Construction Firms: ESOP solves Depreciation Recapture problem
What is Depreciation
Certain large purchases, like a rig excavator or a backhoe, might not be deductible in the year the item is purchased. Instead, the IRS makes you spread the cost of the equipment over a certain amount of years. (In 2020, we can now expense it in our first year.) Example: You might have purchased a full rig excavator for $300,000 in 2012. At that time, your accountant explained to you that you could depreciate it over 6 years, or $50,000 per year. This asset, in 2020, is now fully depreciated.
What is Depreciation Recapture
When this rig excavator is sold, the seller owes tax on the difference between the depreciated value and the sale price. This is known as depreciation recapture, and it’s the point where the deferred taxes are supposed to be paid. To follow the above example, the rig excavator is now depreciated to $0. If you sold it today for $100,000, you would need to pay income tax on the full $100,000 ($100,000 minus $0). This is known as depreciation recapture. With depreciation recapture, you are paying ordinary income tax rates, NOT long term capital gains rates.
When you sell your firm, your taxes might be larger than you expected
When you try to sell your construction firm, all buyers will need to structure this as an asset sale (we’ll get into this in another blog). If you’ve depreciated all of your equipment over the years, you will have a larger than expected tax bill. The IRS will make you recapture all of the tax savings on all of your equipment that you have depreciated over the years. You will have to pay ordinary income tax rates on this depreciation recapture, NOT long term capital gains.
ESOP to the rescue
Do you ever wonder why there are so many construction firms that have become ESOPs? There are plenty of reasons. One small reason (depends on how much depreciation you took over the years ) is the removal of depreciation recapture.
In a traditional asset sale, the owner of a construction firm is hit with a huge tax bill. Not so with an ESOP. When you sell to an ESOP, it is structured as what is called a stock sale – this will remove the depreciation recapture.
Another important fact: If the owner sells to his employees via an ESOP structure, the owner doesn’t have to pay any tax at all. Reat that again please. How? The government allows a special capital gains deferment to owners that sell to an ESOP. And the owner can defer this payment indefinitely. Literally, when you die, the capital gains ‘deferment’ becomes permanent.
To learn more, go to www.mboventures.com or contact me, directly Darren Gleeman to learn more: dgleeman@mboventures.com