United States: Designing Tax Efficient Business Transactions

Last Updated: July 11 2019
Article by Carl Koerner

There is an old joke that a camel is a horse that has been designed by a committee. We all know that it isn't true. In fact, camels are horses that have been bred for maximum tax efficiency. Tax efficiency is the benign term that we use for the tortured process of restructuring a business arrangement to minimize taxes—all taxes, including income, sales, estate, gross receipts, federal, state, city and foreign. When you realize how many taxes there are and how many jurisdictions impose them, the camel design looks pretty sleek.

Throughout my career as a business lawyer, without exception, the most demanding call upon my skills has been to maintain the structure of a business arrangement while striving for the greatest tax efficiency. I have been privileged to do this in partnership with highly skilled tax attorneys. There have been other challenges, however.

Before lawyers invented the concept of the limited liability company (LLC), business partners who sought limited liability for their enterprise were required to force their business deal into the very limited and narrow structure of the business corporation. Those of us who labored in this field were called "corporate attorneys."

As corporate attorneys, we had very few tools to work with: common stock, preferred stock and debt. We worked around these limitations by creating convertible securities—shareholder agreements which restricted transfer of shares or set values for those shares—and special voting arrangements such as voting trusts which ceded company control to one person or group. We could also form limited partnerships, but like their name, they had limited application for operating businesses because of the unlimited liability imposed upon the general partner of the partnership. Over time, laws evolved and the notion of a corporation with limited liability, but taxed like a partnership was introduced into law (the S Corporation). These benefits came with tight restrictions limiting the corporation to one class of stock held by individual taxpayers and not corporations or limited partnerships.

Today the LLC is well established. The flexibility of the LLC framework permits us to write agreements that are virtually only limited by the imagination of our clients. We have a myriad of management structures and equity stacks. Any number of covenants and conditions can restrict or empower management. We can create equity positions that are spread across a spectrum of risk mixing traditional notions of equity and debt. We can even create equity positions that change with time or based upon external events. Life is good. I now call myself a "business attorney."

But tax efficiency will always be with us. It is never about the rates. From the earliest days of the U.S. Income tax, when rates were lower than our current social security withholding rate, taxpayers were contriving transactions to avoid imposition of the tax. The most recent major tax change, the 2017 tax act, lowered rates, but did not reduce the drive for tax efficient transactions. It merely interposed new laws and regulations which require analysis and application.

Since the quest for tax efficiency will always be with us, we should keep in mind some of the steps we can all take to give greater impact to the "efficiency" part of the exercise. Otherwise inefficiency can lead to higher taxes, protracted negotiations, significantly higher professional costs and unhappy parties. Here are some steps that I follow which have helped me:

  • It is never too early to bring in qualified tax advisors. If you think it is too early to bring in the tax advisors, re-read the prior sentence. I pass so frequently between my office and that of John Eagan, an esteemed tax attorney in the next office here at White and Williams, that I have worn a patch in the carpeting. But I know from experience that traveling too far down the path of a business transaction without good tax advice usually means that you will have to reverse course at some point.
  • Acknowledge that taxes are, in most cases, a burden upon the transaction rather than a specific party. Often it appears that a tax is only imposed upon one side of the transaction or the other. But most transactions are driven by net economics. A more tax efficient transaction may lead to a lower cost for the non-taxed party since the net available to the counter-party is higher. And even if it doesn't, the higher yield makes the transaction more favorable and likely to move forward.
  • When a tax creates a zero-sum game, step up to the plate and own it. There are many circumstances under the tax law where treatment that is beneficial to one party will be a tax detriment to the other party. I get an expense deduction, but you get taxed at ordinary income rates. You get capital gains treatment, but I have to amortize my cost over a long period of time or perhaps get not tax benefit at all. The worst negotiations are those where the parties pretend that they are unaware of the tax impact upon the other side to the transaction. The best are the ones conducted by grownups who look each other in the eye and say what is good for me is not good for you and vice-versa. Why don't we work together to fashion a compromise up front and build that into the overall business deal between us?

Tax efficiency is one of the areas where when parties work together, one plus one can equal three. But, it requires attention, cooperation and careful planning.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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