Shareholder Redemptions for Closely Held Companies
Shareholder Redemptions for Closely Held Companies
By Steve York, CPA
Every shareholder in a closely held corporation will have to sell their stock, either while they are alive, or at their death. This is a very difficult decision for shareholders in closely held corporations, because shareholders typically do not want to give up control, and there is no market for their stock. Listed below are the four most common methods for shareholders selling closely held stock.
Corporate Redemption
Often owners will simply redeem some of the outstanding stock by having their corporation purchase their stock in a treasury purchase. This purchase is not tax deductible by the corporation, so to make a $6 million purchase, the corporation must use $10 million of pre-tax income. Typically, the redemption will reduce the valuation of the remaining stock outstanding by the amount of the pre-tax earnings drain that will have to be born by the remaining shareholders. Normally this method is used for owners’ divorces, or if just one of multiple owners desires to leave the business.
Family Member Sales
Sometimes selling shareholders will use bonuses paid to family members or key management so that the increase in pay is paid to the selling shareholder to pay off a seller’s note between the shareholder and the family member or key employees. This will also require the corporation to use $10 million of its pre-tax income to provide the shareholders with $6 million of liquidity. In addition, for the employee receiving the grossed up pay, it will eliminate any tax deductions, exemptions, and credits on their personal tax return, causing the employee to have less net pay than they would have had without the bonus. While the employee will eventually end up with the stock, it can be a hardship on the employee. This also can cause subsequent sales of stock to have a lower valuation because of the drain on corporate earnings. This method is used when there are particular persons that the selling shareholder wants to run the business when they are no longer active in the business.
Third Party
The selling shareholder can sell to a third party. The third party will want a say in running the closely held company, and they will also expect a return of around 25 percent or more on their investment to offset the risk of buying stock with no market. Normally an equity investor expects to hold their investment from five to seven years at which time they will sell their portion of company. Very often inviting an outside investor into a company will result in the eventual sale of the company by all shareholders. Just like in examples one and two, the drain on corporate earnings to buy out the investor at their expected return can make it very hard for subsequent sales of stock to achieve a similar valuation per share.
Employee Stock Ownership Plan (ESOP)
Using an ESOP, the company will be able to prevent a third party from having any control over the affairs of the company. The company will only have to use $6 million of pre-tax corporate income to fund a $6 million stock redemption. The company will have created a market for their stock, and with proper planning the shareholders can receive their sale proceeds and defer paying any capital gains taxes on the gain from their stock sale. This method is used by owners that want to put the most possible into their bank account upon their sale of stock, and take a tax deduction against their corporate taxable income for the cost of funding the stock sale.
The single most important consideration for the owner of closely held corporate stock is to decide what to do with that stock while they have all their options open and they are not under duress from an outside influence. The one thing all owners of closely held corporations want is control of their business affairs. Control can only be achieved when the shareholders are willing to do the planning and make the decisions necessary to transition their stock according to their wishes before an outside influence forces them to sell their stock.
Steve York, CPA is a consultant for Stern Brothers Valuations Advisors in Kansas City. He can be reached at york@sternbv.com.
