Aspen Merchant Capital

The sale of business is a challenging and difficult transaction with several complicated aspects. Whether it’s the complete sale of a business or simply the sale of a partial ownership interest in a company, one of the most troubling issues created by this disposition is the manner in which capital gains and other taxes are addressed. There are not many options available to a business owner, and the few that are come accompanied by complex rules and regulations. There are also restrictions that can increase future risk and possibly trigger IRS penalties.

We are always looking for ways for our business sellers to maximize their transaction proceeds while keeping as much possible through the use of intelligent tax planning and deal structure. I asked Dan Carroll from Brook Hollow Financial to explain a unique way to defer capital gains taxes that are the result of a business sale.

Large Tax Bill Due upon Sale

Capital Gains, Depreciation Recapture and even Income taxes may be levied against the proceeds of the sale of the business. Depending on the initial amount invested and how much the business has grown, these taxes can consume much of the sale price. Currently the Federal Capital Gains Tax stands at 15%. Most states have a Capital Gains Tax as well, with the total amount often exceeding 20% of the gain. We believe that these rates will have near term upward pressure caused by the need for the Treasury Department to make up for the $800 billion shortfall that will result from the repeal of the Alternative Minimum Tax. Other taxes, particularly if held in a ‘C’ Corp., can exceed 60% of the transaction.

Loss of Regular Income

When a business is sold, the owner’s cash flow stops as well. Therefore, the amount of money that was being produced needs to be replaced. Without this regular income, former business owners are left with a significant gap in what they receive each month and must alter any plans or budgets accordingly.

What to do with the Proceeds

Another major challenge that a business owner will face is what to do with the proceeds of any sale. There are many ways to put this money to work for you, but this often means accepting significant risk and investing in markets without much experience. Alternatively, sellers might mitigate risk, but only at the cost of getting a very low return. Either way, inadequate returns and potential loss of capital are serious risk factors that must be considered.

Need to Mitigate Future Risk

Among the challenges presented by investing the new capital is that there may be different goals for the individual at this stage of his or her career. If the sale is prompted by a desire to move away from daily management and responsibility, or simply to cash out at a good time in the market, the owner may want to revisit his or her goals. A review of the financial needs and expectations may reveal a requirement for total investment certainty. While these alternatives do exist, most do little to provide a reasonable return and can make planning more difficult with these limited resources. The need and desire to mitigate future risk should play an important role in any decisions about your investment plans.

The Traditional Business Sale – Cash Transaction

The cash transaction option is fairly straightforward. The seller is paid cash from the buyer. After any loans or other debts are paid, the funds are then made available to the seller. At this point, the seller must pay federal and state taxes on the proceeds, and then the remaining balance is left to invest. This drastically reduces the principle and lowers any future returns. The stock market and other liquid investments carry very significant market risk, and the individual could lose some or all of the money. On the other hand, the individual could place the money into a guaranteed investment such as a certificate of deposit, but the returns will drastically lag other possible alternatives. Investing on your own requires some planning and active management of the portfolio, but more importantly, it may provide for unpredictable future income necessary to manage and care for an investor and his or her family.

Another Approach – The Installment Sale

The Installment Sale is a mechanism that has been available since the 1930’s. In this type of transaction, the buyer of a business agrees to pay the seller a certain amount of money over a fixed period of time. Under this approach, the IRS has ruled that only the amount of distribution in any given year is subject to any applicable taxes in proportion to the total due. The problem here had been reliance upon the buyer to continue to make the payments promised. Often times the business is run poorly and is no longer producing enough revenue to make the promised payments. There has always been recourse in these transactions, so that if the buyer did not live up to his obligation, the seller could foreclose and reclaim ownership of the business. However, this offered little protection if the business has not been run properly or the value lowers for other reasons, since the original seller would now reclaim a much less valuable business.

An Improved Approach – The Installment Sale with Guaranteed Annuity Payments

There is a way to ensure that these types of transactions could still be utilized while eliminating the possibility of default. The transaction takes place as described above, only there is a second transaction that occurs simultaneously. At the time of closing, the buyer purchases an annuity from an A+ rated Annuity company. Therefore the seller receives a guarantee that regardless of the future strength of the business, the payments will be made as agreed upon, and all of the tax deferral benefits remain intact.

The benefits of this type of transaction are as follows:

Seller is able to sell the business without future risk

Tax-deferral creates much greater taxable equivalent return

Flexible planning allows for specific plans tailored to individual needs

Stabilizes future income with certainty for life

Much larger total benefit over time – guaranteed

Payments can continue to pass on to heirs in the event of death

Eliminates need for expensive life insurance

Requires no management responsibility

There are no direct or on-going fees

Expedited closing

A simple way to look at this plan is to compare it to an IRA. With the IRA your investments get to grow on a tax deferred basis for many years and you get the benefit of earning investment returns on the amount not paid in tax. When you draw the funds out of the account, you are then taxed at your then current rate. With the guaranteed annuity installment sale, you may elect to take a portion of the business sale proceeds at close and pay all of the appropriate taxes on that portion.

