Sale of Business

Selling your business?

Make sure to reduce you tax exposure by planning ahead of time


So, you have recently been offered a large sum of money for your business. It seems like a wonderful opportunity. However, without proper planning, this opportunity can result in a nightmare. Without knowing it, you may be handing the fruits of many years of hard work and sacrifice over to the IRS -without having an obligation to do so.

One particular client of mine, had amassed a real estate fortune of over $8 million (equity) only to learn that if he sold his properties, he’d bee looking at a tax bill of over $4 million. By not planning ahead, they had been caught in a web of tax pitfalls. Nonetheless, using some existing techniques, they were able to reduce their tax liability by almost half -keeping almost an additional $2 million for himself. As he later put it “what’s the point of keeping your business expenses down, if you pay full price on the most costly expense of all -taxes”.

The IRS is constantly closing doors for investors (or as they call it: closing “loopholes”). Fortunately, there are still enough tax planning strategies available for those who plan ahead using a responsible professional. In this article, we will summarize some of those options.

Under section 1202 of the Internal Revenue Code, if you are selling your shares in a “small business”, you may be able to effectively reduce your capital gains tax in half. The best thing about this provision of the law is that a “small” business is defined as a business with assets having a value of up to $50,000,000. This broad interpretation of “small” allows many successful family firms to succeed in reducing their tax liability on the sale of their business.

There are certain limitations as to which types of business will be able to avail themselves of this provision. For example, owners of firms offering professional services are generally not allowed the benefits of this provision. Likewise, it is not available to owners of companies engaged in the hotel business, or in other “passive” businesses, i.e. insurance, investments, etc. Another limitation on the use of this provision is the requirement that you must have held the stock of the company being sold for more than five years.

Given these kinds of limitations, the benefits of this provision may not always be available to all business owners. Nonetheless, because of its simplicity, it is always recommended that one analyze whether one’s business can in fact qualify.

Like-kind exchange
In some instances, Section 1031 of the Internal Revenue Code allows taxpayers to defer the taxable event of a sale where the taxpayer buys a “like-kind” property within a specific period of time. Of course, most business owners who sell their businesses are interested in receiving cash and not “like kind” property. However, if the business being sold is one which includes real estate, then the portion of the price that is attributable to such real estate may be deferred by purchasing replacement real estate.

The replacement real estate must be of a commercial nature, for example a rental apartment complex. But if one uses a little creativity, one finds that a “working” ranch is also a commercial venture. There is no prohibition against having a “commercial” property which one also enjoys.

The selfishness of using a charitable remainder trust
The IRS has provided several means of encouraging charitable donations. One of the most established is the Charitable Remainder Trusts. Under this scenario, you would transfer the appreciated business property to the CRT, with a provision by which at least the present value of ten (10) percent of the initial value is left over to a charity at the end of the trust term. Additional provisions would have you (or your designates) as beneficiaries for a period not exceed twenty years. In fact, you may even serve as Trustee.

Immediately, your gift to the trust provides you with a tax deduction equal to the amount that is destined for the charity at the end of the trust. But the benefits do not stop here. Once it takes possession of the gifted property, the trust may sell the properties. Since the trust is a tax exempt entity, it does not pay any taxes on the sale of such assets. Once the trust has the liquid assets in its possession, the trustee may re-invest those assets without incurring any tax liability.

As the trust makes payments (from income and principal) to its beneficiaries (you), the beneficiaries pay tax on such income. However, because the trust term can be as long as twenty years, the effect is to defer taxation of the capital gains over the twenty year period. The net effect of this deferment is reduce your tax liability by over half of the original amount.

Finally, the charitable entity receiving the funds could be a private foundation which you set-up. This adds further flexibility to the structure allowing you maintain the most possible control over your assets.

The key to all business dispositions is planning. The Internal Revenue Code may be filled with pitfalls, but it still contains many escape routes. It is essential that you use a professional guide to help get to them.