Using a CUB (controlled unrelated buyer) with an LBO

One of my favorite planning techniques is a controlled, unrelated buyer (CUB) to engage in an LBO to convert business income to LTCG without losing control. For example, the CUB could be formed via a declaration of a taxable trust fbo an unrelated person (e.g., a key person or an in-law) and all of the stock of an S could be sold to the trust with a 1038(h)(10) or 336(e) election in exchange for a large, long-term, low-interest note. The allocation to goodwill generates LTCG for the sellers and a 15 year deduction for the buyer. Allocation of the price to other assets is generally tax neutral in the sense that the buyer gets matching tax benefits.

The exact structure depends on the facts, but the technique can be applied in almost any situation and is especially valuable for clients with relatively low income. The combination of the low LTCG rate and the reduction in salary can generate savings over 60% and the downside risk is manageable. Even at the high end, the tax savings can easily exceed 30%.

This seems way too complicated for low income taxpayers . And I will leave this to the code section experts to see if this is even legal. I honestly never heard of this or seen it utilized.

I think you mean "338" instead of "1038" above, just for the benefit of others reading this thread.

Mind sharing an article or the pertinent authority behind this?
I'm not understanding how this would convert ongoing business income to LTCG. Maybe that's not what you mean.

I agree that this appears to be far too complex for low income taxpayers to understand and/or want to engage in it.

I have read this post several times and I am clearly too dense to get how this is supposed to be beneficial.

Let's say I have a service business (so no §1245 assets to speak of) with net-to-owner of $100k a year, and we have an independent third party valuation done that arrives at a very generous fair market value of $450k. I set up the trust with my brother-in-law as beneficiary. I assume that I'm the trustee. I sell the business to the trust in exchange for a $450k note. Easy peasy, this part I get.

I continue to run the business and the business makes $100k each year as usual. So we have a 1041 with $100k in ordinary income less $30k amortization and less the nominal interest paid on the note, and of course less that monster $100 exemption. That's taxed at the trust level, hitting the top 37% rate pretty quickly. As I get the loan paid, I only pay capital gains on that income.

Over the next 15 years, I get $450,000 total income taxed as capital gains plus some nominal interest, and it easily could be all tax free given the rates under current law. But now I also have a trust with a lot of money in it -- $1,050,000 minus the trust taxes paid -- but it's for the waste of oxygen that married my sister, not me. And when it's finally time to sell the business to a completely unrelated buyer, the proceeds go to... him, not me.

I'm clearly missing something here.

Greetings, missingdonut (xlnt name),

I could not finish reading your post. It got too far off.

The transaction is nothing more than a leveraged stock sale with a 1038(h)(10) or 336(e) election to treat the sale as an asset sale. The price is paid via a long-term, low-interest note. The trust would be a QSST or an ESBT.

OK, following your example, let's say the appraisal was for $450k. My experience is that the tradeoff in price negotiations is 2:1 for cash verses a long-term, low-interest note. So I'd use $900k. The annual payments on a $900k, 2% note are, say, $70k. The average principal and interest payments would be $60k principal and $10k interest.

That leaves $30k of available cash. The TP's salary would be, say, half of that, saving quite a bit of employment taxes and leaving, say, $13k. A decision must be made as to what to do with that money. The main choices are to pass it to the beneficiary or to bonus it to the TP. The S corporation gets an interest deduction and a $60k goodwill deduction. So the beneficiary will have no taxable income if the available cash is bonused to the TP.

The TP reports his salary and the payments on the installment note. Principal payments will be LTCG. Roughly speaking over the fifteen years the tax savings equals some employment taxes and the spread between OI and LTCG times $900k. (The IRS loses when a business is sold to the extent the price is allocated to goodwill.)

The documents are not tricky. The difficult planning questions are: who is the beneficiary? and what is the nontax purpose? Those answers are the story. Transition planning (e.g, where the beneficiary is a key employee) and estate planning are common purposes.

Regarding tax risk, it's primarily a function of the story. One may quibble about the numbers, but the structure itself is well within the black letter law (i.e., Code and Regs), fully disclosed and fairly common. My experience with appeals is that they give at least 25% in such a scenario, which would be the likely proposed penalty.

I appreciate the clarification. I'm incredibly hesitant to agree with your doubling the value of the valuation based on the extended payment terms, especially because a buyer at arms length should not be willing to pay $900k in this situation. Assuming the $70k/yr is split into monthly installments, that's an effective interest rate of about 13.5% which is basically financing using a credit card rather than a legitimate business loan in 2021.