You then could structure the guaranteed annuity to begin paying you a certain amount starting in 5 years for another 20 years. The investment would be allowed to grow tax deferred for that 5-year period. When you started taking distributions, you would be taxed at the rate you would have been from the original sale transaction. The important thing to remember here is that instead of receiving the entire distribution at closing and paying a huge tax bill up front, you are taking 1/20th of the distribution each year and paying 1/20th of the tax. The remaining portion of the deferred tax stays invested and earns income over the 20-year period. This substantially increases your return on the deferred portion of your sale proceeds.

This mechanism is a great way to secure your proceeds with guaranteed payouts, no ongoing involvement or management responsibility, and beneficial tax treatment. This will ensure the highest possible taxable equivalent return when compared to any fixed-income, guaranteed investment. Remember in a business sale the important number is how much you get to keep.

Venture Capital Fund –Basic Concepts

 

 

Mohit Kumar Yadav

VTH YEAR BA.LLB

NEW LAW COLLEGE,

BHARATI VIDYAPEETH UNIVERSITY,PUNE

 

Introduction:

Venture capital is a type of private equity capital typically provided by outside investors to new businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments are usually high risk, but offer the potential for above-average returns. A venture capitalist is a person who makes such investments. A venture capital fund is a pooled investment scheme that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, who cannot raise funds through a debt issue. The drawback of this form of entrepreneurship is that the investors get a say in the management of the company apart from the equity holding. Laws relating to venture capital funds in India

SEBI (Venture capital funds) Regulations 1996.

The venture capital fund regulations by the Securities and Exchange Board of India are a comprehensive set of laws to be followed by the venture capital funds in India. From the registration of venture capital funds to the action to be taken in case of default, the regulation has been divided in VI chapters.

Registration Of Venture Capital Funds

A Venture capital fund can either be a fund established as a trust under the Indian trust act or a company as defined under companies act 1956.

The regulations provided for the registration of a company or a trust which either was functioning as a venture capital fund before the commencement of this act or proposed to do so after the commencement of this act.

A company or trust (which functioned as a venture capital fund before the commencement of these regulations) shall cease to function as a venture capital fund if it does not apply to SEBI for registration within 3 months from the commencement of the regulations.

Procedure to be followed for registration:

i) An application for grant of certificate to be made to SEBI in Form A along with a fee of Rs 25,000.The fee shall be paid through a draft.

ii) There are certain conditions which must be fulfilled before the certificate of registration is granted by SEBI:

a) In case of a company, the MOA of the company shall have the business of venture capital fund as its main object, and invitation to public shall be expressly barred by the MOA and AOA, in addition to this, any officer of the company shall be involved in any litigation connected to the security market or should not have been convicted of an economic offence.

b) In case of a trust, the trust is in form of a deed and has been duly registered under the Indian registration act. Carrying the business of venture capital fund is its primary objective. Any trustee of the trust is not involved in a litigation connected to security market and has not been convicted of any economic offence.

c) In case of a body corporate, it should be formed under the laws of central or state legislature and it is permitted to venture in the field of venture capital funds.

iii) The application for registration shall be complete in all respect. If SEBI discovers any thing in the application that renders it incomplete, it shall give the applicant a time of thirty days to remove the loophole, failing which the application can be rejected by the board.

iv) SEBI after finding the applicant to be eligible, shall inform the

applicant about it, after receiving the information the applicant shall tender to SEBI the registration fee which is Rs 5 lacs, after receiving which SEBI shall issue the Certificate of registration.

Conditions And Restrictions On Investments

The regulation has applied a lot of condition and restriction to the amount of investment to be made in and by the venture capital fund in India.

An investment in the venture capital fund can be made by any person whether Indian, Foreigner or NRI, but no investment which is less than Rs five lacs can be allowed in the venture capital fund. this however does not apply to investment made by the employees, directors or the principal officers of the company or by the trustee where the venture capital fund is a trust.

The investment strategy at the time of registration shall be disclosed by the venture capital fund. The venture capital fund shall also disclose the duration of its life cycle. Not more than 25% of the fund shall be invested in a single venture capital undertaking .Investment to be made in the following manner:

i) At least 66.67% of the fund to be invested shall be invested in unlisted equity shares or other instruments linked to equity shares of the venture capital undertaking.

ii) Not more than 33.33% of the investible fund shall be invested by the way of IPO of a venture capital undertaking whose shares are proposed to be listed, the debt instrument of the venture capital undertaking in which the venture capital fund has already invested, preferential allotment of equity shares of a listed company, equity shares or equity linked instrument of a financially weak company and SPV’s which have been created by the venture capital fund..

