In our Blogs on Developing an Exit Strategy and How to Prepare to Sell Your Business we talked about how to Maximize the Value of Manufacturing Your Business which is obviously a high priority for every business owner. But what if you could substantially increase the Net Value of your manufacturing business without changing anything in the business at all? As your Business Broker representing you in the sale of your business our primary goal is to sell your business for the maximum value, and we have found we can often help our clients achieve their financial goals by helping them increase the net value (after taxes) from the sale.
What do I mean by Net Value? I’m referring to what you actually realize for the sale of your business after taxes, your net after-tax proceeds. It’s great to build a business, increasing the value over the years, but frankly, it’s agonizing to think of giving up nearly half of the value you worked so hard to build to state and federal taxes!
It’s true you can reduce the tax bite a bit if the transaction is a stock sale as opposed to an asset sale, but even with a stock sale, with most of the value taxed at the lower capital gains tax rate, the tax bill will be a big one!
The old adage there are only two sure things in life, death and taxes, doesn’t have to be wholly true. There are tax strategies used by wealthy investors that can be implemented for small and midsize business owners where you can defer up to 93% of the taxes due at closing and often reduce the overall taxes by as much as 30% or more in some instances. While these tax strategies have been around since the 1970’s, they are not well known, and often overlooked unless your tax advisor-CPA is very familiar with tax strategies for business sales.
Example of Business Sale Tax Liabilities with & without implementing a Tax Strategy
As an example, let’s say you sold your manufacturing business for $5 million with no seller note (I’ll discuss this later below).
Without A Tax Planning Strategy
If you are doing an asset sale, assuming you have very little or no basis in your company since you started it years and years ago, then you are looking at a tax rate of around 39% federal and 11% for the great state of CA. That comes out to a 50% combined tax rate, a potential of $2,500,000 in taxes on a sales price of $5,000,000. If you have the same basis in a stock sale you are looking at a minimum capital gains rate of 20% ($1,000,000). In many cases, some of the sale is treated as ordinary income by the IRS, and then that amount goes up even further!
With A Tax Planning Strategy
Installment Sale – With an installment sale, you are basically selling your business to the buyer with a seller note, often a very large seller note. Meaning you are taking payments over a number of years as the buyer pays for the business. The great part about an installment sale is the fact that you don’t report the income until it is received. So, if you have a 5-year installment (aka Seller) note, you only receive 1/5 of the sale each year. So, you only report 1/5 of income each year. This can be a great way to spread the income over several years, keeping you in a lower tax bracket each year, ultimately saving a lot on taxes.
The drawback to an installment sale is that you do not receive the full proceeds from the sale right away. Therefore, you run the risk of the buyer not being able to make the payments later.
So, in this example, if you were to sell your business as an asset sale with say $2 million dollars down and a $3 million Seller (installment) note, you would pay taxes in the current tax year on the $2 million and pay taxes on the remaining $3 million over the next five years as the income is received (if it is, there is of course risk with a Seller Note).
So you would reduce taxes a bit on the deferred $3 million of income, but this is not a great solution because your still paying taxes on the $2 million received at closing and the remaining $3 million will be taxed over 5 years which really doesn’t defer much income, not to mention the risk of carrying a Seller Note!
Deferred Sales/ Installment Trust – While this tax strategy has many names, they essentially work similarly and have generally the same benefits. Ultimately these have many of the benefits of the installment sale and reduce many of the drawbacks (e.g. the risk of carrying a seller note to the buyer).
In a Deferred Sales/Installment trust, you sell your company to a trust on an installment agreement for 10 years (as an example) and then the trust simultaneously sells the company to the buyer. At closing, you do not have “constructive receipt” of the funds and therefore your individual tax liability is significantly reduced. Now the trust is the one who is responsible for the taxes.
Since the trust just bought the company from you it has a tax basis of 100% of the value, consequently, there is no tax due from the trust. Now the trust has the full proceeds with no taxes taken out yet, so you eliminated the risk of the buyer not being able to make the payments. Since you have an installment agreement with the trust you can take money out of the trust at a schedule determined and controlled by you.
So, you control how often you take money out to keep your tax rate low and deferred for years according to your personal needs. Meanwhile, the trust is investing your proceeds (pre-tax) so your capital continues to appreciate and grow and is taxed when you take the money out of the trust. You can almost determine your own tax bracket (not considering your other income streams).
These are only a few of the tax planning strategies available. There are a lot of moving parts involved with tax strategies that must be handled correctly not only to minimize taxes but also to ensure it is compliant with IRS requirements. A well-structured Installment sale or Installment trust can be a great strategy for a business owner looking to minimize risk and maximize their net proceeds from the sale of their business.
Business Tax Strategy CPA – Advisor
Pacific Business Sales is not a CPA or financial advisor. We work closely with a CPA firm experienced in tax strategies and business sale transaction taxes, Morrow & Company. Darren Morrow of Morrow & Company is the CPA we work with and refer clients to for tax strategy advice and has contributed to this article.
Darren P. Morrow, CPA
Morrow & Co.
Office: (714) 385-1212
Tax liabilities are different for every business sale-transaction based on the transaction type (stock vs asset sale), the tax basis for your company, transaction structure, and other factors. There is no one-size-fits all answer for taxes on the sale of a business. The examples above are general in nature and will not apply to every or any particular transaction. You should review your particular prospective tax liabilities for the sale of your business with a tax advisor-CPA familiar with business sale transaction taxes. Pacific Business Sales and its agents and broker are not tax or financial advisors, the information above is for informational purposes only.