. · a business divorce,...

BUSINESS DIVORCE: PLANNING FOR WHEN BUSINESSES COME APART, PART 1

& PART 2

First Run Broadcast: June 12 & 13, 2012

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes each day)

The owners of closely held businesses sometimes decide they can no longer work together. It

may be that the business is not a success and they want to be done with it – or the business may

be a wild success, but they can no longer bear to be in the same company as the other owners.

They want a “business divorce” – to separate the assets of company, each going his or her own

way, perhaps carrying on the business in whole or part. Sometimes the emotional friction that

attends these separations impairs the operating business or diminishes the value of its assets.

This program will provide you with a practical guide to minimizing the adverse consequences of

a business divorce, including effective transactional techniques to separate operating assets while

allowing the business to continue, limiting adverse tax consequences, dealing with

compensation, competition and intellectual property issues, and much more.

Day 1: June 12, 2012:

Planning for a closely-held “business divorce” – practical legal, tax and financial issues

and consequences

Special issues for S Corps, LLCs and partnerships

Transactional techniques short of liquidation to accomplish a divorce, including buy-sell

agreements, compensation and retirement plan techniques

Dividing assets of an operating business while preserving the business

Minimizing adverse tax consequences after a business divorce

Day 2: June 13, 2012:

Special issues in “distressed” business divorces

Valuation techniques for closely held businesses during a business divorce and financing

a buyout

Role of non-competition agreements

Compensation techniques for accomplishing a business divorce

Important intellectual property issues, including customer lists, goodwill and trade secrets

Preservation of valuable tax attributes

Speakers:

Frank Ciatto is a partner in the Washington, D.C. office of Venable, LLP, where he has more

than 20 years’ experience advising clients on major corporate transactions, including mergers

and acquisitions, corporate finance, antitrust and related tax issues. He is a leader of his firm’s

private equity and hedge fund groups and a member of the Mergers & Acquisitions

Subcommittee of the ABA Business Law Section. He is a Certified Public Accountant and

earlier in his career worked at what is now PricewaterhouseCoopers in New York. Mr. Ciatto

earned his B.A., cum laude, at Georgetown University and his J.D. from Georgetown University

Law Center.

Norman Lencz is a partner in the Baltimore, Maryland office of Venable, LLP, where his

practice focuses on a broad range of federal, state, local and international tax matters. He

advises clients on tax issues relating to corporations, partnerships, LLCs, joint ventures and real

estate transactions. He also has extensive experience with compensation planning in closely held

businesses. Mr. Lencz earned his B.S. from the University of Maryland and his J.D. from

Columbia University School of Law.

VT Bar Association Continuing Legal Education Registration Form

Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: _____________________ Middle Initial: _____Last Name: __________________________

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City:__________________________________ State: _________ ZIP Code: ______________

Phone #:________________________ Fax #:________________________

E-Mail Address: ____________________________________________________________________

I will be attending:

Business Divorce:

Planning for When Businesses Fall Apart, Part 1 Teleseminar

June 12, 2012

Early Registration Discount By 06/05/2012 Registrations Received After 06/05/2012

VBA Members: $70.00 Non VBA Members/Atty: $80.00

VBA Members: $80.00 Non-VBA Members/Atty: $90.00

NO REFUNDS AFTER June 5, 2012

PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit

PAYMENT METHOD:

Check enclosed (made payable to Vermont Bar Association): $________________ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # ________________________________________Exp. Date_______ Cardholder: ________________________________________________________

Vermont Bar Association

ATTORNEY CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: June 12, 2012 Seminar Title: Business Divorce: Planning for When Businesses Fall Apart, Part 1 Location: Teleseminar Credits: 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

VT Bar Association Continuing Legal Education Registration Form

Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: _____________________ Middle Initial: _____Last Name: __________________________

Firm/Organization:____________________________________________________________________

Address:___________________________________________________________________________

City:__________________________________ State: _________ ZIP Code: ______________

Phone #:________________________ Fax #:________________________

E-Mail Address: ____________________________________________________________________

I will be attending:

Business Divorce:

Planning for When Businesses Fall Apart, Part 2 Teleseminar

June 13, 2012

Early Registration Discount By 06/06/2012 Registrations Received After 06/06/2012

VBA Members: $70.00 Non VBA Members/Atty: $80.00

VBA Members: $80.00 Non-VBA Members/Atty: $90.00

NO REFUNDS AFTER June 6, 2012

PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit

PAYMENT METHOD:

