Capital Gains Tax Deferral On Sale of Business
When preparing to sell a business, your tax planning should be near the top of your list of priorities. The IRS expects to take a hefty cut when you sell your business or real estate assets at a profit. Between state and federal taxes, you can expect to lose up to 35% of your profit to taxes. That is why so many business owners come to us wondering how to avoid capital gains taxes when selling their business.
We will start with an overview of how business sales are taxed since it differs from selling stock or other assets. Then, we will look at strategies to reduce, delay, or avoid capital gains taxes on your business sale
How is the Sale of a Business Taxed?
The IRS levies a capital gains tax whenever an investor sells real estate, stocks, Bitcoin, or other appreciated assets. A capital gain is the difference between the purchase price (the cost basis) and the selling price. To incentivize longer investments, the IRS taxes long-term capital gains at a lower rate than short-term gains.
Short-Term
Short-term capital gains are those held for less than a year. They are taxed at the same rate as ordinary income, depending on the tax bracket of your business. That means that federal rates can go as high as 37%.
Long-Term
Businesses and assets held for over a year are taxed at the long-term capital gains rate, with rates at 0%, 15%, and 20% depending on your tax bracket. Most states levy an additional capital gains tax on top of the federal tax.
Structure of the Business
The main types of business structures are:
- Limited Liability Companies (LLC)
- Partnerships
- S Corporations
- C Corporations
The structure of the business matters for tax purposes. The first three structures mentioned above are considered pass-through entities. That means that the individual business owners pay taxes on the profits generated by the company and from the sale of the company. The taxes with the sale of a C Corporation are more complex, and the taxes depend on whether it is considered a sale of assets or stock. Selling stock is more tax advantageous to a seller, but a buyer prefers assets.
Individual Assets
The IRS won’t treat the sale of your business as the sale of a single, complete asset. Instead, it sees it as a collection of smaller, individually transferred and taxed assets. This includes (but is not limited to) stocks, real estate, machinery, furniture, copyrights, patents, and goodwill. Some assets, such as inventory, are taxed as income rather than capital gain.
Allocation of Sale Price
When you sell your business, the IRS requires you to negotiate with the buyer to allocate a sale price for each asset–tangible and intangible. Your overall tax burden will hinge largely on how you allocate the sale price among all of your assets.
This is why it matters: the capital gain for each separate asset is determined by its cost basis (what you paid for it in the first place) and its sale price.
You are motivated to allocate the price in such a way as to minimize your tax burden, but the buyer is trying to do the same, so it will take careful negotiations.
- Cash and deposits
- Certificates of Deposits (CDs) and stock sales
- Receivables
- Inventory
- Real estate and other tangible assets
- Intangible assets
- Goodwill and going concern value
How to Offset Capital Gains when Selling a Business
So, the burning question asked by every client looking to sell their business is, “How do I avoid capital gains taxes when selling my business?” The short answer is that you can’t completely avoid taxes, but you can do several things to reduce, offset, or delay the amount of tax you pay.
Pay Attention to Timing
We have already gone over the difference between short-term and long-term capital gains, and you know that short-term gains are taxed at a significantly higher rate. Ensuring you’ve owned your business for at least a year is a good start.
However, because of how a business sale is structured, you also need to pay attention to the length of time you’ve held each asset within your business. Even if you have been in business for over a year, you might still be hit with short-term capital gains taxes if any of your stocks, real estate, or property is less than a year old.
Negotiate Carefully
Take your time when negotiating the sale’s allocation. You are better off allocating more of the price to capital assets, while the buyers will push to allocate the price to depreciating assets. Strategic negotiations of the sale will save you money in taxes.
Sell to Employees
If you own a C-corporation, one option for limiting your tax burden is to look for buyers close to home. If you sell to employees through an Employee Stock Ownership Plan (ESOP), you can put the profits into an investment plan and defer taxes. This can be a good way to retire or transition out of a business while ensuring it continues.
Reinvest in Opportunity Zones
The federal government introduced Opportunity Zones in the Tax Cuts and Jobs Acts to encourage investment in economically disadvantaged communities. To this end, they have provided tax breaks to individuals or corporations that invest in these zones. By reinvesting the capital gains from the sale of your business into an Opportunity Zone, you can delay or even reduce your capital gains tax liability. The longer you hold the investment, the greater the tax benefit, with the possibility of a complete tax exclusion after 10 years.
Consider an Installment Sale
Using an installment sale can disperse the realization of your capital gains over multiple years. This opens up the possibility for your annual or even overall tax liability to be reduced. A Deferred Trust Sale is one version of an installment sale that is particularly versatile and effective.
What is a Deferred Sales Trust?
A Deferred Sales Trust (DST) is a particular form of an installment sale. You sell your business to an independent, third-party trust, and instead of paying you in cash, they give you a “promissory note” outlining the arrangement between you and the trust. Instead of receiving the profits of your sale directly, the trust takes receipt of the proceeds.
The profits will be delivered to you in installments over a period of time that you predetermined when you set up the trust. Because you have not taken actual receipt of your profits, you do not owe capital gains taxes until you receive it as part of the installment. This allows you the flexibility to reinvest all of your profits before losing money to taxes. Or it allows you to spread out your tax burden over time.
Why Use a Deferred Sales Trust?
So, why use a Deferred Sales Trust instead of one of the above methods? For one, it doesn’t have to be mutually exclusive. You will still want to allocate your sale wisely, even if using a DST.
