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Minimizing Capital Gains Tax in a Business Sale

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In my role and experience as a business broker, it is often the manner in which deals are structured and executed that help preserve the capital of a seller that can be equally as important as the price and terms of a business sale. In a past article, I discussed the concept of Personal Goodwill as a potential tax saving strategy for some qualifying business owners that are considering selling their business. Another tool that business owners should consider when it comes time to sale a business is to potentially defer and minimize capital gains tax liability through the use of a deferred or structured sale vehicle.

 

You may be familiar with the IRC 1031 “Like-Kind” Exchange mechanism commonly used by real estate owners to re-invest gains from the sale of a business or investment property to defer capital gains taxes. Unfortunately, the “Like-Kind” principle of the 1031 Exchange does not make it a practical option for business owners seeking to retire or exit from their business. The “Like-Kind” principle would require the seller to re-invest in personal property of “like-kind” rather than obtain the proceeds from the sale of the business. This principle along with more restrictive exchange requirements for personal property render it useless for all practical purposes when it comes to business sales and acquisitions. Refer to IRS Publication 544 and consult your accountant for additional guidance regarding 1031 Exchanges.

 

Fortunately, there are a couple practical options that business owners should consider and review with their accountant and/or estate planner when selling their business. The two options that I am familiar with involve what are sometimes referred to as a “Structured Sale” and a “Deferred Sale.”

 

The structured sale is based on the process that was originally used in the settlement of personal injury claims. Subsequently, the process was expanded to include the “Installment Sale” of a business pursuant to IRC Section 453. The structured sale involves two components; cash at closing and future, pre-determined installment payments. A seller can basically identify the amount of down payment that will be wired directly from the buyer to a third party assignment company which becomes the substituted obligator for the installment payments. The third party assignment company in a structured sale is an insurance company which purchases an annuity with the funds. An annuity contract is issued in accordance with the seller’s pre-determined schedule of installment payments. The benefit of the structured sale is the deferral of taxes, conservation of capital and low risk associated with an annuity. The disadvantage to this approach is that the seller cannot access the capital or change the payment schedule after the fact without penalty and/or some restrictions should some subsequent financial need arise

 

The second approach is referred to as a deferred sale and is similar in concept to the structured sale. It is also based on IRC Section 453 installment sale rules except it is set up through a trustee process and gives the seller greater flexibility with regard to how the proceeds are invested. For example, the proceeds in the trust account can be invested in bonds, annuities, securities or REITs with varying degrees of risk/return on investment. The deferred sale is a private arrangement between the dedicated trust and the seller. This approach is a relatively new option but is reported to have received a letter ruling from the IRS which can be obtained on a case-by-case basis. We currently have a transaction wherein the seller, after careful review with his accountant, is utilizing this option to defer capital gains taxes and reinvest before-tax proceeds.

 

There may be other estate planning alternatives that business owners should explore in consultation with their accountant and/or estate planning attorney but the structured and deferred sales options should probably be one of the options any business owner seeking to minimize capital gains taxes should review.