Check enclosed (made payable to Vermont Bar Association): $________________ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # ________________________________________Exp. Date_______ Cardholder: ________________________________________________________

Vermont Bar Association

ATTORNEY CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: June 13, 2012 Seminar Title: Business Divorce: Planning for When Businesses Fall Apart, Part 2 Location: Teleseminar Credits: 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

PROFESSIONAL EDUCATION BROADCAST NETWORK

Speaker Contact Information

Business Divorce: Planning For When Businesses Come Apart,Part 1 & Part 2

Frank CiattoVenable LLP - Washington, D.C.(o) (202) [email protected]

Norman LenczVenable LLP – Baltimore, Maryland(o) (410) [email protected]

1

© 2008 Venable LLP

BUSINESS DIVORCES

2

Business Divorces

© 2012 Venable LLP

The 50/50 Partnership Conundrum

Tiebreaker provisions are critical

Valuation Methodology

S Corp v. LLC Tax Issues

Overview of Planning for a Closely-Held “Business Divorce” –

Practical Legal, Tax and Financial Issues and Consequences

3

Business Divorces

© 2012 Venable LLP

For C Corp – capital gain vs. dividend treatment

for redeemed stockholder is the biggest issue

Currently, same 15% tax rate for capital gains

and dividends

Dividend rate set to increase to over 40% in 2013

Special Issues for S Corps, LLCs and Partnerships

4

Business Divorces

Capital gain vs. dividend issue is generally less

important than in the C Corp context

Buy-Sell Agreement at time of formation is

absolutely crucial to ensure compliance with S

Corp rules

Buy-Sell Agreement should prohibit transfers to

ineligible S Corp shareholders such as

1. certain types of trusts

2. corporations

3. multi-member LLCs

4. nonresident aliens

© 2011 Venable LLP

Special Issues for S Corps

5

Business Divorces

Special allocations, disproportionate distributions

and multiple classes of stock are prohibited,

which limits flexibility in the business divorce

context

Distributions of appreciated property are

generally taxable, unless a tax-free spin-off is

feasible

No “look-through” to ordinary income assets on

transfer or redemption of S Corp stock

© 2011 Venable LLP

Special Issues for S Corps (cont’d)

6

Business Divorces

Special allocations, disproportionate distributions

and multiple classes of interests may be used to

effect a “separation” vs. a “divorce”

Appreciated property can generally be distributed

tax-free

Basis step-up inside the LLC/partnership (Section

754 election)

© 2011 Venable LLP

Special Issues for LLCs and Partnerships

7

Business Divorces

Because of flow-through tax treatment, tax

distributions should be mandatory

Election to “close the books” upon transfer or

redemption of stock/interests is generally

available

Cross-Purchase vs. redemption issues should be

considered

Cash can generally be distributed tax-free to the

extent of tax basis in stock/interest

© 2011 Venable LLP

Issues Common to S Corps, LLCs and Partnerships

8

Business Divorces

© 2012 Venable LLP

Buy-Sell Provisions

Russian Roulette

Right of First Offer

Right of First Refusal

Sale upon Divorce (mandatory or optional)

Sale upon Termination (mandatory or

optional)

Consulting Arrangements

Retirement Payouts/Installment Sales

Transactional Techniques Short of Liquidation to Accomplish a

Divorce, including Buy-Sell Agreements, Compensation and

Retirement Plan Techniques

9

Business Divorces

© 2012 Venable LLP

Considerations:

Discrete Business Lines

Payroll, Accounting and Financial Reporting

Functions

Office Space

True Separation v. One Partner Providing

Management Functions to Other

Dividing Assets of an Operating Business While Preserving the

Business, including Spinoffs

10

Business Divorces

© 2012 Venable LLP

Will the separation be accomplished in a taxable

or tax-free manner?

Will the separation be accomplished through a

redemption or a cross-purchase?

Will a basis “step-up” be available?

Will post-closing consultation or compensation

arrangements be used to maximize tax

efficiencies?

Minimizing Adverse Tax Consequences Pursuant to a Business

Divorce

11

Business Divorces

© 2012 Venable LLP

Deeper pocket partner has increased leverage to

absorb a forced financial loss

If Company has cash flow concerns, it likely

means longer payout period and more risk to

departing partner

Distressed scenario means unlikely or harder to

pay salary to non-contributing/departing owner

Departing partner becomes another in a line of

claimants against Company and will be viewed as

an “Insider” for bankruptcy purposes

Business “stress” likely to make a deal among

knowing partners harder to consummate

Special Issues in “Distressed” Business Divorces

12

Business Divorces

© 2012 Venable LLP

Three primary approaches

Asset

Income

Market

Multiple valuation methodologies available under

each of these three approaches.

