3 Strategies to Reduce Taxes When Selling a Business

In the realm of business transactions, understanding and utilizing tax-deferred vehicles can significantly enhance your financial outcomes. At Evolution Tax & Legal, our California corporate tax attorneys structure deals for long-term profitability, tax efficiency, and minimal risk.

Below, we explore three powerful methods of reducing taxes in B2B transactions: Charitable Remainder Trusts (CRTs), Deferred Sales Trusts (DSTs), and Qualified Small Business Stock (QSBS) Exemption.

1. Charitable Remainder Trusts (CRTs)

A Charitable Remainder Trust (CRT) is a tax-exempt vehicle offering the following benefits to its grantors:

• Deferral on the recognition of taxable income and gains
• Charitable contribution deduction for property contributions

A CRT is an irrevocable trust providing grantors an income stream either for life or for a stated period of up to 20 years. Grantors must take an annual distribution of at least 5-50% of the CRT’s assets at the beginning of the year. Successive income beneficiaries, such as spouses or children, can be listed, but the remainder of the assets must eventually go to the grantor’s charity of choice.

Business owners can transfer ownership of their business into a CRT before the sale. This allows for the sale of the business on a tax-deferred basis, spreading gains over the trust’s life and the distribution period. Additionally, grantors receive a charitable contribution deduction equivalent to 10% of the business’s value.

Example: Dr. Thompson, nearing retirement, places his $2 million urgent care center into a CRT. The trust sells the center tax-free, providing Dr. Thompson with a steady income stream based on a percentage of the trust’s assets each year. The remainder eventually goes to a healthcare-focused charity after his passing.

2. Deferred Sales Trusts (DSTs)

A Deferred Sales Trust (DST) is an irrevocable trust used to defer the recognition of taxable income and gains from the sale of highly appreciated assets, offering asset protection.

The seller sets up a DST and sells the appreciated asset to the trust in exchange for a promissory note, which the DST pays over time with an interest rate at the minimum applicable federal rate (AFR). The DST then sells the asset to the buyer, reinvests the proceeds, and pays the seller according to the promissory note.

In a DST, the seller transfers the business to the trust before the sale. The trust sells the business, and the seller receives installment payments over time, deferring capital gains tax and reducing the overall tax rate.

Example: Maria, planning to sell her $3 million pharmacy, uses a DST. She “sells” the pharmacy to the trust, which then sells it to the buyer. Maria receives structured payments over 15 years, spreading her tax liability and optimizing her tax burden from the sale.

3. Qualified Small Business Stock (QSBS) Exemption

The QSBS exemption provides significant tax benefits to shareholders of qualifying small businesses. This exemption allows for up to a $10 million capital gain exclusion per shareholder or 10 times the adjusted basis of the stock, whichever is greater, on the sale of qualified small business stock. This powerful tax incentive is designed to encourage investment in small businesses and stimulate economic growth.

Requirements for a QSBS Exemption

• The stock must be of a C corporation.
• The shareholder must have obtained the stock at its initial issuance.
• The stock must have been held for more than five years.
• The corporation’s assets must not exceed $50 million at any time.
• 80% of the corporation’s assets must be used in a qualified trade or business.

The final, but most stringent requirement for the QSBS exemption is meeting the definition of an “qualified trade or business”, which is defined as including any line of business except:

• a trade or business involving the performance of services including in the fields of health;
• any banking, insurance, leasing, financing, investing, or similar businesses;
• any farming business;
• any business involving the production or extraction of products of a character for which percentage depletion is allowable; and
• any business of operating a hotel, motel, restaurant, or similar business.

Strategies to Maximize QSBS Benefits

1. Stacking: Spouses can each claim the QSBS exclusion, effectively doubling the exclusion amount.
2. Gifting: Shareholders can gift QSBS to family members or trusts, each of whom can separately qualify for the $10 million exemption.
3. Estate Planning: Incorporating QSBS into estate planning can ensure that heirs benefit from the exemption, potentially across multiple generations.

Example: Eric and Alicia started a medical device company in 2016 and sold it for $12 million in 2022. By holding their QSBS for over five years, they each excluded $10 million of their capital gains from federal income taxes, significantly reducing their tax burden.

Protecting Your New Nest Egg with Trust & Estate Planning

While navigating business transactions, it’s also essential to consider the implications for your estate plan. Proper trust and estate planning can safeguard your financial future and ensure your wealth is managed and transferred according to your wishes while minimizing estate taxes.

Key Components of an Estate Plan:

• Will: Dictates the distribution of assets.
• Trusts: Helps manage and protect assets, providing control over asset distribution and tax benefits.
• Power of Attorney: Designates someone to make financial and healthcare decisions if the seller is unable.

Lifetime Estate Tax Exclusion

The Lifetime Estate Tax Exclusion is a critical component of estate planning, allowing individuals to transfer a substantial amount of wealth free from federal estate and gift taxes. As of now, the exclusion amount is set at $12.92 million per individual, which means a married couple can collectively exclude $25.84 million. However, this generous exclusion is set to expire at the end of 2025. If Congress does not act to extend it, the exclusion will revert to the pre-2018 amount of approximately $5 million per individual, adjusted for inflation. This pending change underscores the importance of proactive estate planning to take advantage of the current higher exclusion amounts.

Conclusion

Understanding and leveraging tax-deferred vehicles like CRTs, DSTs, and QSBS can greatly benefit business owners during significant transactions. Additionally, integrating trust and estate planning into these transactions can further safeguard your financial future and ensure your wealth is managed and transferred according to your wishes.

At Evolution Tax & Legal, we are committed to enhancing your financial interests by structuring deals that ensure long-term profitability and tax efficiency. Contact our team of California business law attorneys today.