As a founder, you’ve poured years of your life into building your company. The sleepless nights, the pivots, the hiring decisions, the product launches—all leading to this moment: the potential exit that could fundamentally change your financial future. But while you’ve obsessed over valuation multiples and negotiation tactics, are you overlooking the single factor that could slash your proceeds by 30% or more?
A common, and costly, mistake for a founder is to wait until after the transaction closes to begin tax planning. At that point, the structure is locked in, and many of the most effective tax planning strategies are no longer available. The most advantageous strategies require implementation well before you enter negotiations for an exit. Waiting until after the deal is structured means potentially leaving millions on the table.
The difference between proactive and reactive tax planning can have a material impact on your net proceeds. The time to start planning your exit’s tax strategy isn’t when you receive an offer: it’s now.
When founders begin planning an exit with tax efficiency in mind, the possibilities expand dramatically. Unlike reactive approaches, proactive planning provides opportunities to fundamentally shape the transaction structure to maximize after-tax proceeds. Below, we explore several examples of potential elections and reorganizations, but this is not an exhaustive list. A specialized tax advisor will be able to help you understand the full range of options for your situation.
The traditional wisdom in M&A transactions has been that buyers prefer asset acquisitions while sellers favor stock sales. This dynamic exists because asset purchases provide buyers with stepped-up basis and reduced liability exposure, while stock sales typically offer sellers more favorable tax treatment with a single level of taxation at capital gains rates.
However, this general rule has an important exception due to the aftermath of state responses to the Tax Cuts and Jobs Act implementation. Pass-Through Entity Tax (PTET) elections have created certain scenarios where asset acquisitions can actually provide more tax savings to the sellers than stock sales. These state-level workarounds to SALT deduction limitations have changed the calculus on some optimal transaction structures, upending the conventional wisdom for those transactions.
Section 338 elections present another powerful option, particularly the 338(h)(10) election. This election allows parties to treat a stock sale as an asset sale for tax purposes in an eligible transaction, potentially giving both sides their preferred outcome. The 338(h)(10) is common in middle-market transactions involving the sale of S Corps and the sale of subsidiaries in consolidated groups.
For founders seeking maximum flexibility in S corporation transactions, particularly in partial exits or situations involving equity rollovers, the “drop-down LLC” structure has gained significant traction. This is a pre-transaction structure performed before the equity is acquired or contributed. The approach involves creating an LLC subsidiary beneath the S corporation, transferring the S corporation’s assets to the LLC, and then selling or contributing the LLC’s membership interests.
An alternative version of the “drop-down LLC” that preserves the S Corporation’s legal contracts is where a new S Corporation is formed, the old S Corporation is contributed to it and converted into a QSub, and then the QSub is subsequently converted into an LLC whose membership interests can be sold or contributed. Unlike the more rigid Section 338 elections, the “drop-down LLC” structure accommodates percentage sales and partial rollovers without sacrificing tax efficiency.
The key insight: transaction structure decisions should integrate tax considerations from the earliest stages of exit planning. Each approach carries distinct advantages and limitations that must be evaluated against the founder’s specific circumstances and objectives. Needless to say, this is a complicated topic that requires in-depth analysis from a specialty tax advisor well-versed in the nuances of transaction structuring.
When structuring an exit, it’s often advisable to defer tax recognition. There are several ways to achieve this, each with potential benefits and drawbacks depending on the situation.
Installment sales represent one of the most straightforward deferral mechanisms. By spreading payments across multiple tax years, founders can avoid a massive single-year tax hit. While these arrangements often arise from buyer cash flow constraints, installment terms may also provide sellers with tax advantages. In certain circumstances, it may make sense to elect out of installment treatment, but this represents the exception rather than the rule.
Earnouts provide another powerful deferral opportunity, linking additional payments to post-acquisition performance metrics. The tax treatment of earnouts requires careful structuring. The critical distinction lies in whether the earnout is tied to company performance (more likely to receive capital gain treatment) versus personal performance of the founder (potentially reclassified as ordinary compensation income). This distinction can mean the difference between paying 20% or nearly 40% on substantial portions of the transaction value.
For partnership structures, additional deferral pathways are available. Consider these examples. Partnership redemptions operate under a distinct ruleset that can delay income recognition because basis is paid out first. Additionally, the increasingly popular ‘Up-C’ and ‘Down-C’ structures, originally developed for IPO transactions, allow for the controlled exchange of partnership interests for corporate stock and can also provide for additional economic arrangements regarding the resulting tax benefits through Tax Receivable Agreements. These approaches provide flexibility but complex provisions and concepts must be navigated to avoid undermining an approach’s effectiveness.
