Reduce capital gains tax on the sale of a business
Hopefully, before selling a business, you meet with a certified public accountant or tax accountant and get an estimate of how much of your profits will go directly to Uncle Sam if you pay them a lump sum at the time of sale. You don’t want to save this surprise for after all is said and done, because chances are it’s not just a shock, but you’ve missed your chance to do something about it.
Planning is everything. For this article, I will assume that you are not doing a 1031 trade, that is, selling your business and buying another similar business with all IRS guidelines and deadlines in mind. It is quite rare to see this, but it can defer all capital gains tax if done correctly. A 1031 exchange is most commonly implemented with real estate.
Depending on how the business is sold, the gains may be taxed as long-term capital gains, short-term capital gains, ordinary income, etc. And if you are selling an asset in a C-Corp, you may face double taxation. So the idea is to minimize your tax bill and maximize your profits no matter what situation you are in.
One option is with a self-directed installment sale. The structure must be in place before the purchase / sale agreement is signed. The gist is to receive the proceeds from the sale in installments and only pay capital gains tax as you receive the proceeds. This has the effect of allowing most of the money that you would have paid immediately in taxes to continue to earn compound interest for you for many years, thus increasing your bottom line by a significant amount.
The details are too complex to fully summarize in one short article, but both an LLC and a Trust are created for you and set up to meet the IRS criteria for favorable taxation of installment sales. Your asset is transferred to the LLC prior to the sale and your buyer purchases from your LLC. The trust buys your LLC shares from you through an installment agreement and you pay taxes on your profit only when you receive the payments.
You, the seller, can control when payments start and how long they will be distributed. This allows maximum flexibility to monitor your income and also plan for future tax savings. Since your buyer paid cash for your property, you are not dependent on them for installment payments and you have transferred the risk of refinancing or default. This is done through the use of an independent third party administrator and your money is safely invested in a principle protected insurance product that will be used solely for the purpose of paying fees.
If you pass before all payments due are received, the rest of the installment payments go to the payees of your choice.
Viewing an example of a taxed sale vs. A parallel self-directed installment sale will show you the difference in overall performance that this strategy will provide. This can make the sales process more palatable and provide a reliable income stream for retirement.
The tax benefit of this approach is similar to your 401K or IRA account. It reduces your current income by the amount of your annual contribution and therefore differs the tax you would have paid on that income amount. Those funds are invested in stocks and bonds and their value increases, sometimes dramatically, during the period before you retire and begin receiving distributions. When you start distributions, the amount is treated as ordinary income and taxed at your much lower income tax rate (you are no longer working and earning a large salary) at the time.
Self-Directed Installment Sale allows you to similarly defer capital gains tax from the sale of your business. Rather than paying all of your capital gains at the time of the sale, you set up your SDIS to pay the proceeds of the sale over time. If you pay all capital gains taxes at the time of sale, that money is lost forever. However, with this vehicle, you distribute the receipt of the sale proceeds, for example, 15 years. When you receive your distribution, you are taxed on the part of that distribution that is attributed to capital gains, usually around 15%.
The difference in after-tax income is dramatic and is demonstrated by a complex analysis called illustration. However, I will try to briefly demonstrate the potential impact. If you sold your business and had a capital gain of $ 3.46 million, your lump sum capital gains tax payment at the 15% rate would be $ 519,000. In the SDIS, you would keep the total sale proceeds of $ 3.46 million and take distributions over a 20-year period or whatever period you choose. You receive an annual payment for 20 years, which would consist of 1/20 of the principal, 1/20 of the capital gains, plus investment returns.
If we made an illustration of this case and compared the sale of the business and the payment of all capital gains up front and invest the remaining income in a portfolio of compound growth of 6.85% versus the SDIS that pays 1/20 of the capital gains annually, you would get a head start. Advantage of $ 831,000 in after-tax income. Not bad for a bit of advanced planning.
