The sale of a business can be a pivotal event in an entrepreneur’s life—years of hard work can produce a big payday for the business owner, his/her heirs…and the IRS.
Business owners selling their companies are understandably focused on finding buyers and negotiating terms, but they should consider the tax consequences, too. Business sales can generate massive capital gains and/or income tax bills and possibly future estate taxes.
The right business-sale strategies could reduce those taxes, but business owners’ CPAs and lawyers often are so wrapped up in day-to-day affairs that these strategies may be overlooked. It frequently falls to the business owners themselves to raise this topic. They should clarify their financial goals—minimizing the tax bill is inevitably not the only priority, and a strategy that makes sense for a business owner who hopes to create a nest egg or income stream for himself might not be appropriate for one who wants to leave money to his heirs or a charity. The type of business involved and whether company stock or company assets are being sold matters, too—selling stock tends to be preferable for business owners, because it typically generates capital gains taxes, not steeper income taxes.
Robert Keebler, CPA, suggests the following ways to reduce the tax bill when you sell your business…
Use an “Incomplete Gift Non-Grantor (ING) Trust” to avoid state taxes. If you live in a high-tax state, dropping your business into an “ING” trust prior to the sale could provide substantial savings. The earlier you transfer the stock, the better. These trusts are established in states that won’t tax their income and capital gains, and they’re often referred to by acronyms that specify the state selected—DINGs for Delaware INGs…NINGs for Nevada…and WINGS for Wyoming, for example. Whether this is a viable option for you depends on multiple factors including the type of business and your state’s tax laws—some states make it difficult or impossible to avoid taxes this way. Nevada attorney Steven Oshins, a leading ING expert, has a useful “Non-Grantor Trust State Income Tax Chart” on his website (Oshins.com) that summarizes the relevant state laws.
What to do: If you reside in a high-tax-rate state, ask your estate-planning attorney if this is a viable option for your business. If it seems worth pursuing, have the trust set up by an ING specialist, who likely will be located in a state where these trusts are often established, such as Alaska, Delaware, Nevada, South Dakota or Wyoming.
To avoid state taxes, move to a state that has no state income or capital gains taxes. If you intend to retire to a low- or no-tax state such as Texas or Florida after selling your business, consider moving before selling. If you establish residence in this new state before selling your company stock, your former state likely will have no right to tax the sale—even if your company still is located there. This strategy is less likely to avoid state taxes if you’re selling a business’s assets rather than its stock.
What to do: Follow the residency rules of both the former and the new state to the letter. If you continue to live in your former state of residence while claiming to move to a low-tax state, you likely will be caught. Your former state might examine your credit card records, bank records, cell-phone records and more to prove that you didn’t really move and thus owe it a big tax payment.
Residency requirements vary by state. However, if you can reside in the new state for an entire calendar year before the sale, taking this position will be far more defendable. The key to protecting yourself on audit will be simple evidence, such as a driver’s license, car registration, insurance and bank records, mail…anything proving where you were actually living.
To avoid capital gains taxes, take advantage of the section 1202 qualified small-business stock-gain exclusion. If you’re selling a C Corp, the Internal Revenue Code (IRC) Section 1202 could allow you to exclude up to 100% of your capital gains from taxation. This exclusion is available on capital gains of up to $10 million or 10 times the adjusted basis of the stock being sold, whichever is greater. IRC Section 1045 can provide additional tax savings if your capital gains exceed the Section 1202 limits. Stock must be held at least five years to qualify, and Section 1202’s full 100% exclusion applies only to shares issued after September 28, 2010—shares issued between August 11, 1993 and September 27, 2010, are eligible for 50% or 75% exclusion, depending on issue date. Additional rules apply as well.
What to do: If you’re selling a C Corp, ask your CPA to look into whether Section 1202 applies to you. If your business is not a C Corp and you don’t plan to sell soon, ask whether it’s worth converting to a C Corp so you can take advantage of Section 1202 when you do sell.
Use a charitable remainder trust (CRT) to offset taxes, generate income and give a gift to a charity. If some or all of the assets from the sale of your business are transferred to one of these irrevocable trusts, you’ll receive an immediate income tax charitable deduction plus an income stream that lasts for a predetermined number of years or for life. A charity then receives the assets that remain after your death. But: This isn’t an appropriate option if your goals include leaving assets from the sale of your business to your heirs.
What to do: If a CRT fits your financial priorities, don’t wait until the sale date looms to discuss this with your attorney—you must drop your business into the trust before there’s a binding agreement in place to sell. If you wait until after this agreement is signed, the IRS will consider you—not the trust—the true seller of the business, and you’ll lose the tax advantages. Also ask your attorney to include language in the trust reserving your right to change charities later—it might be decades before assets from the trust are distributed to the charity, and you don’t want to be stuck leaving a big gift to a nonprofit you no longer like.
Use a charitable lead trust (CLT) to offset taxes and leave money to heirs and charity. These sound similar to CRTs, but they’re appropriate for business sellers who have different priorities. If you contribute the proceeds from the sale of your business to a CLT, you could generate a tax deduction sufficient to offset a significant percentage of the taxes generated by the sale. The trust will make distributions to the charity or charities of your choice over a period of years…then the assets remaining in the trust will be distributed to the noncharitable beneficiaries you named. Those noncharitable beneficiaries likely are your heirs.
What to do: To maximize a CLT’s tax benefits, consider funding it sufficiently to offset only the ordinary income generated by the business sale, not the capital gains.
Roll a portion of the sale proceeds into oil-and-gas-sector or opportunity-zone investments. Special tax breaks available for investments in the oil-and-gas sector could be used to offset some or all of the taxes generated by the sale of your business. Investments in “qualified opportunity zones”—designated economically distressed communities—could qualify for temporary deferment of the capital gains taxes. But: These opportunity-zone deferments are slated to expire at the end of 2026.
What to do: Speak with both your investment adviser and your CPA before making these investments. It’s not worth making major investments only for a tax break—these investments must make sense for your portfolio as well.
Spread out the taxes with an installment-sale transaction—but take appropriate precautions. Installment sales are an extremely common way to sell a business—the seller agrees to spread the purchase price out over a period of years, typically with interest. This could help a buyer afford your company and spread your tax bill over multiple years, potentially preventing you from landing in a very high tax bracket in any one year. Installment-sale contracts typically include language allowing the seller to reclaim the business if the buyer defaults on the payments.
Beware: There’s a crucial danger that sellers and their representatives often overlook when they agree to installment-sale terms—if the seller must reclaim the business because of missed payments, the company he/she gets back might be greatly diminished or even worthless if it was mismanaged by an unskilled or cash-strapped buyer.
What to do: Options for reducing installment-sale risk include insisting on a very large up-front payment…carefully vetting potential buyers…and including covenants in the contract that allow the seller to reclaim the business very quickly if necessary. The more your business relies on its reputation, the more important precautions such as these become—a restaurant can be ruined in just a few weeks by serving bad food, for example. If your business is exceptionally reputation-dependent, make sure your attorney understands that the covenants he/she has included in earlier installment-sale contracts might not be adequate for yours.