Are you preparing to exit a private equity investment and wondering how to maximize your after-tax returns? From deal structuring to maximizing deductions, protecting your profits from unnecessary taxes demands a considered tax strategy.
Optimizing Private Equity Exits
Thoughtful pre-exit tax planning isn’t just about preparing for the transaction. You also need to know how to structure the exit for the best tax advantages. Whether you exit through an initial public offering (IPO) or a secondary sale, there are unique tax implications to consider. Some considerations:
- Initial Public Offering (IPO): Going public will allow you to sell shares to the public, which often allows for capital gains tax treatment. So, you can manipulate your tax rate. This is because shares held for more than a year are taxed at a lower capital gains tax rate.
- Sale to a Strategic Buyer: Selling to a company in the same industry (a strategic buyer) may allow for income-splitting opportunities if structured correctly. Income from the sale can sometimes be divided across different tax years to the tax burden of a single large lump-sum payment.
- Secondary Sale to Another Private Equity Firm: Similarly, selling to another private equity firm, may also offer deferred tax benefits based on the transaction terms.
- Leveraging Tax-Favorable Jurisdictions and Structures: States with low or no corporate income tax, such as Delaware, Nevada, and Wyoming, can reduce the tax impact on exit transactions.
- Structure exits through tax-efficient vehicles: Holding companies or offshore entities can provide benefits like reduced rates or the option to defer taxes, depending on the jurisdiction.
- Implementing Tax-Deferred or Tax-Free Exchange Transactions: For real estate assets involved in a private equity exit, a Section 1031 like-kind exchange allows you to defer capital gains taxes by reinvesting proceeds into similar properties. For corporate transactions, a Section 368 reorganization can qualify certain mergers or acquisitions as tax-free exchanges. This can defer taxes on gains and maximizing post-exit capital.
Managing Capital Gains Tax Liabilities
A smart capital gains strategy is at the center of maximizing returns on your private equity exit.
- By holding assets for more than a year, you can take advantage of long-term capital gains rates. This is typically lower than ordinary income tax rates. The IRS taxes long-term capital gains at 0%, 15%, or 20%, based on your income, while short-term gains on assets held for less than a year are taxed at ordinary income rates. This can be at a rate as high as 37%.
- Employing strategies like tax-loss harvesting can also help offset your gains. By selling some investments at a loss you counterbalance capital gains from other investments. This effectively lowers your overall taxable income.
- Certain exemptions, such as Qualified Small Business Stock (QSBS) or Qualified Opportunity Zones (QOZs) can also reduce or eliminate capital gains taxes under specific conditions. With QSBS you can exclude up to 100% of the gain on qualified stock held for over five years. QOZs, however, will enable you to defer taxes on gains reinvested in designated economically distressed areas.
Employee Incentive and Equity Compensation Planning
Thoughtful planning around employee equity compensation can also help to minimize tax liabilities for both management and employees during a private equity exit.
- Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs): With ISOs employees can defer taxes until they sell their stock, and any gains can be taxed at the lower capital gains rate if they meet certain holding requirements. NSOs, while taxed as ordinary income when exercised, can still provide a way to reward employees with company growth potential.
- Restricted Stock Units (RSUs) and Phantom Equity Plans: RSUs allow employees to receive stock at a future date, and tax is generally only due when the units vest. Phantom equity plans compensate employees based on company performance, often without granting them actual stock. This also defers tax, allowing for favorable financial structuring.
Considerations for Cross-Border Exits
If your private equity exit involves international operations, you’re in for a ride when it comes to navigating cross-border taxes. Besides the fact that rates vary widely, non compliance can lead to unexpected costs in penalties.
Transfer pricing – the pricing of transactions between related entities across different countries – requires precise documentation to ensure compliance.
However, you can leverage tax treaties to optimize your tax outcomes. These agreements help to prevent double taxation, essentially preserving more of your profits for a more beneficial exit.
Tax Compliance
For private equity transactions, especially those involving significant capital gains, it’s crucial to complete these forms accurately to ensure tax compliance.
- Form 8949 – Sales and Other Dispositions of Capital Assets: This form is used to list individual sales or dispositions of capital assets, such as stocks, bonds, and other investments. It includes details like the asset’s cost basis, sale price, and any adjustments. These help determine the capital gain or loss for each transaction.
- Schedule D (Form 1040) – Capital Gains and Losses: Schedule D is used to summarize the capital gains and losses reported on Form 8949. It calculates the overall net capital gain or loss. This is added to your total income reported on Form 1040.
- Form 4797 – Sales of Business Property: If the exit involves business property, such as equipment or real estate used in a trade or business, you will report the sale on Form 4797. It applies to property held for over a year, distinguishing it from standard capital assets.
At Fusion, our CPAs understand the intricacies of private equity exits. We are ready to work with you to maximize returns in private equity. Contact us today.
_______________________________________________________
This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. We base articles on current or proposed tax rules at the time of writing. Older posts are not updated for tax rule changes. We expressly disclaim all liability regarding actions taken or not taken based on the contents of this blog. The same applies to the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.