Capital Gains Deferral in a Business Sale
The sale of business is a challenging and difficult transaction with several complicated aspects. Whether it’s the complete sale of a business or simply the sale of a uncompletely ownership interest in a company, one of the most troubling issues produced by this disposition is the manner in which capital gains and other taxes are addressed. There are not many options obtainable to a business owner, and the few that are come accompanied by complicate rules and regulations. There are also restrictions that can increase future risk and possibly cause IRS penalties.
We are always looking for ways for our business sellers to maximize their transaction proceeds while keeping as much possible by the use of intelligent tax planning and deal structure. I asked Dan Carroll from Brook Hollow Financial to explain a rare way to defer capital gains taxes that are the consequence of a business sale.
Large Tax Bill Due upon Sale
Capital Gains, Depreciation Recapture and already Income taxes may be levied against the proceeds of the sale of the business. Depending on the initial amount invested and how much the business has grown, these taxes can consume much of the sale price. Currently the Federal Capital Gains Tax stands at 15%. Most states have a Capital Gains Tax in addition, with the total amount often exceeding 20% of the gain. We believe that these rates will have near term upward pressure caused by the need for the Treasury Department to make up for the $800 billion shortfall that will consequence from the repeal of the different Minimum Tax. Other taxes, particularly if held in a ‘C’ Corp., can go beyond 60% of the transaction.
Loss of Regular Income
When a business is sold, the owner’s cash flow stops in addition. consequently, the amount of money that was being produced needs to be replaced. Without this regular income, former business owners are left with a meaningful gap in what they receive each month and must alter any plans or budgets consequently.
What to do with the Proceeds
Another major challenge that a business owner will confront is what to do with the proceeds of any sale. There are many ways to put this money to work for you, but this often method accepting meaningful risk and investing in markets without much experience. Alternatively, sellers might mitigate risk, but only at the cost of getting a very low return. Either way, inadequate returns and possible loss of capital are serious risk factors that must be considered.
Need to Mitigate Future Risk
Among the challenges presented by investing the new capital is that there may be different goals for the individual at this stage of his or her career. If the sale is prompted by a desire to move away from daily management and responsibility, or simply to cash out at a good time in the market, the owner may want to revisit his or her goals. A review of the financial needs and expectations may show a requirement for total investment certainty. While these alternatives do exist, most do little to provide a reasonable return and can make planning more difficult with these limited resources. The need and desire to mitigate future risk should play an important role in any decisions about your investment plans.
The Traditional Business Sale – Cash Transaction
The cash transaction option is fairly straightforward. The seller is paid cash from the buyer. After any loans or other debts are paid, the funds are then made obtainable to the seller. At this point, the seller must pay federal and state taxes on the proceeds, and then the remaining balance is left to invest. This drastically reduces the rule and lowers any future returns. The stock market and other liquid investments carry very meaningful market risk, and the individual could lose some or all of the money. however, the individual could place the money into a guaranteed investment such as a certificate of place, but the returns will drastically lag other possible alternatives. Investing on your own requires some planning and active management of the portfolio, but more importantly, it may provide for unpredictable future income necessary to manage and care for an investor and his or her family.
Another Approach – The Installment Sale
The Installment Sale is a mechanism that has been obtainable since the 1930’s. In this kind of transaction, the buyer of a business agrees to pay the seller a certain amount of money over a fixed period of time. Under this approach, the IRS has ruled that only the amount of dispensing in any given year is unprotected to any applicable taxes in proportion to the total due. The problem here had been reliance upon the buyer to continue to make the payments promised. Often times the business is run poorly and is no longer producing enough revenue to make the promised payments. There has always been recourse in these transactions, so that if the buyer did not live up to his obligation, the seller could foreclose and reclaim ownership of the business. However, this offered little protection if the business has not been run properly or the value lowers for other reasons, since the original seller would now reclaim a much less valuable business.
An Improved Approach – The Installment Sale with Guaranteed Annuity Payments
There is a way to ensure that these types of transactions could nevertheless be utilized while eliminating the possibility of default. The transaction takes place as described above, only there is a second transaction that occurs simultaneously. At the time of closing, the buyer purchases an annuity from an A+ rated Annuity company. consequently the seller receives a guarantee that in spite of of the future strength of the business, the payments will be made as agreed upon, and all of the tax deferral benefits keep intact.
The benefits of this kind of transaction are as follows:
Seller is able to sell the business without future risk
Tax-deferral creates much greater taxable equivalent return
Flexible planning allows for specific plans tailored to individual needs
Stabilizes future income with certainty for life
Much larger total assistance over time – guaranteed
Payments can continue to pass on to heirs in the event of death
Eliminates need for expensive life insurance
Requires no management responsibility
There are no direct or on-going fees
A simple way to look at this plan is to compare it to an IRA. With the IRA your investments get to grow on a tax deferred basis for many years and you get the assistance of earning investment returns on the amount not paid in tax. When you draw the funds out of the account, you are then taxed at your then current rate. With the guaranteed annuity installment sale, you may elect to take a portion of the business sale proceeds at close and pay all of the appropriate taxes on that portion.
You then could structure the guaranteed annuity to begin paying you a certain amount starting in 5 years for another 20 years. The investment would be allowed to grow tax deferred for that 5-year period. When you started taking distributions, you would be taxed at the rate you would have been from the original sale transaction. The important thing to remember here is that instead of receiving the complete dispensing at closing and paying a huge tax bill up front, you are taking 1/20th of the dispensing each year and paying 1/20th of the tax. The remaining portion of the deferred tax stays invested and earns income over the 20-year period. This significantly increases your return on the deferred portion of your sale proceeds.
This mechanism is a great way to obtain your proceeds with guaranteed payouts, no current involvement or management responsibility, and advantageous tax treatment. This will ensure the highest possible taxable equivalent return when compared to any fixed-income, guaranteed investment. Remember in a business sale the important number is how much you get to keep.