Mergers and acquisitions (M&A) can be exciting opportunities for business owners, investors, or companies. However, they are a complex transaction that has long-lasting effects on the financial health of the business or investor. Whether you are buying or selling, the tax implications are one of a deal’s most critical yet often overlooked aspects. Understanding how capital gains taxes will impact your deal is essential to minimizing your tax burden and maximizing your profits.
The Deferred Sales Trust (DST) is a powerful, flexible solution for deferring capital gains taxes. A DST allows sellers to defer capital gains taxes by structuring the sale through an independent third-party trust. In this blog, we will explore the tax implications of M&As and strategies for reducing or deferring capital gains taxes. And we’ll explain how a Deferred Sales Trust can help you maximize returns when structuring an M&A deal.
Types of Mergers and Acquisitions
The taxes you owe will depend, in large part, on the way that your M&A is structured. Mergers and acquisitions can be complex, but these are three of the most common types of deals and the tax implications of each.
Asset Purchase
In this arrangement, the buyer purchases specific company assets and liabilities. This type of deal provides tax benefits for the buyer, as it allows them to “step up” the value of assets to the current market value, reducing their tax liability in the future. Sellers don’t tend to like this type of structure, as some of the gain can be treated as regular income instead of capital gain, with higher tax rates. There is also a potential for sellers to face double taxation if the company is a C corporation.
Stock Sale
In this type of sale, the buyer purchases the entire company, including its assets and liabilities, by acquiring the company stock. This type of sale does not give buyers the same benefit of a step-up in tax basis, but it is more favorable to sellers who qualify for capital gains tax treatment.
Merger
A merger occurs when two companies combine to form one. Depending on how this is done, it can be taxable or tax-free. For a merger to qualify as a tax-free reorganization, shareholders in the company being acquired exchange stock with the acquiring company.
Understanding Capital Gains Taxes in M&A Deals
Capital gains taxes are triggered anytime you sell an appreciated asset and earn a profit. Whether you are selling property, a business, stock, cryptocurrency, or your highly appreciated baseball cards, if your asset has increased in value, you owe capital gains taxes when you sell.
Capital Gains Taxes in M&A
When it comes to M&A, you are selling or buying tangible assets, intangible assets, financial assets, stock, or a combination of all of the above, which will trigger capital gains taxes. Tangible assets include real estate, equipment, and inventory. Intangible assets include goodwill, brand names, patents, contracts, and intellectual property.
In an asset sale, all of the assets have to be valued. The seller will be taxed on the difference between those assets’ original value and selling price. Some assets are taxed as ordinary income (at the higher income tax rate), and some assets are taxed as capital gains. When structuring an asset sale, the buyer and the seller must negotiate the allocation of the purchase price among assets. Allocating more of the purchase price to assets taxed at capital gains rates will benefit the seller.
A stock sale is a bit more straightforward. Capital gains are the difference between the original stock price and the selling price. Depending on the seller’s income bracket, capital gains tax rates vary between 0% and 20%.
Short-term vs. Long-term Capital Gains Taxes
No matter the type of asset, capital gains are taxed at different rates depending on whether they are short-term or long-term gains. Short-term gains are profits made on any asset that you’ve held for less than a year. Short-term capital gains are taxed at the ordinary income tax rate, which can be as high as 37%.
Long-term capital gains taxes are applied to any asset you sell after holding for over a year. Long-term capital gains rates are 0%, 15%, or 20%, depending on your income bracket.
Why Business Owners Need Tax Deferral Strategies
There is no way to completely avoid paying taxes when you sell a business, so why go through the hassle of capital gains tax planning? Why not just get it over with and pay it upfront?
There are several advantages to deferring your capital gains taxes that may reduce your overall tax liability and maximize your returns. When you structure a sale so that you receive your profits spread out over time, you not only spread out your tax payments, but you can potentially keep yourself in a lower tax bracket and lower your tax rate.
When you defer your capital gains taxes, you hang onto your money longer, and you can put it to work in the meantime. Between state and federal capital gains taxes, you can owe up to 30% of your profit to the government. By deferring capital gains taxes, you are able to reinvest that 30% that you would have otherwise paid to Uncle Sam, and it can continue bringing you returns.
However, it is crucial that you start your tax planning early and work with a tax professional. Mergers and acquisitions are complex, with varied and involved tax implications. A tax attorney or experienced Deferred Sales Trust trustee can help you structure a sale that considers capital gains taxes and maximizes your returns.
The Deferred Sales Trust (DST)
A Deferred Sales Trust is a flexible solution for getting the most value out of your business sale. Here’s how a DST works:
- As a business owner, you sell the company to an independent third-party trust (the DST) instead of directly to the buyer.
- The DST sells the business to the buyer and holds the proceeds in trust, tax-deferred. Because you haven’t received a direct payment, no capital gains taxes are triggered.
- The DST gives you a contract, also known as a promissory note, detailing the terms of repayment. You can choose to receive the proceeds of the sale in regular installments over years, or to receive interest-only payments which keeps the capital gains tax in a 100% deferral state.
- The trust reinvests the profits from the sale into real estate, stocks, cryptocurrency, or any combination of investments based on your goals, desires, and risk tolerance. The proceeds continue to grow tax-deferred.
- You receive regular payments according to the terms set up in the promissory note. You only pay capital gains taxes on the portion of the proceeds that you receive each year. If you choose to only take interest payments, you will pay regular income taxes on those payments.
Key Advantages of the DST in M&A Deals
A Deferred Sales Trust offers a few key advantages, especially when compared with other tax deferral strategies.
- You defer capital gains taxes, increasing your overall earning potential.
- A Deferred Sales Trust can provide as much liquidity as you need based on the frequency of installment payments.
- You can reinvest the proceeds in stocks, bonds, real estate, or other ventures, making the Deferred Sales Trust extremely flexible.
- The Deferred Sales Trust has a firm legal track record, with a lengthy history of IRS audits closing with no changes.
Planning Ahead
A merger and acquisition is an exciting step for business owners but comes with complex tax challenges. An experienced and qualified tax professional can help you understand the different sale structures and how each of those will impact your overall tax burden and returns.
A Deferred Sales Trust is a tax solution that allows you to sell your business while deferring capital gains taxes. This not only maximizes your returns but can also make your M&A negotiations easier by taking some of the stress of taxes away.
It is essential that you contact a Deferred Sales Trust trustee early in the process so that you can weigh all your options and build a sale that best fits your tax and investment needs.