For business owners who may have worked for decades to build up their companies, deciding to sell the business can be an emotional process. But it’s also a practical one where savvy business owners need to find ways to minimize the tax implications of selling a business to benefit themselves and other stakeholders. There are a number of strategies, particularly during the planning stage and the sales process, that can help sellers maximize their return through tax efficiency. Here’s a look at some of the important variables and tax strategies that can be utilized to create tax efficiency when selling a business.
Key questions and variables
Before estimating a sale price and searching for viable buyers, a number of key questions must be considered that will directly affect the sale process.
The legal entity of the business determines the methods by which the business owner can proceed with the sale. If the business is structured as a sole proprietorship, partnership, or a limited liability company, it must be sold as an asset. However, if the business is incorporated as a C-corporation or an S-corporation, the sale can be made as either an asset or a stock sale.
Asset vs. stock sale
Whether the business is being sold as stock or being sold as individual assets directly influences the motivations of both the buyer and the seller. When a business is sold as individual assets, the buyer will essentially pick and choose the assets they want to buy. Every business has some form of assets, whether it be mostly goodwill, or other tangible items such as real estate, heavy machinery, or other forms of equipment. Each type of asset has its own tax characteristics, so buyers are usually very strategic in which assets they choose to take on in the sale if given the option.
However, when a business is sold as a stock, the buyer does not have the option to pick and choose which assets they want to take on. It’s essentially an all-or-nothing approach. This method has become less popular in today’s market, as sellers want the freedom to analyze and pick which assets to buy from an acquired company.
Another key factor when selling a business is determining which type of goodwill is involved in the sale, whether it be personal or corporate. Goodwill is all of the intangible things that make up a business: the business’ name and reputation, the future customer base, customer loyalty, and brand recognition.
Personal goodwill is usually brand recognition that is tied to the owner of the company that is classified as a personal asset, not a business asset. An example of this would be a small-town business in which customers identify with the business owner more than the business itself. This type of goodwill is much more attractive to the seller because it does not have to flow through the company’s taxation process as personal goodwill is the property of the owner, not the business.
Corporate goodwill, however, is goodwill that is a corporate asset. This will get taxed as a normal asset during the sales process and does not afford the potential tax benefits that personal goodwill does.
Three types of tax-efficient strategies when selling a business
When seeking to minimize the tax implications of selling a business, there are three main types of strategies to consider: Estate transfer, deferrals, and income tax deductions.
Estate transfer strategies are efficient ways for business owners to pass on the asset to their children or other important family members while sheltering value from estate taxes, and one of the most common ways is with a grantor retained annuity trust (GRAT).
When implementing a GRAT, the business owner transfers their ownership stake to an irrevocable trust, and, in exchange, retains an annuity payment for a predetermined timeframe. This allows the business owner to reap the fair market value of their business, and upon the expiry of annuity payments, grants the ownership stake to their children or family member free of any transfer or estate taxes.
Tax deferral strategies involve taking advantage of certain tax codes to drastically reduce tax implications on the sale of a business. One of the most popular uses of this strategy is selling to an ESOP. Selling a business to an employee stock ownership program (ESOP) is a useful strategy to both instantly find a buyer and create a liquidity event.
An ESOP is an employee benefit trust which allocates stock to individual employees on a vesting schedule. In other words, this allows employees to own a portion of the company they work for.
Selling a business to an ESOP requires it to be adequately funded beforehand, so if a seller intends to go this route, there will need to be adequate planning — five to seven years before the sale being the recommended timeframe.
Comprehensive financial and succession planning is needed with this strategy, but it affords both the seller and the employees of the company an opportunity to realize a number of tax and other financial benefits.
Income tax deductions
Tax deduction strategies involve shifting tax exposure, when applicable, to reduce any state income taxes involved when selling a business. A popular way of doing this is with an incomplete gift non-grantor trust (IGNT).
This type of strategy takes advanced planning, as the process can take multiple years, but can be used to shift tax implications from a high-tax state to a low-tax state to reduce or eliminate state income tax on the sale of a business.
Life after the sale
After the successful transfer of a business, the seller is left with a very important question: What now?
Previously, the seller had their business to rely on if they needed to increase their income in the short and long term. A sale usually provides a windfall of cash and newfound liquidity, but now takes away their ability to impact the outcome of their financials.
It is extremely important to plan for life after the sale. Market volatility, interest rates, taxes, and several other factors can completely derail an otherwise well-thought-out retirement plan.
Therefore, the decision to sell a business should be the first in a long line of planning. From presale tactics to minimize tax implications to planning for life after owning a business, it’s important to consider every aspect of the process to maximize the opportunity at hand.
Are you a business owner looking to sell your business? Contact Granite Harbor Advisors to schedule a complimentary consultation with our team of experienced financial professionals and we’ll discuss tax-efficient strategies to maximize your return and achieve your financial goals.