I agree that the difficult planning question is the nontax purpose, because this makes no sense to me without it. If my true goal is to transition my company to my in-law/key employee, I can understand a few fact patterns that would properly fit this type of structure. But outside of those, I could just wait until I'm ready to retire and sell it to them then, which has the distinct advantage of allowing me to continue earning $100k a year until I sell it plus realize the FMV of my business during retirement. Sure, I pay more taxes, but I ultimately have higher after-tax wealth. Or maybe I can wait until about three years before I'm ready to retire and I have an employment contract to help the transition. At least in those situations, it also gives me an "out" in case the in-law divorces my family member, or the key employee decides to move to another state.

Even if everything is legitimate on the tax side (and even you admit that you don't expect it to fully hold up on audit) the trust aspect makes me nervous. It's been a while since my college business law class, but it seems like setting up a trust to buy an expensive, illiquid asset at an inflated value that generates mediocre returns isn't being done in the beneficiary's best interest. And when there are suspected big pots of money around, when someone thinks they've been screwed, it's not uncommon for an aggrieved party to call a lawyer.

The effective interest rate is the interest rate on the note, which is 2%. I have no idea where you came up with 13/5%.

It's easy to come up with facts that don't work. And it's easy to kill deals.

I agree that the price seems high in comparison to a cash price. Note, however, that the technique can easily be designed to provide a positive cash-flow to the buyer. So the odds of success depend on the story.

I know what happens when the technique is not employed. I'm saying that properly understood the technique applies in many more situations than you are imagining, such as the TP anticipating transition in several years, (i.e., the situation you described above as not working.) It just takes some creativity.

The structure I described above cut several corners in order to cleanly educate you on the basics without discussing important side issues, like the down payment and what happens when the note expires. A full explanation would heavily depend on the facts and would be designed to minimize the downside economics. The question then becomes whether the resulting downside economics are justified by the tax savings. I'm saying you would be surprised at how often the technique would be considered well worth the effort.

Finally, I must comment that I have compared the technique to ESOPs and see opportunities in that arena -- because I tend to view ESOPs as tools to convert OI to LTCG. I came to that view after Bush's tax cut put the estate tax on the chopping block. Estate tax planning was half my practice. So I started thinking about converting OI to LTCG, like in the 80s when we would sell subdivided real estate to a controlled buyer. I ended up looking at everything that crossed my desk from that perspective and concluded that the opportunities are far broader than I had previously considered. (See the post I am about to write on asset sale stockholder agreements.)

Please send a link to an article or some kind of resource where you (or someone else) has described all the pertinent considerations and authority supporting this treatment. You have what is a somewhat novel concept here. You're going to have to share more information for it to meet the aim of the forum.

Unless you are solely here to drum up business with the expectation we would send clients to you to craft this strategy. Is that your aim?

Otherwise, this just seems like a lot of 'p**sing in the wind'.

Whoa, Capt,

From your previous posts I am well aware that you are talented enough to be well aware of the authority. I have to assume you don't understand the transaction.

I say that because at its core it's a simple and very common LBO stock sale with an asset sale election. All I did was ask myself if the tax benefits of a simple LBO sale could be achieved where my client controlled the buyer. That's the only nuance.

If that scares you as a matter of principle, then don't consider it. I'm saying there are a lot of missed opportunities where the story is good enough and the downside economics are low enough that it's a worthwhile transaction. (E.g, starting a transition buy-out five years earlier.) But you have to look for those opportunities in order to see them...

As to drumming up business, I did that for about three weeks 40 years ago. After that all I've done since is compete with my desk. Work always replaces itself...

I've never participated in an internet forum before. As to the aim of this one, I haven't read anything in that regard, but have been operating under the assumption that turning other tax advisors onto uncommon ideas that I have would be welcome. I have not considered it to be like writing a memorandum with authority for all statements.

If there is a particular issue you would like me to comment further on, please advise and I will be happy to respond.

From your previous posts I am well aware that you are talented enough to be well aware of the authority. I have to assume you don't understand the transaction.

I can assume what you're driving at, but without actually sharing it, I'm doing just that...assuming. I prefer not to do that. I don't feel this an unreasonable request in any regard.

