We have been fortunate to enjoy one of the country’s longest periods of economic growth on record. However, every economic boom must inevitably go bust. That means we can likely expect a recession at some point in the future, even if we cannot say with certainty when it will happen.
Certainly, no one is rooting for a recession; however, as the trite saying goes, “When life gives you lemons, make lemonade.” So, when business owners find themselves mired in a gut-wrenching recession and the sale of their company seems light years away, they can put some plans in motion that could pay huge dividends when that sale eventually arrives. As we wrote in our previous post on this topic, “Even if the potential sale is 10 years down the road and even if it is only in the back of their minds, business owners should always be contemplating their exit and the incremental steps necessary to maximize business value, including those steps that present themselves during a recession.”
As we also wrote in a previous post, while a recession may signal doom and gloom for some business owners, it can be a tremendous opportunity for the owner who is prepared with ample dry powder on hand to invest into their business so they can create additional sale value down the road, regardless of exit timing. In addition, the owner who proactively invests in their business while their counterparts are panicking and battening down the hatches during an economic storm has an opportunity to take advantage of lower valuations brought about by uncertainty to fortify their business and thus, come out ahead when the good times return. For example, the owner might use the recession to invest in distressed assets/businesses or hire talented employees who have been laid off or displaced due to the prevailing uncertainty.
Here are four more less obvious ways the enterprising business owner can benefit from a recession:
Convert from a Corporation to a Limited Liability Company (“LLC”): Companies were either organized as a corporation or partnership prior to the creation of the LLC structure. There may now be strong business or ownership reasons for the owner of a corporation to want to be organized under a more flexible structure (LLC), but the economics of such reorganization are prohibitive. More specifically, since the reorganization from a corporation to an LLC is a taxable event, it can be quite expensive for the owner to make that conversion. Doing the conversion during a recession when business and asset values are depressed can significantly reduce if not eliminate the realized gain and tax liability from the liquidation of the corporation and reorganization of the corporation as an LLC. This type of reorganization is not insignificant so the business owner must recognize the opportunity early in the recession in order to capitalize on the opportunity.
Change tax elections: Economic uncertainty and the resulting depressed valuations also present an opportunity for the owner to change the company’s tax election from a “C” corporation to an “S” corporation. Being organized as an “S” corporation compared with a “C” corporation gives the owner more flexibility to sell stock or assets when that time comes as well as the opportunity to realize a better after-tax outcome when the buyer will only consider an asset transaction. The change in the tax election though does have the “built-in-gain” booby trap. Broadly speaking, the built-in-gain is calculated at the time of conversion (but no tax is paid upon the conversion). It represents the difference between the fair market value of the company’s assets (including goodwill) and the tax value of the company’s assets, i.e., sale value versus the tax basis of the company’s assets. If the owner sells their company in an asset transaction within five years of the conversion, the owner would pay higher taxes (compared with a company that has been an “S” corporation for at least five years) based on the amount of the built-in-gain, but less taxes than if they had remained a “C” corporation. Hence, changing this tax election when the business value is low reduces the tax liability on an asset sale within five years and lowers it even further due to the elimination of the built-in-gain if the company is sold more than five years after the conversion. Either of the foregoing scenarios results in a better after-tax outcome than if the company had remained a “C” corporation. Both conclusions of course assume that the sale value exceeds the value of the company at the time of the conversion.
Estate Planning: Although estate planning may seem like the last thing on an owner’s mind during a down economy, there are some exciting opportunities for owners who think about it from a long-term perspective. Specifically, transferring assets to heirs during a recession can be appealing to business owners who are seeking to maximize tax efficiencies in their estate. The recession creates significant uncertainty around business valuation so it can support a lower valuation and higher percentage transfers. In other words, if the owner has confidence that the company and its value will recover once the economy experiences an upswing, then they can be more efficient with their estate by transferring more to their heirs at a lesser value. Basic estate planning options that benefit from this strategy include the outright gift of company stock, the contribution of company stock to a GRAT (Grantor Retained Annuity Trust), a preferred stock recapitalization or “freeze,” or the sale to an intentionally defective grantor trust. An experienced estate planning attorney can provide guidance on which structure is most appropriate, depending on the owner’s specific circumstances.
Equity grants to key employees: During a recession, the owner may seek creative ways to motivate and compensate key employees without using cash. The owner may decide to grant stock or other equity rewards while valuations are lower in order to give key employees a bigger piece of the upside when conditions improve, and the company is sold. Again, this requires the owner to have confidence that the business will emerge stronger once the recession is over and the economy bounces back.
For business owners who can dig deep, have the time to see through the fog of the recession, and have confidence in the long-term strength and value of their company, there are meaningful opportunities on which they can capitalize in preparation for an eventual sale. Many of these methods require the advice of a tax planning or estate planning professional, so owners should seek guidance accordingly. However, by identifying these opportunities and allying themselves with expert advisors, the owner can take the sour lemons of a recession and make lemonade, reaping the sweet rewards of one or more of these strategies when economic conditions improve, regardless of the timing of their exit.
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