Creating a Tax Strategy for Selling Your Business
The biggest thief of profit when selling your business comes at the hands of the government. Good old Uncle Sam believes he deserves a giant chunk of what you’ve created, showing up with his hand out any time you prosper. Welcome to the legal equivalent of highway robbery: taxes.
Your yearly pound of flesh will feel like nothing compared to the plundering you’ll experience paying the government “their fair share” of the profits from the sale of your business.
At Exit Consulting Group, we work to educate you about the options available to discuss with your accountants, CPAs and attorneys that will minimize the damage Uncle Sam does to your profit.
Insert tax strategy. Better yet, this is tax avoidance strategy.
Businesses that invest time, energy, and resources into creative tax planning can save tens to hundreds of thousands of dollars in the amount they are required to fork over to the government as part of the transaction. While these strategies vary depending on the state, business, and immediate needs of the business owner, below are several examples we have encountered so you can see the power these strategies have at keeping your hard-earned dollars where they belong, with you.
All strategies should be reviewed in depth with transactional oriented accountants, CPAs, and attorneys prior to implementing.
Fundamentals of Strong Tax Strategy
We have worked with accountants and CPAs on three approaches to tax strategy. First, try to avoid taxes through measures taken before the sale, referred to as pre-sale strategies. Second, work to avoid taxes following the sale, unsurprisingly called post-sale tax strategies. Finally, strive to defer taxes.
These are legal approaches that require out-of-the-box thinking and counsel with an attorney. Sometimes these strategies take several years to properly implement, as you’ll see in some of the examples.
Evaluating State Income Taxes
Each state has a different approach to income taxes. Our home state of California has taken an aggressive approach, meaning they want a bigger cut. Other states, such as Nevada and Florida, don’t have state income tax.
With the rise of Internet businesses, which can be operated from anywhere, we have seen smart owners with an exit on the horizon relocate to a more pro business state. The key is to know this early, as they have to establish residency several years prior to the sale.
To demonstrate, consider a New Yorker running an Internet empire that sells for $5 million. If that owner moves to Colorado, it moves the state income tax from 9.8% to 4.6%. The state income dues downsize from $480,000 to $230,000. A move to Texas or Florida eliminates income tax completely.
Understanding State Specific Laws and Their Reach
Some states have decided that regardless of where the business is located, residents still have to pay their dues. Yes, I’m talking about good old California. We call it the California World Wide Income Grab. In short, if the business is located in California or if you live in the golden state, you are required to pay state income taxes. Apparently California decided too many business owners were residing in the state while choosing to operate their business in a more tax-friendly environment.
Now take a business owner living in Wyoming, another state with no income tax. They have a profitable business they plan to sell, but simultaneously want to move to California to live out their retirement at the beach. In this case, the owner should complete the sale and finalize the transaction before moving. Not doing so will cost an extra 12.3% of the sale, the state of California’s current tax rate.
If the business sells for $1 million, that’s a $123,000 check. A $5 million business writes a $615,000 check.
Factoring in Entity Type
If your business is a C-Corp, you’re no stranger to the double taxation. C-Corps get one final double hit when selling. The proceeds of the sale go through the corporation tax process before being passed on to the shareholders or owner. The corporate tax rate gets first dibs before each owner or shareholder is subject to the person’s income tax rate. Basically there is one transaction with two taxable events.
One work around we’ve seen is to sell off the stocks of the business. Typically you have an asset sell where the new owner creates a new business entity, then purchases all the assets, such as equipment, contracts, and employees. When you do a stock sale, the buyer purchases the existing business structure, which also means assuming the existing risk and liability. As we’ve written on this topic in depth, we’ll keep this section brief. Check out How Corporate Entity Type Impacts Sale Price to dig in deeper.
Another option is exploring an Employee Stock Option Plan, which we cover in Inside Sale vs. Outside Sale.
Utilizing a Charitable Remainder Trust
Creating a Charitable Remainder Trust (CRT) gives business owners a great avoidance strategy as well as allows them to support a cause they are passionate about. Your attorney will create the CRT and when you sell the business you put all of the proceeds directly into this trust, completely tax-free. The key is that all the monies are in a trust that upon your death will pass directly to the 501C3 nonprofit established as the beneficiary. The government uses the tax-free incentive to encourage the support of transferring wealth to charities.
Here’s where things get interesting. Up until the money passes, you’re the official trustee. As the trustee, you can be paid for your work as well as enjoy flexibility in covering your expenses.
Calculating in Calendar Years
You get taxed based on when the cash is received in a calendar year. Obviously this isn’t new news. We can utilize this strategy to spread out your income from the sale over several years, moving you into a lesser tax bracket. For example, we’re going into the end of the 2017 calendar year. If you sold your business in December, we could stagger installments to fall in different calendar years, such as January 1, 2018.
December to January is a little too blatant. While not illegal, you’re not winning any warm fuzzies from Uncle Sam. Postponing the second payment until March or June is a little less in your face. Additionally, we could set up a three-year installment period. For owners worried about actually getting their promised sum, we can put the full payment into escrow.
If you sell your business for $1 million, marking that as income for the year lands you in a 39.6% tax bracket, or a $396,000 tax bill. Breaking that payment into installments over four years moves you to the 33% tax bracket. Over the four years, your entire tax bill will be $330,000, shaving off $66,000 in total.
Investing Into A Caliber Team to Save Thousands
Oftentimes business owners forgo using an elite team of service providers due to sticker shock. The truth is that the combined total of everything you pay service providers to help you through this transaction won’t even touch the fee the government is gunning to take.
The key is to partner with skilled transaction-oriented providers and a team of professionals early on. Not only can you slim down a nasty tax bill, they can help walk you through the entire process. At Exit Consulting Group, we do everything from preparing the business for market, bringing qualified buyers to the table and working with tax professionals to incorporate strong tax strategies into the transaction and more.
I can’t tell you how much we’ve saved Exit Consulting Group clients over the years with creative tax strategies. I can tell you the number would be staggering, often times saving an individual client well beyond our fees.
If you have an exit on the horizon, even as far out as three to five years, contact our team today.