Planning for Closely Held Business Owners Flashcards
1
Q
Angel Investors
A
- Angel investors typically form groups to provide equity financing to start-up companies. Angels should be considered if the new business owner(s) cannot qualify for adequate bank financing, but still require outside financing. Because angels can set their own terms, care should be taken when negotiating this financing.
- Most angels will want to assist with advising the business; however, they do not seek control.
- They may also set certain contingent guidelines and goals for the business.
- Angel investors generally hope to achieve a return of three to five times their original investment.
- Two types of financing may also seem similar. With debt, the corporation has a formal obligation to make regular interest payments. With equity, the corporation has an informal obligation to pay dividends to its shareholders
2
Q
Venture Capital
A
VCs provide financing for high growth companies in exchange for significant equity. VCs are generally funded by risk-tolerant private investors who seek high returns within a short period of time. VCs typically strive for annual returns of at least 20 percent to 40 percent with investment periods ranging from three to seven years.
3
Q
Mezzanine Financing
A
- Mezzanine financing may be characterized by a hybrid types of security, junior to venture capital and senior debt, often requires little to no collateral, equity conversion feature in case of default.
- Mezzanine capital. These are typically structured as either a subordinate debt or preferred stock investment with claims below that of the other debt issued by the entity but above that of the common stockholders. Entities that obtain financing in this manner must pay a higher cost due to the investor’s junior position.
4
Q
Leveraged Buyouts
A
At its most basic level, an LBO is a method of acquiring a company with money that is nearly all borrowed. This allows investors to make a large acquisition without committing a lot of capital. The acquirers of the target company often attempt to sell or take the target company public after five or ten years in the hopes of making sizable profits. Doing an LBO can be expensive and complex, but if successful can provide considerable returns.
5
Q
Distressed Debt
A
Since this area focuses on investing in entities that are in default, under bankruptcy protection, or headed in that direction, investors must evaluate not only the ability for the entity to make a comeback but also which class of securities might be more beneficial to hold during a restructuring process.
6
Q
Restructuring
A
Restructuring includes mergers, acquisitions, divestitures, recapitalizations, leveraged buy-outs, reorganizations, downsizings, and other types of restructuring of a corporation.
7
Q
C-Corporations
A
- A corporation is a unique entity that is separate and distinct from its shareholders. A corporate shareholder is only liable for corporate debts and liabilities to the extent of his or her investment in the corporation.
- The death, insolvency, or bankruptcy of a shareholder does not terminate the existence of a corporation. Unlike a partnership, LLC, or LLP, a corporation can have an unlimited life span.
- The corporate structure, although initially cumbersome and complex, may be ideal for companies with expansive growth plans.
8
Q
S-Corp
A
- Generally not an income tax-paying entity. It is treated as a “flow-through” entity and its shareholders are currently taxed on corporate income in a manner similar to partnership taxation.
- Items of income, loss, deduction, and credit will be passed through to shareholders and included on the shareholders’ returns, in the form received, paid, or incurred by the corporation.
- This is often an ideal structure for the closely held business because it provides the legal protection of a corporation with a single-level tax structure similar to a partnership. The S corporation can actually be more advantageous than a partnership because dividend distributions are not subject to self-employment tax.
- 100 or fewer shareholders and all shareholders must generally be either individuals who are U.S. citizens
- The S corporation structure is the ideal structure for a business desiring liability protection, corporate format, and flow-through taxation.
9
Q
S-Corp Considerations
A
- Shareholder-employees must be compensated with wages, subject to withholding.
- Distributions, or dividends, must always be proportional to stock ownership.
- Only one class of stock is allowed. Thus, the corporation cannot have preferred stock or any other class of stock that differs from another in any aspect other than voting rights.
- Non-U.S. persons cannot be added as shareholders nor can a current “community property” shareholder marry a non-U.S. person.
- Reasonable compensation must be paid to shareholder-employees.
10
Q
Limited Liability Companies (LLC)
A
- Generally has the flexibility of a partnership with the limited liability of a corporation. An LLC member’s personal liability is normally limited to the amount of his or her investment.
- LLC income flows through to each member’s individual income tax return
- Single-member LLC is treated as a disregarded entity and is taxed as a sole proprietorship. Legal liability protection is typically the motivation for a sole proprietorship to operate as an LLC.
- Thus, the LLC structure would be appropriate for a sole proprietor seeking liability protection without the creation of a corporate tax entity. The LLC would also be appropriate for a partnership seeking liability protection without the constraints and paperwork requirements of the corporate structure. The LLC offers the advantageous combination of flexibility and liability protection.
11
Q
Partnerships
A
- Exists for tax purposes whenever a profit-motivated business is carried on by two or more people who share in income and expenses
- Partners are “jointly and severally” liable for partnership debts
- Assets and income stream of the partnership are jointly owned by the partners and are allocated according to agreement
12
Q
Limited Partnership
A
- Formed under state law and has two types of interests: general partnership interests whose partners assume personal liability for the partnership’s liabilities and limited partnership interests whose partners share in liability only to the extent of their capital contributions (thus, no personal liability)
- To have a valid limited partnership, there must be at least one general partner and at least one limited partner.
13
Q
Family Holding Companies
A
- A family holding company (FHC) is also sometimes called an asset holding company and is a method of recapitalization.
- Typically, the FHC is operated as an LLC or LP
- Authorized to issue both voting preferred stock and non-voting common stock and is set up to manage the assets of another entity or entities
14
Q
Section 1202 Stock
A
- IRC 1202 allows individuals to exclude 50% to 100% of the gain realized from the sale of qualified small business stock held for more than 5 years
- Exclusion is limited to the greater of $10 million or ten times basis. Taxable amount taxed at max 28% rate
15
Q
Buy-Sell Agreement
A
- A buy-sell agreement is an agreement between the owners of a business, or among the owners of the business and the entity, to purchase and sell interests of the business at a price set under the agreement upon the occurrence of certain future events
- Control of ownership
- Provide liquidity for ownership interests upon the occurrence of certain “triggering events”
- Avoid “deadlock” among owners
- Protect the business from competition from former owners
- Establish value for estate tax purposes
- Does not typically provide a mechanism for establishing or determining the best price