Timing is still important, and a Deferred Sales Trust makes optimizing your timing and minimizing your taxes even easier.
If you want to reinvest in Opportunity Zones, the Deferred Sales Trust can help you do that, all while deferring your taxes.
It Can be Used with Any Business Structure
While some methods only work with one type of business structure (a C corporation, for example), a Deferred Sales Trust is a versatile method that can be used with any of the common business structures.
You Can Maximize Your Earnings by Reinvesting All of Your Profits
If you are ready to retire and live off of passive income, you want to maximize your returns by investing as much of your profits as possible. Rather than losing 30% of your gains to taxes and then investing the other 70%, a Deferred Sales Trust allows you to reinvest 100% of your gains. You will only pay taxes on the interest you receive from your investments.
It Gives You Flexibility
No business or business owner is the same, so you need flexibility in your exit plan as well. A Deferred Sales Trust can be structured to custom-fit your unique needs as you exit your business. Do you have a steady income source and want to reinvest all of your proceeds for a passive income stream? We can do that.
Do you want to get out of managing the day-to-day and change courses into real estate? We can certainly help with that. Do you want to retire but need some liquid cash flow to live off of while reinvesting the majority of your business proceeds? A DST can be set up to do just that.
Who Can Benefit from a Deferred Sales Trust?
A Deferred Sales Trust can be an ideal solution in a wide variety of circumstances. If you have ever wondered how to offset capital gains taxes on the sale of a business, here are some scenarios where you might want to consider reaching out to a Deferred Sales Trust trustee to see if a DST is a good fit for you.
- You are selling a highly appreciated business and facing steep capital gains taxes.
- You are exiting a business and do not want to continue holding investment property.
- You are selling a business that is not tied to real estate
- You want more flexibility and control than in a traditional seller carry-back contract
Why Choose Capital Gains Tax Solutions?
You Need a Professional Team
While it is not a complicated concept, executing a Deferred Sales Trust should not be attempted without the assistance of seasoned professionals. There are many moving parts–you have to find a buyer, structure the trust and the installment schedule, execute the sale, reinvest the proceeds into a diverse portfolio, and create a wealth succession plan.
You will want the assistance and advice of a whole team of professionals, including tax attorneys, financial advisors, CPAs, and trustees. Here at Capital Gains Tax Solutions, we have all the professionals you need, ready to build an exit strategy and wealth plan perfectly suited to your unique situation.
We Have Years of Experience
We have participated in over $500 million of tax deferral transactions, including Deferred Sales Trusts, Multifamily Brokerage, 1031 exchanges, Delaware Statutory Trusts, and commercial real estate.
We know the intricacies of the business and can help you find the best strategy for your needs. We have over 14 years of combined experience in the Deferred Sales Trust, and we partner with seasoned financial professionals with the expertise and experience to transform your wealth.
A Trusted Process
Skeptics of the Deferred Sales Trust will argue that it is an untested tax strategy. We want to reassure you that this is not the case. We have closed thousands of transactions. The Deferred Sales trust has withstood 12 IRS audits, four advisor-level audits, and eight state audits that closed without changes.
Also the DST has been tested in nearly every financial market for 30 years. An added benefit of working with Capital Gains Tax Solutions is that each DST has lifetime audit defense.
How Does it Work?
To help you understand the process, we will walk through a case study of a hypothetical business sale. Dr. Jones has owned and operated a successful dental practice in California for 25 years. His original basis was $1 million. He is ready to sell his practice for $10 million, with a profit of $9 million. If he were to sell directly, he would owe approximately 37.1% in taxes (20% for federal, 13.3% for California state tax, 3.8% for Medicare). That means that he would owe $3.339 million in taxes and only have $5.66 million to reinvest. Dr. Jones decides to look into a Deferred Sales Trust for his exit and wealth plan.
The first thing he does is make a call to Capital Gains Tax Solutions. In the first phone consultation, he gets clarity on his current tax liability and the possibilities of a Deferred Sales Trust. He doesn’t have to make any commitments, but he walks away with some immediate changes he can make to his deal to pave the way for a Deferred Sales Trust.
Once he has identified a prospective buyer, he meets with the Capital Gains Tax Solutions team again to sign a non-disclosure agreement and work with a tax attorney to build the structure of a DST that meets his goals. All of his questions and concerns are addressed, and he is under no obligation. He doesn’t pay anything until the deal closes. He is excited about the prospect of a Deferred Sales Trust and decides to move forward.
When ready to close the deal, he sells his business to the Deferred Sales Trust and is given a promissory note in return. He has essentially become a lender. The Deferred Sales Trust sells to the buyer and takes receipt of the proceeds. Dr. Jones has not received any profits, so he does not owe any taxes. The Deferred Sales Trust does not owe taxes either, as they sold the business for the same price they bought it. The Deferred Sales Trust can now invest all $9 million in profits into a diverse portfolio of investments, as chosen by Dr. Jones. Dr. Jones has a steady stream of passive income and will only pay taxes when he receives interest payments or the portion of the proceeds he receives in installments.
Act Now
Setting up a trust takes time, and you want to make sure you allow yourself the time to conduct due diligence.
Reach out for your free consultation today so that you are ready to act when the right buyer comes along. Find out how a Deferred Sales Trust can give you freedom and transform your wealth and legacy.
