As the successful business owner nears retirement, one of life’s more difficult questions must be faced: What to do with the business? In the past, I’ve covered estate planning strategies that can be used to transfer the business to the next generation. But often a family member does not want to take over the business. Then the owner has to sell the business to a non-family member. The question becomes: How can the sale be structured to minimize the tax bill?
It’s great when your accountant or business adviser tells you the business is worth, say, $3 million. But then you learn that your tax basis in the business is close to zero, so most of the sale price will be taxable. At a 20% capital gains tax rate, you’ll pay $600,000 in taxes. Your state probably will charge taxes on top of that. Suddenly a quarter of your business’s value has disappeared.
But there’s more. You operated the business as a corporation. Few business buyers want to buy corporate stock. They want to buy the assets. That way they avoid any legal liabilities of your corporation, and they get to increase their tax basis of the assets to the actual purchase price. If they buy stock, they don’t get to increase the tax basis for depreciation and other purposes.
So your corporation sells the assets and pays capital gains taxes. Now the cash is in the corporation. To get the cash out, you have to liquidate the corporation and pay taxes again at capital gains rates on your personal return. Or, even worse, pay the cash out as a dividend. Either way, you now have paid over a third of the sale price in taxes.
There has to be a better way, and there some options.
One option is to keep the corporation operating after the sale and invest the sale proceeds. The corporation would be considered a personal holding company, which means that it has to distribute all its income as dividends or pay a tax penalty. You can pay yourself a salary for managing the investments, and deduct that salary against the investment income. But you probably cannot justify a high enough salary to cover all the investment income, so the rest will be dividends. The personal holding company might save money, or you might end up paying more taxes than if you liquidated. Your accountant will have to run the numbers.
Another option is to be sure the corporation is an S corporation when the sale is made. That way there is no corporate tax. The gain from the sale is taxed only once on your personal tax return. But you get this treatment only if the corporation was an S for at least 10 years before the sale. Otherwise, the corporation is taxed on the sale, and you are, too.
If these solutions don’t help, here are some more creative options.
The assets of the business can be sold by the corporation, but you can determine that there is “personal goodwill” attributable to you that is separate from the business assets. This is particularly likely with a personal service busi-ness, where one can argue that a hefty portion of the business’s value is attributable to the individual owner. If you determine that there is personal goodwill, payments for this bypass the corporate tax return and go straight to your personal return, where you like can treat it as a capital gain. The buyer of the business gets to deduct the goodwill payment over 15 years.
The IRS doesn’t like this strategy. And it is relatively new, so there aren’t many court cases. You’ll need a tax advisor to carefully review the court cases and rulings to see if the goodwill really can be attributed to you rather than the corporation and if it qualifies as capital gains..
Another option is to sell the corporation on an installment basis. That way, instead of one big payment with a big tax bill, payments are spread out over the years. You might be able to generate deductions that offset some of the taxable gain each year, or you might stay below the top tax bracket.
The difficulty with an installment sale is that someone else is running the business, and you depend on that business to generate income for the rest of your life. If the new owner doesn’t run the business well, you take the business back after the new owner defaults on the payments. You have to run the business,and it might be too late to restore the business to its past level of profitability. So there is risk with an installment sale.
Next consider a consulting agreement. You sell the business or its assets for one price. Then you sign an agreement to consult with the buyer for a number of years. The payments are treated the same as any other consulting income. You have income on your personal tax return that is subject to income and self-employment taxes. The buyer gets to deduct the payments to you, which allows you to effectively charge a higher price for the business.
This is another area the IRS doesn’t like, but it can be made to work. In one case, the seller took only 17% of the asking price as the purchase price of the business. The rest of the price was paid in 12 years of monthly consulting payments. (Brain, TC Memo 1990-35) Be sure that a tax adviser structures the deal so that it does qualify as a consulting agreement and not a sale of the business. The disadvantage of this strategy, again, is that you are paid over time and depend on the new owner to run the business profitably.
A final strategy is the two-step sale.
First, you sell a majority interest in the corporation to the buyer. You are selling the stock, not the assets. The new owner agrees to buy out your remaining shares after your death for a price that reflects its present value, taking into account interest and inflation or appreciation. At your death, the corporation redeems the stock from your estate, or the new owner buys it from the estate. This avoids taxes on that portion of the business, because the estate gets to increase the tax basis of the shares to their fair market value at the time of your death. So, waiting to get the money for your heirs can be worth avoiding all those taxes.
You want to sell enough stock the first time to satisfy your lifetime financial needs. You’ll have to reduce the sale price a bit, since the buyer won’t get to increase the tax basis. On the other hand, the buyer takes control of the corporation without having to pay the full value of the company. And corporate assets can be used to buy life insurance that will pay for the rest of the stock. So it can be a good deal for the buyer.
You need to structure this deal carefully so that you have adequate assurances of receiving the eventual purchase price for your estate, and also so that the two transactions are not treated by the IRS as one sale.
Selling a business is not only an emotional decision but also a difficult tax and financial decision. The key is to look at all the possible structures and their tax effects before going into a deal. Otherwise, you’ll negotiate a purchase price and sign a contract without realizing the full tax cost of the sale. You and your heirs will be better off if taxes are considered in advance.