Installment Sales
Business owners who do not need all of the sale proceeds upfront may want to consider utilizing an installment sale as a potential option to reduce their sale tax liability. Since capital gains rates range from 0% to 20%, depending on taxable income, using an installment sale could keep the selling business owner in a lower capital gains tax bracket. Moreover, net investment income tax (NIIT), an additional tax of 3.8%, is assessed on adjusted gross income of $200K for single tax filers and $250K for married filing joint filers. Considering the 0% capital gains bracket at $94,050 and the standard deduction of $29,200 (married filing jointly), a business owner who sells their business in 2024 and realizes a $2 million gain through a 20-year installment sale could potentially end up paying 0% in capital gains. Installment sales may also be attractive to buyers since some buyers may have limited access to favorable financing options.
While installment sales offer advantages, they also come with potential pitfalls as they expose the sale to the credit risk of the buyer. Additionally, if the seller passes away before the final payment, the fair value of any outstanding installment payments will count towards the estate’s value for purposes of the Federal estate tax calculation. This could result in a significant issue for the estate if sufficient liquid assets are not available. Another pitfall for an installment sale that includes sizable real estate assets is that taxes on depreciation recapture are due upfront, while installment payments are received by the owner over time. This asset-liability mismatch could result in a liquidity issue for the seller.
One potentially aggressive strategy that some advisors recommend are deferred sales trusts (“DST”), which have features of installment sales. In this structure, a third party trust buys the business from the buyer, invests the proceeds, then makes installment payments to the seller over time. While the goal of this structure is to get the potential tax benefits of an installment stale and avoid credit risk from the buyer, the DST itself becomes a credit risk to the seller. The installment payments could be at risk if the trust’s investment performance is poor. If investment performance is good, it is retained by the trust. Potentially this may incentivize the DST trustee/provider to take on unnecessary risk in the investment portfolio.
Employee Stock Ownership Plans (ESOP)
ESOPs can provide business owners an opportunity to gradually obtain liquidity for their shares over time, offering an alternative to relying solely on the valuation of a future sale as part of their personal exit plan. An ESOP can allow an owner to get some liquidity and still receive potential upside on their remaining shares in the future. Since shares sold to the ESOP are managed by a trust, the owner can potentially continue to exert control over the shares sold to the ESOP through the governance structure. Meanwhile, participants can take distributions upon death, disability, retirement, etc. Given that an ESOP provides broad company ownership, incentives are aligned to increase the profitability and value of the shares over time. Companies that are good candidates for ESOPs usually have strong cash flow, a solid succession management team in place, and believe the company’s value can be increased through employee ownership and productivity.
Depending on the structure of the plan and the type of business, several tax-saving strategies are potentially available by utilizing an ESOP:
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S corporations can attain tax-exempt status.
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Owners of C corporations enjoy preferential capital gains rates.
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Pre-tax funds can be utilized to acquire owners’ shares.
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Both the principal and interest used for purchasing the owner’s shares are tax-deductible.
Despite the advantages, ESOPs may not be suitable for every business owner due to potential drawbacks. Given that a trust manages the share purchase, the owner can only obtain fair value for their shares upon sale. However, a sale to an ESOP creates a market for the initial sale of company shares, establishing a put option that serves as a minimum price for an external buyer. Additionally, the company will need to have sufficient debt capacity in order for the trust to finance the purchase of the shares.
Charitable Strategies
Entrepreneurs that are planning to sell their business with significant interest in charitable giving should consider various charitable strategies. These strategies can not only amplify their philanthropic impact but also potentially reduce their liability for capital gains taxes, income taxes, state taxes, and/or estate taxes. For example, a selling business owner can leverage charitable remainder trusts (CRT) as a strategy by donating shares to a CRT ahead of the transaction. This approach offers:
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An upfront tax deduction that can help offset the significant tax liability resulting from the business sale.
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An income stream through an annuity after the sale in exchange for the funds going to charity at the end of the annuity term. The remainder given to charity must be at least 10% of the initial deposit to the trust.
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Deferred capital gains taxes can be reduced as the capital gain tax on the sale is only assessed when the owner receives annuity payments, leading to potential savings. Potentially, a business can receive the annuity capital gains at rates of 0% or 15% over time instead of the 23.8% upfront capital gains rate without this type of structure.
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If the owner is in good health and the owner receives annuity payments for a period longer than the expected IRS mortality tables predict, the value of the amount received through the annuity could more than offset any remaining amount given to charity.
A simpler charitable strategy would be to eliminate capital gains and receive an upfront charitable deduction on shares that are donated to a donor advised fund (DAF). Some DAF providers, like Fidelity Charitable and Schwab Charitable, can receive shares of privately-held companies and the donor can “advise” the DAF to distribute the funds to the charity of their choice at any time in the future. Until the funds are distributed, the funds can be invested and consequently potentially increase the magnitude of giving impact.
By considering these comprehensive strategies and working closely with a team of attorneys, CPAs, bankers, and financial planners, business owners can align their personal and financial goals while enhancing their preparedness for a successful business sale.
David Flores Wilson, CFP®, CFA, CEPA is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.
