Taxes At Transition - a Business Transition Expert Extra!

By Tom Bixby, President & CEO, LEVEL Management Partners
Published April 28, 2016

LEVEL Expert Network™ member Gary Smith, Business Attorney with Bass, Dunklin, McCullough & Smith, PLLC, contributed to the Value Growth Series™ article "Business Transition - People and Taxes". Here, Gary shares additional details about minimizing the tax bite during a business ownership transition.

There are many things to think about if you intend to minimize taxes at a business transition. Some of those things include:

  • Tax Deferrals May Catch Up with You
  • Use Charitable Trusts or Foundations for Donations
  • Choice of Business Entity Is Critical
  • Avoid Double-Taxation
  • Advance Planning Pays Off

Tax Deferrals May Catch Up With You

Most people are concerned about their current year’s tax liability. Unfortunately, most people don’t ask how their current actions will impact their future tax liability. It is important to remember that many “tax saving” strategies simply defer taxes to a later time. Many clients I work with aren’t happy when their small deferrals of taxes each year result in hundreds of thousands of taxes being due when they can no longer defer them. One business I worked with wasn’t able to pay the entire tax liability due when the owners liquidated the assets after 20 years of tax deferrals.

Use Charitable Trusts or Foundations for Donations

Planning in advance allows you to choose a course of action that will minimize the tax you have to pay on a sale. For example, if you have a desire to donate a portion of the sales proceeds to charity after you sell your business, you can create charitable trusts or a private foundation in certain circumstances where you contribute ownership to the trusts or foundation before closing. As a result, upon closing, the total tax due on a sale will be reduced and the amount of cash the charity gets is increased.

Choice of Business Entity Is Critical

If you want to keep as much cash as possible in your own pocket for retirement and future needs, you need to consider how your business entity is taxed. Is your business taxed as a C corporation, S corporation, partnership or sole proprietorship? If your business is purchased by a publicly traded company and a portion of your purchase price was being paid in stock, you have an opportunity to defer the tax due on the stock you receive if your entity is taxed as a corporation through certain types of mergers and reorganizations. If your entity isn’t taxed as a corporation, and you’re planning more than one tax year in advance, you might have the opportunity to change how your entity is taxed. You generally can’t change how your entity is taxed immediately prior to a sale and get the benefit.

Avoid Double-Taxation

If your exit strategy involves a transfer to “insiders” (family or key employees), the typical source of cash to fund your exit is profit generated by the business. You typically aren’t going to be paid the total cash you want at closing. If you aren’t careful in this situation, you can end up paying taxes twice. One client had been advised to sell stock of the corporation to the key employees. In this structure, the key employees would take cash generated by the business, pay tax at ordinary income tax rates on that cash, and use the after-tax cash to pay the purchase price in installments to the former owners. As the former owners received the cash, the owners would pay tax on the gain from the sale of the stock. Each dollar generated by the business was being taxed at ordinary income rates and again at capital gains tax rates! We were able to implement a structure with this client where the “double tax” was mostly eliminated, and they saved approximately $1.6 million in taxes on an $8 million purchase price.

Advance Planning Pays Off

Without proper planning in advance, you will most likely pay more taxes than you should. When you look at your tax strategy for the current year and beyond, keep in mind what your total tax picture will be given your plans over the next three to five years. What seems like the right decision today may be one you regret tomorrow.

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