By Kristin Carter, CPA – Tax Officer
Selling a business can be complicated and daunting – and may bear substantial tax consequences. Consider these tax planning tips to help you prepare for the sale of your business and minimize the tax impact.
TAX TREATMENT OF THE SALE
There are two common methods in which a business can be sold, either through an “asset sale” or through a “stock sale”. Both methods are discussed below, as well as some thoughts on selling to an ESOP.
In an asset sale, the purchaser acquires the assets of the buyer and may also assume the related liabilities. The seller retains ownership of the legal entity. An asset sale requires both the buyer and seller to agree on an allocation of the purchase price to all assets sold by filing IRS Form 8594. Gain or loss on each asset is then calculated by the seller based on the allocated sales price versus the seller’s basis in each asset.
The tax treatment of each asset sold – either preferential “capital gains rates” or less favorable “ordinary income rates” – is determined based on the type of property being sold. Depreciation recapture on fixed assets such as equipment, vehicles, machinery and buildings must be taken into account in calculating the amount and type of gain on the sale.
For example, in a $10 million dollar sale, ABC Company (buyer) and XYZ Company (seller) agree to allocate $3 million to the business’ building. XYZ’s basis in the building is only $1 million due to low purchase price and subsequent depreciation, thereby creating a $2 million gain on the building. Part of the gain will be taxed at ordinary income rates due to depreciation recapture, and any excess gain would generally receive capital gain treatment.
An asset sale is less favorable for the seller because it commonly results in a higher overall tax bill due to the ordinary income tax rates being applied to many of the asset types being sold. An asset sale is more favorable for the purchaser because much of the purchase price can be deducted through depreciation or amortization.
In a stock sale, the legal entity and its contents are sold to a buyer. The purchase price allocated to each shareholder (usually based on ownership percentages) in excess of the shareholders’ individual basis results in capital gain (or loss) treatment for each shareholder. This treatment is more favorable for the seller due to the preferential capital gains rates applied to the gain (versus ordinary income tax rates potentially applied to an asset sale). A stock sale is less appealing for the purchaser because of the risk of assuming liabilities of the company – “skeletons in the closet” – that the purchaser could become liable for in the future.
Owners of partnerships, LLCs and sole proprietorships do not own stock, and therefore can sell their ownership “interests” to a buyer. Tax treatment is similar to a stock sale, however.
If your potential buyer falls through, another option is to sell the company to an ESOP (employee stock ownership plan), which would provide employees with a stake in the company. As an added bonus, ESOPs do not pay Federal tax, and are exempt in most states as well. This method generally works incredibly well for families who would like to sell their ownership interests but who do not have a buyer, or who do not want to turn over leadership of the company to a new person or entity.
TAX SAVINGS STRATEGIES
There are several options available to you to minimize, or manage, the tax hit associated with the sale of a business, as discussed below.
An installment sale can be used to spread the purchase price over several years. The gain amount will be calculated as of the sale date, but tax on the gain will only be paid as you receive the proceeds over the term of the agreement. Any interest income assessed as part of the installment sale will be taxable at ordinary income rates as it is received. The installment method is optional and cannot be used on a loss transaction. Refer to IRS Publication 537 for more information and helpful illustrations.
If you are charitably inclined, there are various options for creating a charitable tax deduction in the same year as the business sale in order to offset the gain incurred from selling your business. A charitable remainder unitrust (CRUT) and a charitable remainder annuity trust (CRAT) can be wonderful options for providing lifetime income to income beneficiaries. The remaining principal of the trust is paid out to charity at a predetermined point in time (generally at the death of the grantors), depending on how you would like the terms of the trust to be drafted. There are pros and cons to each type of annuity trust, and the choice of structure will depend on your income needs and intentions.
- CRUT – A charitable remainder unitrust provides income to beneficiaries based on a fixed percentage of trust assets (i.e. 5% of the year-end market value, paid out in monthly installments). Because the market value of trust assets will fluctuate from year to year, the income provided will also fluctuate. The idea is for market performance to outweigh the CRUT payout percentage paid out each year so that the trust can grow over time. If the payout percentage outweighs market performance, the trust can shrink over time. For example, 7% growth in fair market value outweighs a 5% payout percentage, leaving 2% market growth inside the trust.
- CRAT – A charitable remainder annuity trust provides income at a fixed dollar amount each year (rather than a fixed percentage), regardless of trust performance or trust income. For taxpayers who would like a more fixed income stream, setting up a CRAT may be a good option. If trust income is less than the fixed dollar amount, trust principal will be invaded to make up the difference. Alternatively, if trust income exceeds the fixed income amount, excess income will be added to trust principal and the total trust principal will grow.
The minimal downside to setting up a CRUT or CRAT is that additional administrative tasks will be required, such as obtaining legal counsel, filing annual CRUT/CRAT tax returns, etc.
There are many upsides to creating a CRUT/CRAT:
- You receive an immediate tax deduction for the value transferred to charity at the time the CRUT/CRAT is funded (based on an IRS calculation discounting the present value of the future gift to charity). Aligning the charitable tax deduction in the same year as the business sale will help offset the income tax hit realized from the business sale.
- Lifetime income is provided to beneficiaries, at a minimum of 5% per year.
- A transfer of assets to a CRUT/CRAT will also remove the assets from your taxable estate, which is very beneficial in the event that you are concerned with paying estate tax on assets in excess of the lifetime exclusion amount ($11.4 million per person in 2019). Please note that a transfer to a CRUT/CRAT is irrevocable.
- You may also transfer appreciated assets to the CRUT/CRAT and receive the charitable income tax deduction based on fair market value, as well as avoid paying capital gains tax on the appreciated assets. This is a powerful planning tool for those taxpayers who hold highly appreciated assets and no longer wish to hold them.
IRREVOCABLE LIFE INSURANCE TRUST (ILIT)
In some cases where a large charitable donation is being considered, the grantor/donor is concerned with not leaving enough money for heirs. To remedy this loss of wealth, an ILIT can be set up to acquire a life insurance policy on the grantor. Upon the grantor’s death, the life insurance proceeds (which are not taxable) would be held within the ILIT and paid out to the beneficiaries per the terms of the trust document, either by holding the funds in trust and paying out over time or through a lump sum distribution to beneficiaries. Any earnings on the insurance proceeds will be taxable according to trust tax law. The benefits of this wealth replacement strategy should be considered against the cost of premiums.
A contribution to a donor-advised fund will also result in an immediate income tax deduction. Most donor-advised funds are set up through a community foundation (or through various brokers) and do not bear the same administrative burdens as CRUTs/CRATs (i.e. no annual tax return required to be filed or additional legal fees). The donors can provide a “wish list” of charitable organizations that they wish to support to the trustee of the donor-advised fund, but ultimately control is given up when assets are transferred to the donor-advised fund. Generally, the trustees of donor-advised funds will take the donors’ wishes into consideration when making grants to charitable organizations.
We hope that this discussion has been helpful in giving you more insight into your potential tax situation. If you are interested in any of these ideas, we would be happy to provide more information to help educate you. If we can be of further assistance to you and/or your CPA or estate planning attorney, please reach out to the Central Trust Company team.
*The information in this article is not presented as personal, financial, tax, or legal advice and should not be relied upon as a substitute for obtaining advice specific to your situation.