Selling a business may be the deal of a lifetime, but how these transactions are taxed can have implications for generations.
That’s why it is critical for business owners to consider the most tax-advantaged strategy for their financial goals—whether that’s funding their retirement lifestyle, philanthropic ventures, or maximizing the inheritance of their loved ones.
Individuals can employ varying approaches to deploying the cash they receive from a sale by depending on what they hope to accomplish, though there’s no one-size-fits-all solution, says Jere Doyle, a Boston-based estate planning strategist with BNY Mellon Wealth Management.
For instance, an owner could choose to defer gains through an installment sale, where purchasers make at least one payment in a different tax year. That strategy, however, comes with the risk (though not the certainty) of higher future tax rates. Earlier this year, the Biden administration called for doubling the capital gains tax rate over the current maximum of 20%.
Business owners who instead choose to give away business-related property to someone else while receiving nothing in return—or an amount below the property’s full value—will be required to pay gift taxes on the amount above the annual exemption of US$17,000 a year or US$12.92 million over a lifetime. The rates can range from 18% to 40%.
Before going this route, an owner should make sure their property receives an outside appraisal, Doyle says. Without it, discrepancies between how the IRS and the business owner value a closely held business can have tax implications.
For owners planning to pass along money to their heirs, using an intentionally defective grantor trust is among the most desirable strategies, he says. These trusts allow an individual to still get income from certain trust assets, such as business holdings or real estate. Though the owner pays taxes on this income when he or she is still alive, their estate is reduced and there are no estate taxes paid on the trust upon death.
Penta spoke with Doyle about various strategies investors can use to manage the windfall from the sale of their business.
Understand Asset Versus Stock Sales
Owners have a choice between selling shares in their business or selling the business’ individual assets and liabilities. Each choice has tax implications, yet, a lot of business owners aren’t familiar with the difference, Doyle says.
The DealStats business acquisition database estimates about 70% of business sales in the U.S. are asset sales. They are attractive because buyers can allocate high values to quickly depreciating items like equipment, and lower values to more slowly depreciating items, says Doyle. This approach reduces an owner’s tax burden sooner, yet it generates higher taxes for sellers who may pay ordinary income tax rates on certain assets.
A stock sale allows sellers to potentially be taxed at a lower rate of up to 20% in capital gains taxes on any profits.
Consider How Charitable Donations Can Help
Before a sale, many business owners will ask whether they can donate stock to charity and receive an income-tax deduction, Doyle says.
“If you’re going to do that to minimize your capital gains you want to make sure you give the stock to charity well in advance of the closing date,” he says. “You can’t wait until the last minute or the government will tax you.” In about four out of five cases, people try to gift stock after a deal is solidified, by which point it’s too late and they won’t receive the tax break.
Business owners can also use a charitable remainder trust to defer taxes before or after a sale. Assets that can be donated into this kind of trust include cash, private company stock, and real estate. The structure allows people to draw income from the trust at a rate of 5% a year for up to 20 years or the life of one or more beneficiaries, according to the IRS. When the term is up, any remaining dollars are passed on to a designated charitable organization.
An individual who uses this vehicle gets a charitable income tax deduction in the year the trust is funded equal to the remaining value the charity eventually receives. Meanwhile, income taxes are due on the annual distributions.
“You’re really deferring the recognition of the gain to a future year so you avoid it in the current year,” Doyle says, paying instead in installments over the trust term.
Consider Opportunity Zones
One option owners have is to funnel any proceeds they receive from the sale of their business into an investment in an opportunity zone, which is a geographic area qualified as economically distressed by the federal government.
By investing in qualified businesses or real estate in these areas, or in opportunity-zone funds that own multiple qualified assets, owners can defer capital gains from a business sale. Available to accredited investors, opportunity zone funds often require a minimum US$100,000 investment. Knowing the status of the holdings of these funds is critical—funds must prove 90% of their assets qualify twice annually. If they don’t, the investment may get returned.
This type of investment not only defers taxes on invested gains until Dec. 31, 2026, according to the U.S. tax act of 2017, but if the investment is held for 10 years, investors can avoid paying capital gains taxes on appreciation over the initial amount. Because maximizing tax benefits happens long term, this is a good option for those who don’t need immediate cash for a portion of their business sale proceeds. Investors must also be comfortable with the risk levels in the underlying investment.
