Tax Tips For Selling a Closely Held Business
Little ghosts and goblins walking down the street, they’ll knock on your door in the dead of the night. If you want to avoid a trick, you’ll have to give them a treat. As we prepare to open our doors to little monsters this Halloween, perhaps now is a good time to discuss a fear that keeps many high net worth individuals awake at night – the fear of the tax consequences of selling a closely held business.
This article explores the tax implications of liquidating a closely held business. Included are some tax tips you can use to help you overcome the fear of selling. It should be noted these tax strategies apply to taxpayers whose businesses are structured as C corporations.
Tax Implications of Selling
Those inclined to sell a closely held business should be aware of the tax consequences. If your business sells for a gain, 26 U.S.C. §§ 1(h)(1) and 1231 generally come into play. They require you to pay tax on capital gains. Gain from sale of business assets held for less than one year or after depreciation is taken may be subject to tax at ordinary income tax rates, 39.6 percent at some income levels. Individuals whose income exceeds certain thresholds may also be subject to a 3.8 percent tax on net investment income. Most states also impose an income tax on the sale of business interests.
Using Incomplete Non-Grantor Trusts
Strategies devised to minimize or defer the taxes imposed on high net worth individuals typically focus on federal tax laws. In some states, however, income-tax rates can reach into the double digits. If you live in a high tax state and relocation isn’t feasible, you may be able to save taxes by transferring the interests of your closely held business into an irrevocable non-grantor trust. In certain states, these trusts can be used as a conduit to sell a closely held business free of state capital gains taxes. To derive this benefit selecting the proper situs of the trust is critical. The situs of the administration of the trust must be in a state that allows a settlor to fund a trust for her benefit that will not be subject to the claims of the settlor’s creditors. The situs should also be in a state that will not tax the trust’s income. If the trust is designed as an incomplete gift non-grantor trust you can transfer your business interest to the trust without any gift tax consequences as well. In any event, proper structuring of the terms of the trust document is essential to ensure that the trust will not be considered a grantor trust for federal income tax purposes.
Using Section 1202 Stock
An even more aggressive strategy that has been gaining in popularity is to fund a non-grantor trust with 26 U.S.C. § 1202 qualified small business stock (“QSBS”). If a trust’s business interest is considered QSBS the trust is permitted to exclude from income up to 100% of the gain realized on the sale of the stock, provided the stock is held for more than five years. The amount of the gain excludable is capped at the greater of $10 million or ten times the sellers cost basis in the QSBS. Some states follow the U.S. federal rules regarding taxation of QSBS, which allows for state QSBS exclusion of gain too.
To qualify as QSBS generally, stock must be originally issued after 1993 by a C corporation that has gross assets of less than $50 million and uses at least 80% of its assets in a qualified trade or business. A qualified trade or business is any trade or business other than one devoted to performing certain professional services, banking, farming, mining, hotel, motel, restaurant, or other similar businesses.
QSBS acquired by gift generally satisfies the original issuance requirement if the donor acquired the QSBS on the original issuance by the corporation. You can double the Section 1202 exclusion by gifting a portion of your QSBS stock (up to the statutory limit) to a non-grantor trust and retaining ownership of the rest. A non-grantor trust and its settlor are each entitled to a separate full exclusion amount.
Donations to Donor-advised funds or other types of public charities
Business owners with philanthropic inclinations might consider donating a portion of their closely held business to a donor-advised fund or other public charity. The benefits of such giving may be derived both before and after a donated business interest is sold by the public charity. A charitable deduction generally equal to the fair market value of the business interest donated may be taken on your personal income tax return in the year the donation is made. Your adjusted gross income is not impacted by any gain arising from any portion of your closely held business sold by a tax-exempt charity. Through a donor-advised fund, a donor can determine flexibly over time which among various charities even with differing purposes will be the beneficiaries of her generosity.
Donations to Charitable Remainder Trusts
Donating to a Charitable Remainder Trust (“CRT”) may be the best option for some philanthropic business owners such as those who need the proceeds from the sale of a business for personal use. A CRT is a tax-exempt irrevocable entity. It receives donations from which it pays income to the donor for life or for a certain term of years and gives the remainder of the assets to a donor specified charity. The benefits of the CRT are numerous. In the year a donation such as a business interest is made to a CRT you get an income tax deduction equal to the estimated present value of the remainder interest that will ultimately go to a charity. Because CRT’s are tax-exempt they can sell your business interest tax-free and reinvest the sale proceeds for asset accretion undiminished by taxes. Payment of tax on capital gains from the sale of a business interest can essentially be deferred until payments of trust property are made to you in the satisfaction of your income interest.
With a little tax planning selling a closely held business need not lead to a substantial tax bill. Caution should be taken before proceeding with any of the above-mentioned business sale techniques. They could have unintended tax consequences unless some preliminary pre-sale steps are taken before a sell is consummated. Please contact your local Withum tax advisor to discuss how these tax savings tips can be incorporated into your wealth management strategy.
Author: Marcus Dyer, CPA, JD. | [email protected]
