With the recent increase in dividend recapitalization activity, consider these wealth planning implications before taking action.
Dividend recapitalizations (“dividend recaps”) have long been a useful tool for business owners looking to generate additional liquidity for their shareholders. Over the past few years, however, there has been a significant increase in the number of dividend recaps being used by private businesses.
Key drivers for this uptick in activity include concerns over potential changes in federal income tax rates and estate and gift tax exemptions, as well as recent economic uncertainty, which has led to strategic decisions to diversify balance sheets by taking money out of businesses.
How a Dividend Recap Transaction Works
In a dividend recap transaction, a company assumes new debt and uses the proceeds to pay a one-time dividend to its shareholders.
Dividend recaps are common among private equity investors when they invest in a business as a way to return some capital to investors in the near term rather than waiting until the business is ultimately sold or listed publicly. A growing number of business owners, however, are revisiting dividend recaps as a means of providing family members with additional liquidity for diversification or, at times, to buy back the shares of family members who would like to exit the business.
Wealth Planning Opportunities for Owners Considering a Dividend Recap
Before pursuing a dividend recap transaction for your business, there are some wealth and tax planning opportunities that you should be aware of.
Lock in the Current Tax Rate on Qualified Dividends
Currently, qualified dividends paid to shareholders as part of a dividend recap transaction are taxed at a top qualified dividend rate of 20% (plus 3.8% Net Investment Income Tax). Paying the dividend now may help reduce the tax burden on your shareholders if the tax rate on qualified dividends increases in the future.
Transfer Shares Post-Transaction at a Lower Valuation
The additional debt that a business takes on as part of a dividend recap transaction decreases the value of the shares of the business. As a result, you may want to consider gifting shares of your business post-recap to trusts, or contributing these shares to a GRAT, in order to take advantage of the lower valuation these shares will have. Doing so would use less of your available lifetime gift tax exemption.
Reduce Your Capital Gains Tax Down the Road
The value of shares in your business will decrease post-recap due to the additional debt the business will have to assume. This decrease in value will, therefore, decrease the capital gain to you and the other owners if the shares are later sold.
Receive Tax Deduction on Interest Payments
For businesses organized as C-corporations, interest payments on new debt raised in connection with a dividend recap transaction may be deductible at the company level.
Diversify Your Balance Sheet Without Giving up Ownership
The proceeds distributed from a dividend recap provide a way to take cash out of the business without the need to sell shares. As a result, you can diversify your own balance sheet by investing the proceeds from the dividend recap, while retaining future cash flows from the business and exposure to future appreciation in the event you decide to sell shares in the future.
Dividend Recap Considerations
When weighing the costs and benefits of a dividend recap, it is important that you are comfortable your business can handle the increased financing burden it will be assuming by taking on new debt as part of the transaction. Further, understand that a dividend recap on its own will not solve any issues with respect to transitioning ownership of the business. Finally, bear in mind your fiduciary duty to any minority shareholders of the business. Ensure you are not increasing the debt load of the business for the benefit of some shareholders to the detriment of others.
Dividend Recap Example: Now vs. Later
The following illustrates the potential tax savings that could be realized from executing a dividend recap transaction at today’s tax rates versus executing later, assuming the tax rate on qualified dividends is increased as is currently being discussed by policymakers.
As the owner of a private business, dividend recaps are an important strategy to consider, both to create liquidity for shareholders, and as a wealth planning tool. Northern Trust has multiple teams available to collaborate and help guide you through every step of a dividend recap transaction.