Selling a business is a complex process, particularly when it comes to minimizing tax implications and planning for your retirement income.
We’ve been involved in this process with a few clients. When they seriously started discussing the idea, they realized more options were available than they had originally considered. They also discovered the work and thought process to do it right was more cumbersome than desirable. Transactions can be cut and dry or challenging; it’s dependent on how it’s structured, the parties involved, and the seller’s ultimate financial goals.
To ensure it is a successful sale, educate yourself on selling options and begin the planning process a few years before the desired selling date. The sooner you start the planning process, the greater your chance of fulfilling your idea of a successful transaction.
Here are steps to consider during your sale that could help minimize taxes and set you up for the ideal retirement plan:
1. Start with a business valuation
Hire an independent, professional appraiser to help you determine the fair market value of your business; you want a thorough and accurate appraisal. This is important because it will help you set a realistic selling price for your business. In the case of a family business, the valuation enables the owners to properly value discounted shares if sold to relatives or children and is a good defense for IRS (Internal Revenue Service) scrutiny.
2. Consider the structure of the sale
There are two primary ways to structure a business sale: an asset sale or a stock sale. The tax implications of each structure are different.
Asset sale: In an asset sale, the buyer purchases the assets of the business rather than the shares of the company. The buyer can choose which assets they want to purchase, and the seller can keep any assets that are not part of the sale. Tax implications include:
Capital gains: The seller must pay capital gains tax on the profits from the sale of each asset, potentially resulting in a higher tax bill than a stock sale.
Depreciation recapture: If the assets being sold have been depreciated, the seller may have to pay depreciation recapture tax. This tax is designed to recapture any tax benefits that the seller received from the asset's depreciation.
Stock sale: In a stock sale, the buyer purchases the shares of the company rather than the assets. This means the buyer takes over the company as it exists, including any assets, liabilities, and tax obligations. Tax implications include:
Capital gains: The seller must pay capital gains tax on the profits from the sale of their shares in the company.
Lower tax rate: The tax rate for long-term capital gains is typically lower than the tax rate for ordinary income. This means the seller may pay less in taxes on a stock sale than on an asset sale. However, various states have different capital gains tax rules. California, for example, taxes capital gains at ordinary income tax rates.
No depreciation recapture: In a stock sale, there is no depreciation recapture tax, as the buyer is taking over the company as it exists.
3. Use estate planning strategies
If you are selling or transferring business ownership to your children, consider using estate planning strategies such as gifting or creating a trust too. This can help minimize taxes and provide for your retirement income.
If you are selling to your children, here are some of the most common estate planning strategies:
Gifting: You can gift shares of your business to your children, either gradually or all at once. The annual gift tax exclusion for 2023 is $17,000 per recipient. You can gift up to $17,000 worth of shares to each child annually without incurring gift tax. If you exceed this limit, you may need to file a gift tax return, but it doesn’t mean you are subject to the gift tax. The lifetime gift tax exclusion is currently $12.06 million.
Family Limited Partnership (FLP): An FLP is a legal structure that allows you to transfer ownership of your business to your children while maintaining control over the management of the business. In an FLP, you transfer ownership of the business to a partnership, and then gift or sell partnership interests to your children. You can retain control over the partnership as the general partner, while your children hold limited partnership interests. This can help you reduce your estate tax liability while still maintaining control over the business.
Grantor Retained Annuity Trust (GRAT): You create a GRAT and transfer ownership of the business to the trust, retaining the right to receive an annuity payment from the trust for a set number of years. At the end of the term, the remaining assets in the trust pass to your children. The value of the gift is calculated based on the present value of the annuity payments, which can help you minimize your gift and estate tax liability.
4. Terms of the sale
Negotiate the terms of the sale with the buyer, including the price, payment terms, and any other relevant details. Be sure to have a written agreement in place to protect both parties.
Installment Sale: In an installment sale, you are selling your business over time, with the purchase price paid in installments. This can be a tax-efficient way to transfer ownership of your business, as you can spread out the tax liability over several years. Each installment payment usually consists of three parts: 1) interest income, 2) return on the basis and 3) gain on the sale. In each year payment is received, the seller must report the interest income (taxed as ordinary income) and the partial gain on the sale (capital gain).
Lump sale: A lump sale is just like it sounds. You, the seller, get a single payment from the buyer; this results in an immediate capital gain or loss to be recognized in a single tax year. The capital gain could push you into a higher tax bracket depending on the amount and your current tax status.
5. Plan for your retirement income
Consider how you will use the proceeds from the sale of your business to support your retirement. A financial advisor can help you develop a retirement income plan. Now that you’ve received this lump sum or installment payments, it’s important to make sure a plan is in place so you can live a long, enjoyable retirement.
As I said earlier, selling a business can be a complex process, so it’s important to seek professional advice from a team of experts including an attorney, a tax professional, an appraiser, and a financial advisor. You’ve worked hard to create a business. The final stretch is making sure the sale is efficient and effective, so you can keep most of your hard-earned money and get it working for you and your goals. We want you to sail off into the sunset of retirement feeling good about what you’ve accomplished!
~ Rachel Bubb