Planning your Exit

Recently, I spent some time preparing materials for a presentation at an upcoming BrewerIRS-logoy & Distillery Law conference, where I’ll be speaking on formation and entity selection issues.  The great thing about preparing for a speaking engagement like this (or, really any speaking engagement where you can’t just make stuff up) is that it forces you to stay current on recent developments in the law.  It also requires you to try to find a way to collapse a semester’s worth of material down into an hour.  That’s less great, but pretty important if the speaker wants to keep the audience on his side without resorting to cheap gimmicks.

For this presentation, while considering whether to try to demonstrate the distinctions between member-managed and manager-managed limited liability company governance through the nuanced medium of interpretative dance, I found myself questioning one of my primary biases about choice of entity.

First, let me offer some explanation behind my bias; I strongly dislike paying tax.  That isn’t entirely true.  I strongly dislike paying tax when I have little confidence that my contributions to our government will be used wisely or for good purpose.  And in a time when our government keeps even the price of some of our military hardware confidential, it is difficult to feel that your money is being prudently spent.

So given my inclination away from paying tax, I naturally find myself recommending to clients business structures that will minimize their immediate tax burdens.  Thus, my bias in entity selection is typically to recommend an LLC or other flow-through entity form over that of a traditional corporation (assuming that the two forms are equally suitable for all other purposes).  As I prepared my materials, however, I began to question the extent to which my bias was influencing my advice.

This issue comes up regularly in the context of advising startup distilleries.  As the reader will understand, any startup can be capital-intensive and distilleries are above average in this regard.  The amount of cash necessary to get from test-still to a cash-flow positive (let alone profitable) operation is often substantial.

More often than not, the startup’s founders will not have quit their day jobs as they’re trying to turn their dream into reality.  That isn’t necessarily a choice on their part – it is more of a necessity.  They need to continue to be able to buy cappuccino and pay their mortgage while they try to get their distillery up and running.  Because they’re still working at other jobs, and because the startup is likely incurring significant losses in its early stages, the LLC recommendation is typically easy to make.  After all, by utilizing an LLC (or any other structure to be taxed as a partnership), the founders are able to avoid the potential for two levels of tax relative to the business.  Plus, they can often utilize the distilleries’ losses to offset other income on their personal tax filings.  Feels like my anti-tax bias is leading clients in the right direction, doesn’t it?

Well, it may be.  But then again, the answer isn’t definitive.   Some colleagues’ recent article on rethinking choice of entity had me doing exactly that.  Using a corporation, and assuming that the startup distillery isn’t absurdly well capitalized (>$50m in assets before or after the issuance of shares), the shareholders of your average distillery startup could potentially exclude significant amounts of gain in the event of a potential sale of those shares down the road.  How much gain?  Each shareholder could exclude up to the greater of $10 million or 10X that shareholder’s tax basis in the shares.  This is due to the magic of what our tax-guru friends call Qualified Small Business Stock.

Many knowledgeable people will tell you that you should assume it will cost somewhere approaching $1 million to get a startup distillery off the ground.  And it will take at least a couple of years to begin making anything you can sell.   After that you may quickly become profitable and begin to pay yourself – but it is more likely that you will continue to invest cash generated by the business back into the business in order to grow.  So the likelihood that a startup distillery makes any distributions to its equityholders in the short-term is relatively low.  What does that mean?  It means that in all likelihood the shareholders of the startup distillery corporation are unlikely to find themselves suffering from two levels of tax because they won’t be paying themselves dividends.  Any losses will not flow through to shareholders and will need to stay at the corporate level (where they will hopefully be useful to offset later profit).  But the founders were likely going to be working their day jobs anyway – and may be willing to trade currently deductible losses for the potential to shelter future gains on the sale of their shares.

Why is this important?  Well, if the trends in the craft beer industry are any indicator, then we should expect to see consolidation coming in the distillery space in the years ahead. Having seen Anheuser Busch InBev acquire label after label of craft beers, would we be surprised to see similar moves by Diageo in the craft spirits industry?  Such strategic transactions are almost certainly on the horizon.   The question, then, is whether any individual distillery’s circumstance (or, rather, the circumstances of the owners of the distillery) are such that the present tax benefits of the LLC outweigh the potential tax benefits of the corporation.  There will be math involved in figuring out the answer to that particular question.  That’s something that interpretative dance simply can’t address, so if you’re looking at this issue I’d recommend you find yourself a tax professional.

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