By Jacob A. Stewart JD
In my last blog post (on business succession planning), I briefly mentioned the importance of an exit strategy for your business. Today, I want to tell you about John (not his real name), who will soon be selling his business for $4MM. John has been in the construction and landscaping business for many years. He holds several very valuable government contracts. John was recently diagnosed with a severe medical condition and needs to retire. Luckily, he found a buyer who is willing to pay him the full value for his business. The buyer wants to close the sale as soon as possible, and John is afraid he might lose the buyer if he doesn’t comply, even though selling a $4MM asset is not something that should be done overnight.
I am helping John with the purchase agreement, but we also talked about how waiting a month or two—in order to implement one or more tax strategies—could save him close to $1MM in taxes. Here are some of the options we discussed:
1) Charitable remainder trust (CRT)- This option would give John about $1MM in capital gains savings, plus another chunk of savings through an immediate income tax deduction. Although the potential tax savings are substantial, there are two drawbacks to this strategy: 1) John would have limited access to the assets in the trust (usually 5% to 10% per year); and 2) when he and his wife both die, whatever is left in the trust goes to a charity or charities they have chosen instead of to their family members. The second drawback can be addressed through life insurance, in case someone dies too soon. We could also set up a private foundation run by the family members and list that foundation as the qualifying charity. Using a CRT would provide John with the most money to invest and would provide him and his wife with a bigger income stream for the remainder of their lives.
2) Deferred sales trust- The idea of this type of trust is to spread out payments over a period of years, rather than reporting all of the income all at once. John would get all of the money in the end, but he would only have access to (and pay taxes on) a certain amount each year. The savings would vary depending on other income and on how much John takes out each year, but my guess is that this type of strategy would save him somewhere around $100k by the time all is said and done.
3) ERISA plan transfer- Here, the buyer and seller agree to accomplish the money transfer through a qualified ERISA plan. The buyer pays into the plan on behalf of the seller for a set number of years (while the seller helps transition the business ownership as a consultant). Contributions to the plan are tax deductible for the buyer and tax-deferred for the seller, yielding a net savings of hundreds of thousands of dollars.
There are other options as well, but the point is, if John does nothing, he will take the full tax hit and be left with only $3MM to use how he pleases. Although $3MM sounds pretty good to most of us, $3.5MM or $4MM likely sounds better. At a 5% annual return, that would mean the difference between an annual, ongoing income of $150k (if the seller is left with $3MM) vs. $200k (if the seller is left with the full $4MM). That can really add up over 10 or 20 years. When exiting or transferring a business, each case is different and different tools work better for different people at different times. In any case, planning ahead with the right professionals makes a big difference.
This article is meant to provide general information and should not be construed to contain individual tax or legal advice. Feel free to contact me at 801-923-8350 or firstname.lastname@example.org with any questions or for more information.