For reading #12 in PWN(2), can anyone give me a little more detailed explanation of how this could be structured? I’m curious regarding some of the details - how does the corporate debt capacity come into play regarding avoidance of taxable stocks sale? Also, if someone could explain a littel more how the put option available to the lender works that would be awesome. I’m trying to figure out what the distinction of roles and obligations is with respect to the owner as an individual and the company that he owns.
How can you use corporate debt to avoid paying taxes on stock sale?
Imagine that you are the owner of a private company. If you want to create some liquidity for yourself, you have the option of selling all your shares to a financial/strategic buyer (which means you’re going to lose control of your company), recapitalize (which again implies that your are going to lose control at some point), sell a noncore asset (but what if you don’t have any?), sell to your employees (which dosen’t create much liquidity and is risky). IN all these cases, the proceeds of the sale will be taxed. So they might not mesh well with a client who needs liquidity, dosen’t want to give control away, and also wants to avoid a large tax liability. The other option is for you do borrow money on behalf of the company, and then use the proceeds to cover your needs. This option might not be available (since nobody is going to provide you with a credit if the company is not doing well and has no collateral). In any case, on that debt the company and the owner pays no tax. So instead of selling a portion of their company and pay taxes on the proceeds of the sale, they can just secure a personal line a credit.
How the put option available to the lender works?
The put arrangement is created in a variety of ways. The lender wants a guarantee that the company is going to fullfil it’s promise of repaying the debt, so it might ask a company to have a letter of credit issued by a bank or inssurance for that purpose. If the company dosen’t pay it’s debt, the bank or inssrance will have to pay it.
Hey man, thanks for the info! One thing that I’m still not sure of though and maybe I’m just not as familiar with the tax issues and what not as I should be but, how is it that the company, which is operating as a distinct legal entity from the entrepreneur, can borrow money and then disburse the funds directly to the individual without this having to be viewed as some kind of taxable income or whatnot? I think the actual mechanics of the transaction and the legal points are what I’m most curious about.
The entrepreneur is collaterlizing his own percentage of ownership of the company. Say s/he owns 20%. The company has NO say in that unless there are prewirtten retrictions on company shares owned, like restricted stock, selling or redeemption clauses.
In the tax world, if their’s no legal sale there’s no taxes: no capital gains to tax or tax losses to harvest. (You have to retain some kind of risk n control or the IRS will deem it an effective sale.) If you collaterize your shares, you still own it, you are just borrowing money against it. If you don’t pay, the lenders have rights to sell or take your collateral, your 20% ownership in XZY company.
According to CFAI text, “the exercise of the put to the company as a source of repayment of the loan would likely be considered a taxable event to the business owner.”
Could someone explain this please, as in why does repayment of the loan be considered a taxable event?