Kate Lister sold her business — offering vintage airplane rides — after running it for 16 years. "We thought we were retired. Then we got the tax bill. That's when we realized we were more unemployed than retired. I've never written a check with that many zeros (and hope to never again)!" For Lister, the tax burden wasn't entirely unexpected. She'd run the numbers before the sale. But there were some factors that made her taxes harder to handle, such as depreciation recapture — the business owned six airplanes that were almost fully depreciated.
But there are ways to minimize the tax burden that goes along with selling a business, allowing you to keep more of the money you've earned over the years.
The Structure of the Sale
The type of sale can make a difference in your tax burden. While the majority of business sales are simply a sale of the business' assets directly to a buyer, there are other options, such as a stock sale. Neil Shroff, the managing director of Orion Capital Group, advises his clients during business sales. Shroff suggests, "The first way to minimize taxes is to really push for a stock sale because it is beneficial for several reasons. First of all, if the seller receives a significant amount of the buyer's stock, it might allow a seller to defer the taxes until the sale of the buyer's stock. Second of all, if the company is a C-corp, the sale of stock generally won't be taxed twice. Finally, the entire transaction should be at capital gains rates. If there is an option to do a stock sale instead of an asset sale for a slightly reduced price, it may be worth considering. A good adviser should be able to figure out the best way to maximize your take home."
There may be situations in which a buyer is not interested or able to handle a stock sale. "If the buyer insists on an asset sale, you would want to make sure that the value of certain items such as the non-compete, non-capital assets (i.e., inventory, accounts receivable), and depreciated assets are valued as low as possible as they might contribute to the amount you will pay as ordinary income tax," says Shroff.
The Structure of the Payout
Because the IRS takes its cut based on the amount you receive from the sale of your business, changing the structure of the payment can help you minimize the taxes you will owe. Joseph Caffrey, a business broker with Worldwide Business Brokers, suggests structuring your sale so that you receive income from it over time. "To reduce taxes, a seller can finance, in whole or in part, the purchase price. This has the effect of spreading out the revenue over the term of the note. This 1) eliminates a big tax hit up front and 2) moves the income to years when, presumably, the seller is in a lower bracket. (It has the ancillary benefit of providing a reasonably handsome return on the seller's investment as the note will pay several points higher than most conventional investments; the question 'where are you going to put the money?' comes into play.)"
There are other ways to achieve similar results, such as a structured sale in which the buyer purchases an annuity to pay the seller. Caffrey breaks down how such a sale would work: "The seller bought the business for $1 million 15 years ago and has grown the business so that it is now valued at $10 million. Instead of cashing the seller out, the buyer makes a down payment of $2 million to cover sales costs and incidentals and then purchases an annuity for $8 million. The terms of the annuity can be set up to reflect the seller's lifestyle, age considerations, estate issues, etc. Each payment consists of a) non-taxable recovery of the seller's initial and ongoing investment, b) taxable gain and c) interest. Because there is interest earned on the annuity investment, the total payout is significantly higher than the initial annuity value."
The Charitable Option
Don't overlook long-term solutions when you're considering ways to protect your assets. Heath Goldman, a financial planner, points to charitable considerations: "A charitable remainder trust may work fabulously...a combination of a CRT and an outright sale would have some great tax relief." A charitable remainder trust is similar to other trusts in that it holds property or money. A CRT allows the donor to use the property or money, and even receive income from it, but after a specified period of time or an event, the trust passes to a charity. If you take this route, you can avoid capital gains tax, as well as receive an income tax deduction. The details can vary significantly based on how the trust is established, but it can be a worthwhile option.
Plan Your Exit in Advance
Planning your exit strategy long before you're ready to sell can make a crucial difference in how long you have to figure out these details. If you can do so when you're writing the first draft of your business plan, you should. An exit strategy should go beyond simple tax planning, of course. Details like how a transition will take place are better to sort out before you're in the rush to sell.
Steven Bankler is a CPA and has assisted his clients in both buying and selling businesses. He suggests speaking with a tax professional as early in the process of building your business as possible: "The time to plan for an exit strategy is at the formation stage of the business. The business owner should meet with a tax professional to insure that an exit (either by bringing in future owner/manager, another generation, and/or sale) can be accomplished in a tax efficient way."
He goes on to point out that while consulting with a tax professional when you start negotiations for sale can reduce your tax bill, but it won't let you minimize it as much as may be possible.