Tax Advantaged Structuring
Entity Structure Impacting Returns
While uncertainty still exists with the overall U.S. tax code and rates, one thing that is not expected to change is the tax advantages of structuring a business as a flow through entity to avoid the double taxation of a C-Corp. By utilizing an LLC structure, we have the ability to structure the ultimate exit of a portfolio company as either an asset or stock sale with only a slight difference in the overall tax liability. This creates significant flexibility and advantages.
During an acquisition, we are generally willing to pay more when we can acquire the assets of the business. Not only can we benefit from the tax benefits of amortizing purchased goodwill but we believe we can limit our overall liability exposure that can arise from the contingent liabilities of the seller. We believe these same favorable considerations create an opportunity for the next owner when we exit our businesses. Those advantages often lead to an overall higher valuation.
Structure Creates Tax Advantages
In the right situation, we have the ability to improve the IRR dramatically by taking advantage of the build-up in owner basis that is available when owning an LLC. This structure allows us to make a “tax free” distribution to the owners during the holding period of a portfolio company. On the other hand, due to the high “double” tax burden this would create in a corporate structure, a corporate dividend is generally not viewed as an option. If add-on acquisitions or other productive uses of cash inside the business do not make sense, the best option to a portfolio company organized as a C-Corp with excess cash flow is generally paying down debt and the most efficient way to return capital to owners is by selling the stock of the company. The LLC structure gives us many more options. It allows us to be more strategic when timing our exit without foregoing the ability to tax efficiently returning capital while still continuing to own the business.
To highlight these benefits, we have provided the following example. We assume that during the life of the portfolio company, all income is taxed at the current highest Federal rates for corporations and individuals. The rate for corporations is 35% and the rate for individuals is 43.4% for ordinary income and a 23.8% rate for dividends and capital gains.
Example of improved investor returns when utilizing an LLC structure
We acquire the assets of a business that is generating $4m of EBITDA for $20m. We capitalize the business with $15m of bank debt and $5m of equity. We assume the business is able to increase EBITDA by $.5m in each year we own the company and under the LLC structure we borrow additional debt in year three to recapitalize the company and return twice the invested capital to the owners. We assume that a company owned in the C-Corp structure does not pay a dividend due to the double tax cost but instead, continues to pay down additional acquisition debt. We exit the portfolio company at the end of five years at a gross value of $35m.
We assume the buyer is willing to acquire the stock of the business, in which case we have the ability to convert the LLC to a C-Corp prior to sale so that the treatment of the gain at exit is consistent with that of the C-Corp.
Results: You “keep” more in a LLC structure
On a pre-tax basis, the C-Corp structure looks better as it returns a gross cash multiple of 7.42x versus 6.90x. However, as an LLC the after-tax cash proceeds would be $1.2m higher or a 4.7% improvement as an LLC owner benefits from the build-up in tax basis during the holding period. The after-tax IRR is higher for an LLC, 54.9% vs. 42.6%, impacted by the higher net proceeds and the recap distribution paid in year three. Not considered in the analysis are any additional returns that could be generated by our investor from the “tax free” distribution that went back to them in year three. The full distribution can be invested depending on their risk tolerances which may be different than how cash is invested in the C-Corp.
I’m happy to share my spreadsheet analysis with anyone who has interest.
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Mike Harding, CFO
August 15, 2014