Financing Options

Life Insurance

“Seller” Financing

Third-Party Debt

Valuation Techniques for Closely Held Businesses During a

Business Divorce and Financing a Buyout

13

Business Divorces

© 2012 Venable LLP

Identifying and defining assets owned by business(and not individually by founding partners) is criticalbusiness divorce objective

Protecting Company assets through:

Confidentiality Provisions

Noncompetition and nonsolicitation provisions

Trade secret and intellectual property provisions

Provisions Need to be Supported by ValidConsideration and Narrowly Drawn to OptimizeEnforceability

Pro-competitive Business Divorces

Lower purchase price and no barriers to entry

Free-for-all environment should still bedocumented

Role of Non-Competition Agreements & Important Intellectual

Property Issues, Including Customer Lists, Goodwill and Trade

Secrets

14

Business Divorces

© 2012 Venable LLP

Installment Sale or Promissory Note

Employment Agreement (usually to maintain

benefits)

Consulting Agreement

“True” consulting

Disguised purchase price

Earn out or other post-closing profits-based

consideration

Compensation Techniques for Accomplishing a Business

Divorce

15

Business Divorces

© 2012 Venable LLP

C Corp NOL preservation is most crucial issue

Must avoid an “ownership change” (i.e., change

of 50 “percentage points” of ownership over any

3-year period)

In corporate, LLC and partnership “spin-offs”,

must allocate tax attributes among the surviving

entities

Preservation of Valuable Tax Attributes

16

© 2012 Venable LLP

Contact Information

Frank A. Ciatto, Partner

[email protected]

t 202.344.8150

f 202.344.8300

YOUR VENABLE TEAM

Norman Lencz, Partner

[email protected]

t 410.244.7842

f 410.244.7742

www.Venable.com

17

© 2011 Venable LLP

the road ahead forABC CORPORATION

Thank you for attending.

308998

BY

FRANK A. CIATTO

VENABLE LLPWASHINGTON, D.C.

1. TYPE OF CORPORATION

(a) C corporation

(b) S corporation

2. PARTIES TO THE AGREEMENT

(a) All shareholders

(b) If not all shareholders, how will excluded shareholders be dealt with

3. GOVERNANCE

(a) Vote pooling arrangements for Board of Directors and officers.

(b) Shareholder voting arrangements and veto rights over certain corporate actions.

(c) Minority shareholder protections.

4. TRANSFERABILITY OF SHARES

(a) Permitted lifetime transfers to third parties

(i) Rights of first refusal

(ii) Gifts – outright and in trust

(b) Pledges

(c) Tag along rights

(d) Drag along rights

5. STOCK BUYOUT PROVISIONS

(a) Triggering events:

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(i) Death

(ii) Disability

(iii) Retirement

(iv) Termination of employment

Voluntary

Termination with/without cause

Termination for good reason

(v) Removal/resignation from Board of Directors

(vi) Other buyout events

Bankruptcy of shareholder

Loss of professional license by a shareholder if entity is a professionalcorporation or association

Dissolution or change of control of corporate or other entity-ownedshareholder

Shareholder providing services to, or owning an interest in, a competingbusiness

(vii) Russian roulette provisions

(b) Mandatory versus optional buyouts

(i) Cross-purchase versus redemption

(ii) Possible buyout scenarios:

Corporation and other shareholders have an obligation to purchase thestock and the shareholder has an obligation to sell

Corporation or other shareholders have an option to purchase (i.e., call)the shareholder’s stock

Shareholder has an option to sell (i.e., put) the stock to the corporationor other shareholders

Coexistent cross-options between the shareholder and the corporation(and/or other shareholders)

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(c) Consider buyouts in related entities that do business with the corporation

6. STOCK PURCHASE PRICE CONSIDERATIONS

(a) Book value

(b) Capitalization of earnings formula

(c) Discounted cash flow formula

(d) Appraisal procedure

(e) Annual valuation updates

(f) Use of minority discounts and control premiums

(g) Contingent purchase price adjustment if corporation experiences a “change ofcontrol” transaction