When using these strategies, maintaining the tax structure should be top of mind. From incorporating deferral mechanisms in the deal terms to post-closing company activities, it’s important to properly account for deferral and any associated triggers to obtain the intended tax results.
When there are significant gains at stake, several advanced strategies can dramatically enhance tax outcomes when implemented with proper foresight.
Qualified Small Business Stock (QSBS) planning represents one of the most powerful approaches for noncorporate shareholders of eligible C Corporations. If certain conditions are met, including holding the stock for more than five years, individuals may exclude up to $10 million, or 10 times their basis, whichever is greater, of capital gains from federal tax. Understanding the qualification criteria early, such as gross asset limits and active business requirements, is essential for founders and investors considering an eventual exit. Founders may also qualify for tax-deferral through a rollover into another qualified small business. Some states also conform to QSBS treatment; California is an example of one that does not.
For corporations, reorganization transactions offer pathways to defer portions of exit proceeds through strategic exchanges. Rather than triggering immediate recognition on the entire transaction value, these approaches allow for deferral of recognition for the portion of the transaction that qualifies. The trade-off for this deferral comes in the form of having to meet statutory and judicial qualifications that often need to be maintained for a period after the transaction.
Partnership structures continue to offer the greatest flexibility for tax planning, but this flexibility comes with corresponding complexity. The extensive anti-abuse provisions require meticulous attention to structural details and timing requirements. While partnerships can facilitate remarkable deferral outcomes, they demand sophisticated guidance to navigate successfully.
The unifying theme across these advanced techniques is their dependence on early implementation. Some strategies may require planning years in advance, while others may only need a small amount of lead time. For founders building companies with significant growth trajectories, integrating these considerations into early-stage planning can yield extraordinary tax advantages when an exit eventually materializes.
When tax planning begins after a transaction closes, founders find themselves in the worst possible position. By the time a deal closes, most high-impact tax strategies are off the table. While some post-exit planning options exist, they’re often limited in scope—and rarely as effective as proactive approaches.
At that stage, your ability to optimize has passed. The transaction structure, payment timing, and entity considerations are permanently set, leaving only limited remedial options rather than truly optimal strategies.
If you are an individual who has already completed your exit, or are too late in the process to make material changes, all isn’t lost. There are several approaches that can mitigate the tax exposure you’ll face after selling your business:
Qualified Small Business Stock: Incidentally, your corporate stock may still qualify as QSBS, even if no planning or eligibility testing was conducted previously. Although it’s not ideal to find out post-transaction, if you were a founder of the business, this situation could save you a significant amount in taxes. Additionally, you may be able to achieve deferral by rolling over the proceeds into another qualified small business.
Opportunity Zone Investments: Your capital gains from the exit may be rolled over into a Qualified Opportunity Zone (QOZ) Fund. While recognition of those gains would only be deferred until 12/31/26, any appreciation in the fair market value of your interest in the QOZ fund would not need to be recognized if you hold the interest for at least 10 years, since your tax basis would be stepped up to fair market value.
Strategic Charitable Planning: You may be able to create a sizeable tax deduction through charitable contributions to charities, foundations, and donor-advised funds, aligning tax benefits with philanthropic goals.
While these approaches can help reduce the impact of a tax-inefficient exit, they are merely alleviating the impact of capital gains rather than achieving true optimization. They reinforce a key truth: proactive planning is the only way to access many of the most valuable tax-saving opportunities.
Executing an effective exit tax strategy requires a coordinated effort between the various deal advisors. This collaborative approach ensures that tax considerations and long-term wealth management objectives inform the transaction structure.
The implementation timeline is equally critical. A reorganization may require pre-transaction planning, while more straightforward strategies like installment sales benefit from being factored into the deal terms early. Throughout this process, you’ll need to balance immediate liquidity needs against long-term tax efficiency to achieve optimal results. Regardless of structure, early conversations with a tax advisor can help you identify planning opportunities—whether you’re aiming to defer tax or maximize after-tax proceeds.
Sapowith Tax Advisory helps businesses and their owners structure exits to maximize their outcomes. From installment sales and earnouts to reorganizations to QSBS, we provide the expertise needed to transform tax planning from an afterthought into a significant value driver.
If you’re considering an exit, contact Sapowith Tax Advisory today to schedule a free consultation. Starting the conversation now could preserve millions when you finally sign the closing documents.