Reducing the Tax Impact on the Sale of Your Business
Whether you’ve been running a business your entire professional life or you just started it a couple of years ago, there comes a time when any business owner considers selling. Maybe you want to cash out to pursue bigger ventures or maybe you’re ready to retire — either way, this is an exciting time!
It’s also a financially complicated time, and the bigger your business is, the more complicated it is. Generally speaking, the money you make off of selling a business is considered capital gains — you started with some cash of your own, invested more in the business, and now it’s worth more than what you started with. If that increase in value is taxed like normal capital gains, you could lose almost 40 percent of your sale price to taxes.
But don’t worry. There are ways around the potentially oppressive tax bill you’re about to receive. We’ll spell out a few options you can pursue, but the main takeaway is this: don’t take this on by yourself. Without the help of professional financial advisors, you could misfile important paperwork or claim deductions you aren’t entitled to, and that’s a fast track to an audit. Here are a few things to keep in mind.
Employee Stock Ownership Plan
An Employee Stock Ownership Plan (ESOP) lets you sell your business to your employees gradually and on a tax-deferred basis. The system was created by Congress to incentivize businesses to sell to their employees, thus allowing the employees to accrue a stake in the company.
Technically, you’re not selling directly to the employees themselves — you’re selling to a trust, held for the benefit of your employees. The trustee will manage the company, hopefully keeping its value high, and your employees will get a payout of their share of ownership when they retire.
You negotiate the sale like you normally would, but you won’t get the full purchase price all at once. Instead, the ESOP will send you a promissory note that pays out over the next several years. Often, the ESOP will select an S Corp status for your company, which means the company’s income belongs to the ESOP and is tax-free.
That means the ESOP can pay you the full price of the company, as long as you’re ok with getting paid over time instead of all at once. Getting paid in yearly installments will keep your income down, which helps with the tax bill, coo.
Qualified Small Business Stock Exception
There are a lot of rules on what constitutes a “qualified” small business in the eyes or the IRS, but if yours is, the tax break can be significant. Qualified small business stock (QSBS) is any stock that’s held more than five years in an active C Corp with less than $50 million in total assets.
Essentially, it works like this. If:
- You’ve held the stock since it was issued
- You’ve held it for more than five years
- Your company is eligible
Then the sale of that stock can be entirely or partially excluded from your income. There are other caveats and limits to how much you can gain in a year, but if you have the right kind of small business, you can basically sell your entire stake tax-free.
Converting a C Corp to an S Corp
According to the Affordable Care Act, if you sell a C Corp, you have to pay an extra 3.8 percent tax on any investment income that brings your AGI above $200,000 for individuals and $250,000 for married couples filing jointly.
That rule doesn’t apply to S Corps, so converting to an S Corp can save you a lot of money. You have to stay an active owner of the business and sell your stock, so this isn’t a viable option if you’re looking to cash out quickly, but it might make sense as a preparatory step a few years in advance.
Estate Freezing and Transfer
If you’re looking to pass on your business to your children while also reducing their tax bill, there are ways to “freeze” the value of the business at what it’s worth now, transfer the asset to your child, and then sell it later. Some common strategies include:
- Annual gifting: you can transfer up to $15,000 per child ($30,000 for married couples) of stock to your children each year, completely tax-free. It might take a long time to transfer a whole company that way, but it’s a start.
- An installment sale to a trust: you’ll sell the entire business to an irrevocable trust for the benefit of your children in exchange for a note, years in advance. When the business is sold, the trust receives the proceeds and repays the note to you, the seller. Any growth the business experiences in the meantime goes to the trust, exempting it from gift or state tax.
- Private annuities: Similar to an installment sale, this involves selling your business to your children in exchange for an unsecured annuity that they’ll pay you back for life. This strategy is slightly riskier since, if the business fails, your annuity payments will dry up.
- Grantor retained annuity trusts: a GRAT involves selling shares of a business to a trust in exchange for an annuity paid by the trust to the seller. If the business appreciates, the trust keeps those profits and the value of the annuity is unchanged. As long as the business’ earnings and appreciation exceed the value of the annuity, this strategy can last you the rest of your life.
Talk to First Western
If there are two things you learn from this article, they should be that selling a business with a reduced tax impact can be very complicated, and that planning ahead is a good idea. If you want to sell your business with minimum tax liability, you can’t do it overnight and you probably can’t do it on your own. Luckily, we’re here to help. At First Western Trust, we can examine every single facet of your business, your finances, and your priorities to find a strategy that works for you. If you’re ready to take the sale of your business seriously, get in touch today.