7. PAYMENT TERMS UPON PURCHASE OF STOCK

(a) Cash

(b) Insurance funding

(c) Bank financing

(d) Selling shareholder financing

(i) Payment term

(ii) Frequency of payments

(iii) Rate of interest

(iv) Collateral

(v) Guarantees

(e) Restrictions on annual deferred payments if there have been multiple stockbuyouts

8. PLANNING FOR OTHER CORPORATE STRATEGIES

(a) Initial public offering

(b) Lock-up agreements

(c) Demand or piggyback registration rights

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9. TAX CONSIDERATIONS

(a) Buyouts of stock

(i) Qualification as sale or exchange under I.R.C. Section 302 for corporaterepurchase; evaluate any potential impact of family attribution rules underI.R.C. Section 318

(ii) Installment reporting under I.R.C. Section 453 for deferred payments

(iii) Avoidance of imputation of interest for deferred payments under I.R.C.Section 1272

(iv) Alternative minimum tax considerations under I.R.C. Sections 55 and 56 iffunding with corporate-owned life insurance in the case of a C corporation

(v) Stock basis implications associated with cross-purchase versus redemption

(b) S corporation considerations

(i) Preservation of S corporation status, including safeguards against thirdparty transfers to impermissible S corporation shareholders

(ii) Imposition of liability upon shareholders who jeopardize S corporationstatus

(iii) Permitting periodic distributions to shareholders to cover tax liability onallocable share of S corporation taxable income

10. STATE CORPORATE LAW RESTRICTIONS ON CORPORATE REPURCHASES

11. RESTRICTIVE COVENANTS

(a) Confidentiality agreement

(b) Assignment of intellectual property rights

(c) Covenants against competition and solicitation of customers and employees

(d) Duration and scope of restrictions

(e) Specify civil and equitable remedies in the event of a breach

12. MISCELLANEOUS CONSIDERATIONS

(a) Indemnification for guarantees of corporate obligations

(b) Indemnification of officers and directors

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(c) Dispute resolution

(i) Mediation

(ii) Arbitration

(iii) Judicial

13. AMENDMENT OF AGREEMENT

(a) Unanimous?

(b) Less than unanimous?

(c) Combination of (a) and (b) depending upon the event triggering an amendment?

14. TERMINATION OF AGREEMENT

(a) Use a date certain

(b) Buyout of a certain number or percentage of shareholders

(c) Agreement by shareholders

(d) Survivability of certain provisions post-termination

Special Buy-Sell Provisions for S Corporations

In addition to the normal provisions of a buy-sell agreement for a regular corporation, the

agreement entered into by the owners of an S corporation (and the corporation itself) must

contain a number of provisions mandated by the tax status of the corporation, so as to preserve

the S election status of the corporation.

1. The agreement should grant an immediate option to the corporation and other

shareholders to purchase any stock whose transfer would jeopardize the S

election, exercisable at a price which the corporation and the remaining

shareholders determine, in their sole discretion, to be “fair” and to hold the

transferor liable for any damages which are incurred either by the corporation or

the remaining shareholders as a result of the attempted transfer.

2. The agreement should permit lifetime or testamentary transfers to trusts for

descendants of shareholders or others, only if the trust is either a Qualified

Subchapter S Trust1 or an Electing Small Business Trust.2 Some agreements go

on to require the consent of the other shareholders and an opinion of counsel that

the transfer will not jeopardize the S election.

3. The owners of the S corporation should give consideration to the income tax

consequences of a withdrawing shareholder. Unless an election were made under

Code Section 1377(a)(2), all income and losses for the entire year are allocated on

a per day basis, with the withdrawing shareholder bearing the tax consequences

on his or her proportionate interest.

1 Code Section 1361(d). 2 Code Section 1361(e).

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A 1377(a)(2) election, on the other hand, would permit the S corporation to

allocate income and losses as though there were two tax years: one ending upon

the withdrawal of the shareholder and the second beginning on the day after that

event. This election permits the terminating shareholder to avoid the

consequences (or to share in the benefits) of post termination income and losses to

the corporation.

The agreement might require that all of the shareholders of the S corporation

agree to make the 1377(a)(2) election.3 The agreement should go on to provide

that the departing shareholder should actually receive the net income earned by

the S corporation up to the termination of his interest, in view of the fact that he is

being taxed on those earnings.

4. The value paid for the interest of the departing shareholder should reflect any

increased income tax liability which is thereby imposed upon the remaining

shareholders.