I suppose we all have different aims in this forum, to some extent. I likely overstepped in making any statements as to what the "aim of the forum" was or is. I shouldn't speak on behalf of anyone else here. Most of us enjoy a good debate of potential strategies that serve our clients. There is often a spectrum of conservative and aggressive stances and the discussions I've enjoyed the most are those where enough information is provided to allow those lines to be drawn by each practitioner based on their comfort level(s).
This particular thread doesn't appear to be heading down that path. I'd like it to. It's your thread, your proposal, your responsibility to share what your basing your strategy on.

I feel like what I've described is easy to understand. (I call it a CUB, a controlled, unrelated buyer.) So I'm perplexed by your reaction and would not even know where to start in responding to your request for authority. What particular part of it bothers you? What questions do you have?

For starters, twice you said 1038(h)(10). Not very authoritative. We think you mean 338(h)(10)

my egg

If owner wants to sell company to key employee, why doesn't he just do that with a 3 year note? Or sell 1/3 each year? Owner gets LTCG. Buyer gets 15 year writeoff of 197 intangibles. Why would the key employee pay $900K for a business valued at $450K?

(I keep losing posts...)

Hi, sjrcpa,

The transaction is designed so that the owner maintains control while converting OI to LTCG. A simple sale doesn't do that.

As to your question re the price, I have three comments. First, the $450k price is cash, the $900k price is an LBO with 15 year low-interest note which leaves room for the buyer to profit. Second, the key employee is a beneficiary who pays nothing. And third, the structure can be changed mid-stream. For example, the key employee could become trustee when $450k of principal has been paid and thereby take control without even being on the hook. Or the key employee could buy the stock for $450k cash or some other consideration at any time.

Unless you are solely here to drum up business with the expectation we would send clients to you to craft this strategy. Is that your aim?
Otherwise, this just seems like a lot of 'p**sing in the wind'.

CaptCook I believe is onto gatorguy.

Gatorguy is a tax attorney with over 40 years of experience. He uses the word "WOW" in a lot in the subject lines of his posts and proclaims he found the biggest tax loopholes in the past hundred years that no one, yes no one, ever thought about. How likely is that?

What do tax attorneys do? They sue. They sue the IRS (not easy to do).
They sue tax preparers. The bar is far lower in this case.

So, if you inquire about his tactics in a PM, he'll find out who you are.

Protect yourself, protect the business you've worked so hard for and protect your clients. They may soon be ex clients if you do not do due diligence and research the tactics gatorguy came up with.

Why so negative? Sounds like you easily impute motives to others. And your understanding of what tax attorneys do is juvenile.

In any event, I regret and apologize for using the work Wow. It was classless. I'm new to chatting and was trying to get extra attention because I'm excited about the structure. It is powerful, easy to understand and implement, clearly within the law, and very rare in the wild. Anyone working in this arena should be happy to be made aware of it. (I published an article in the Florida Bar Journal on the technique and got no negative feedback, although I made a significant mistake.)

BTW, as to my actual motives, you may be interested to know that I've been a registered Libertarian for 40 years.

Practical question: If you sell a business how do you retain control afterwards?

Create and control the buyer.

Background: Before the 2001Bush tax cuts half my practice was estate planning for potentially taxable estates. I realized I had to shift focus. I remembered a technique which was widely employed in the 80s, to wit: converting OI on sales of subdivided realty into LTCG via a bulk sale to a new S owned 90% (or more) by the client in exchange for an installment note. So I began to wonder how far I could take that technique. I looked at everything that crossed my desk in that light and eventually realized that the technique could be widely employed. I concluded that we're all so far into the box that we miss lots of opportunities. For example, almost every stockholder agreement I've ever seen calls for a stock sale on death. A sale of a business can be via stock sale or asset sale. The latter has big tax benefits. (See my post on the subject which shows that giving a survivor holding 50% of an S an option to pay the cross-purchase or redemption price via an asset sale to a controlled buyer can generate tax savings equal to as much as 60% of the price to be paid to the decedent's estate.) Another example is we merge and divide businesses without considering two sales instead. Eventually I realized that the technique could be applied to just about any business not held in a C corporation. The planning issues revolve around the nontax reason for the transaction.

But if you create and control the buyer you have sold bugger all (I’ve been on a conference call with fellow Scots this morning and I’m still in the zone).

Where’s the substance? I don’t see it and, to be brutally frank, I remain to be convinced that a Tax Court judge would see it either.