No venture capital fund shall get its units listed on any recognized stock exchange till the expiry of thee years from the date when they were issued to the investors by the venture capital fund. The venture capital funds shall also not invite any member of the public by way of advertisement to subscribe to its units. The venture capital fund may receive investments only through private placements of its units.

Placement Memorandum or Subscription Agreement

Every venture capital fund shall issue a placement memorandum which contains all the terms and conditions relating to the scheme through which money is proposed to be raised from the investors. The venture capital fund may also enter into a subscription agreement with the investors which would specify the terms and conditions of the scheme through which money is proposed to be raised. The venture capital fund shall submit a copy of such placement memorandum or subscription agreement with SEBI along with the report of the money actually raised through such agreement or memorandum.

The placement memorandum or the subscription agreement shall have the following essential:

It shall contain the details of the trustee and the trust as well as the details of the directors and the principal officers of the venture capital fund. It shall also stae the minimum amount of money to be raised to start the venture capital fund and the minimum share to be invested in every scheme of the venture capital funds. Tax implications which would be applied to the investors shall also be stated. The manner of subscription to the units of the fund, the period of maturity of the fund if any and the manner in which the fund would be wound up shall also be stated.

Every venture capital fund shall maintain a book of record for a period of eight years which would generate the true picture of the venture capital fund. SEBI at any time can call for information regarding the working of the venture capital fund, the information shall be submitted to SEBI in the specified time period.

Investigation

SEBI on receiving a complaint from the investors or suo motu appoint one or mo
re person as investigating officer, who would undertake investigation in relation to the maintenance of the account books of the venture capital fund, compliance of the regulation and the affairs of venture capital funds. A notice of at least ten days shall be given before the investigation is carried on though if SEBI deems it to be in interest of the investors it may not serve a notice at all. It shall be the duty of every officer of the venture capital fund to cooperate with the investigation officers, they shall be provided with all the documents, books etc which are in the custody of the officers of the venture capital fund. The investigation officer shall also be furnished with any statement he demands for. After the completion of investigation the investigation officer shall submit his report to SEBI. The board after considering the investigation and giving the venture capital fund to be heard may direct the venture capital fund not to launch new schemes or prohibiting the concerned person from disposing off the property of the venture capital fund or to refund to any investor any amount of money or asset.

Action In Case Of Default

Any venture capital fund that fails to act in accordance with the regulations, or fails to furnish reports of the affairs of the venture capital fund to SEBI or furnishes report that is not true, does not cooperate in any enquiry instituted by SEBI or fails to act on the complaints made by the investors or does not give a satisfactory reply in this regard to SEBI, shall be dealt with in manner provided in SEBI (procedures for holding enquiry by enquiry officers and imposing penalty) regulations, 2002.

Seems the new 2008 housing bill was not a savior for all of us – like a scorpion there is a little kick in the tail! However, struggling home owners can breathe easy, the kick is not directed at them, in fact, it is aimed at real estate investors.

Whoever it is aimed at in the real estate market, it will not give the realty world a much needed boost as it is yet another deterrent to buying a home, this time aimed at investors.

Capital gains tax is always part of the profit and loss formula when investing in realty, and the levels were generously high for both investors and regular residents who live in their home. Residents still have the same concessions but now it has changed for investors.

To re-cap on the capital gains that was – and still is for residents owning one house in which they are living and have lived for two years: the allowance on capital gains is $250,000 for a single person and $500,000 for a married couple.

Capital gains taxation is only charged on the profit made on the sale of the house, which is usually not necessarily on the actual sale price of the house.

However, there is a marked change in the taxation laws for people who buy a home and rent it for a while and then move into the home for a two year period prior to selling it.

It used to be possible to sell the home and convert all the profits that were made when it was a rental into tax free income under the capital gains umbrella. The new law has changed all that.

Even though investors may have lived in the rental home for two years before selling it, their capital gains allowance is no longer sacred. The new law says it must be calculated pro-rata and is divided between the taxable years that it was a rental property and the non taxable years when the owner lived in it.

This new rule comes into effect on January 1st 2009 and this is a hypothetical example of how it might look. You buy a home in June 2009 for $400,000 and you rent it out for three years, live in it for two years and sell it in June 2014 for $700,000. (Dream on!)

This means that you have a capital gain of $300,000 (assuming that nothing can be used as tax write-offs). Under the old system you could be exempted from capital gains tax by using your single person’s allowance of $250,000 capital gains exemption. This means that you would have only had to pay capital gains tax on the last $50,000.

This no longer applies; now the tax department will tell you that yes, you may claim the capital gains exemption for the two years that you were actually living in the residence i.e. you can claim two fifths of the $300,000 profit against your own personal allowance of $250,000. This calculates into $120,000.

However, for the other three years -when it was a rental property – the capital gains tax is applicable. Therefore, you will pay the percentage rate of capital gains tax on the remaining $180,000 (three fifths) of the profit of $300,000 that you made when you sold the house.