5. The agreement should deal with the possibility that a corporate redemption may

not qualify for capital gains tax treatment in the hands of the departing

shareholder.

If the redemption does qualify as a sale or exchange, the departing

shareholder will have taxable gain only to the extent the payment received

exceeds his basis and only a proportionate share of the corporation’s accumulated

adjustment account t (AAA) is deemed to have been distributed.

If the redemption does not qualify as a sale or exchange, on the other

hand, the order of distributions is as follows: (a) the distribution is non-taxable to 3 Regulations Section 18.1377-1.

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the extent it does not exceed the corporation’s AAA; (b) any excess distribution

over that is treated as a dividend subject to ordinary income taxation to the extent

of the corporations’ accumulated earnings and profits; (c) any excess distribution

over that is treated as a non-taxable return of basis; and (d) any excess distribution

over that is treated as a capital gain distribution. If the shareholder’s stock is

redeemed as a result of his death and the agreement is funded with insurance on

the shareholder’s life, there can be significant dividend problems. That is, the

receipt of the insurance proceeds increases the basis of the shareholders, but does

not increase AAA. If the redemption proceeds exceeds the corporation’s AAA

(which is not increased by the amount of the insurance proceeds), dividend

treatment to the deceased shareholder may result.

6. If the redemption takes place by the distribution of appreciated assets of the S

corporation, there is a deemed sale of those assets, with any gain reportable by all

the shareholders. The impact of this consequence on the remaining shareholders

should be taken into consideration when the redemption price is determined under

the agreement.

7. The agreement should prohibit loans, stock options or other transactions which

would constitute a second class of stock.

8. The agreement should provide that the corporation will, at a minimum, distribute

at least quarterly sufficient dividend income to enable the shareholders to pay

their resulting income tax liability. Care should be exercised, however, to avoid

the second class of stock argument by distributing the same amount pro rata


among all the shareholders and not basing distributions on their relative tax

brackets.4

4 Regs. Section 1.1361-1(a)(2)(v), Example 6.


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BUSINESS DIVORCE – MAJOR TAX ISSUES

byNorman LenczVenable LLP

Tax issues inevitably arise during the course of any business separation. If one

business owner or group of owners buys the interest of another business owner or group of

owners for cash, the transaction will be taxable. In other circumstances, however, the parties

often can accomplish their business separation on a tax-free basis. In all circumstances, the

parties should consider the tax issues arising in their business divorce and balance those issues

with the other business issues involved in the overall transaction. The questions listed below

represent some of the major questions that are likely to arise during any business divorce

negotiation.

1. Will the Separation be Accomplished in a Taxable Cross-Purchase?

(a) Buyouts for Cash

(i) Tax Consequences to Seller

(ii) Tax Consequences to Buyer

(b) Buyouts for Notes



(c) Buyouts for Other Property



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2. Will the Separation be Accomplished in a Taxable Redemption?

(a) Redemption v. Cross-Purchase

(b) Corporate Redemptions


(ii) Tax Consequences to the Company

(iii) Tax Consequences to the other Shareholders

(c) Partnership/LLC Redemptions


(ii) Tax Consequences to the Company

(iii) Tax Consequences to the other Partners

(d) Efficiencies in Making Deductible Payments

3. Can the Separation be Accomplished on a Tax-free basis?

(a) Unavailability of Section 1031

(b) Separating C and S corporations

(i) Spin-offs, Split-offs and Split-ups

(ii) Consequences of Qualifying under Section 355

(iii) Consequences of Failing to Qualify under Section 355

(iv) Qualification under Section 355

(1) Business purpose requirement

(2) Active trade or business requirement

(3) Continuity of interest

(4) Change of control limitations

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(5) Continuity of business enterprise

(6) Other requirements

(c) Separating Partnerships and LLCs

(i) General Partnership Distribution Rules

(ii) Exceptions

(1) non pro rata distributions

(2) disguised sales

(3) anti-mixing bowl rules

(d) Effect of Continuing Interests

4. Will any Special Compensation Issues Arise?

(a) Efficiencies in Making Deductible Payments

(b) Treatment of Stock Options and other Equity Compensation

(c) Splitting 401k Plans

(d) Consequences of Termination of Employment

5. Will any Valuable Tax Attributes Need to be Preserved?

(a) Taxable Corporate Separations

(i) General Rules

(ii) Impact of Section 382

(b) Tax-free Corporate Separations

(c) Partnerships and LLCs