If you’re a founder of a successful company, you may wonder how to save taxes when you sell the business. If you are living in a high-tax state like California, this is a common concern.
This article will provide an outline of the variou ways you can do it. It’s in no way exclusive. Also, you should consult your team of advisors (CPA, tax professional, attorneys, etc…) before implementing any of the below.
Table of Contents
Deal structure
Structuring the deal correctly is one way of reducing your tax burden. If your business is taxed as a partnership, for instance, you must allocate the sales price to the business’s assets. As a seller, it’s better for you to alloate most of the sales price to capital assets. The buyer may want the sales price allocated to assets they can depreciate.
Allocating the sales price will be a point of negotiation and can be helpful in reducing your ultimate tax bill.
Corporations can structure deals as stock-for-stock deals instead of cash-for-asset deals. The tax code (see Section 368) lays out a number of ways of trading your selling company’s stock with the purchaser’s stock in a way that would be tax free. The details of this code section could fill a book.
Bottom line here is using a Section 368 tax-free reoganization would end up with you holding stock in the purchasing company instead of your company. If it’s public company stock, you would need to think of an investment strategy to diversify your portfolio.
Leaving high tax states (Bye, California?)
Living in a high tax state like California has it’s advantages. Silicon Valley and increasingly Los Angeles are home to technology start-ups, venture capital money and investors. It’s a good place to start and grow a business. But the taxes are high and when it’s time to sell your business, one way to avoid paying state income taxes is to simply relocate to a lower tax state.
California’s franchise tax board tries to make that difficult. California taxes residents of the state on all income including income from sources outside of the state. To determine residency status, California uses a list of factors. This list is not-exclusive and even having one can mean you have to pay California income tax as a resident.
Here are some of the things California considers:
- Amount of time you spend in California versus amount of time you spend outside California.
- Location of your spouse and children.
- Location of your principal residence.
- State that issued your driver’s license.
- State where your vehicles are registered.
- State where you maintain your professional licenses.
- State where you are registered to vote.
- Location of the banks where you maintain accounts.
- The origination point of your financial transactions.
- Location of your medical professionals and other healthcare providers (doctors, dentists etc.), accountants, and attorneys.
- Location of your social ties such as your place of worship, professional associations, or social or country clubs
- Location of your real proeprty or investments
- Permanance of your work assignments
- Did you leave California and keep a vacation house there? Did you move but keep your California driver’s license?
- You may still be a California resident!
Bottom line is that if you leave California prior to selling your business, you need to completely cut ties. That means selling your house, changing your driver’s license. Everything. You really can leave nothing behind. So you have to consider that before you decide.
Section 1202 (Qualified Small Business Stock)
Section 1202 is only one code section, but it’s deceptively complex. Here’s the high level summary: under 1202, a (noncorporate) shareholder of aa Qualified Small Business (QSB) can exclude up to 50% of the gain from the sale of stock in QSB if the stock has been held for 5 years.
The 50% exclusion applies to stock acquired prior to February 18, 2009. It was increased to 75% for stock acquired between Feb. 18, 2009, to Sept. 27, 2010, and increased again to 100% for stock acquired on or after Sept. 28, 2010.
There are a number of tests that the QSB must meet to use this benefit. At the time the stock is originally issued by the QSB, the QSB must be a C-Corporation, it must pass a qualified assets test, and an original issuance test.
The qualified assets test ensures the 1202 benefit is used by “small” businesses. It says that at the time the stock is issued and immediately thereafter, the gross assets of the corporation can’t exceed $50 million. (There’s a whole other definition of “gross assets”, but we’ll leave that for now.)
“Originally issued” means the shareholder has to receive the stock directly either in exchance for cash or services. You can’t have bought it from another shareholder. Legislative history of 1202 indicates that stock acquired via options, warrants or convertibe debt are included.
The Sec. 1202 benefit is limited to the greater of:
$10 million less any exclusion taken into account in prior years (the cumulative limit), or
10 times the adjusted basis of QSB stock sold that year (the annual limit).
So, if you exclude $10 million of gain for stock sold in year 1, you may be able to use the exclusion again in year 2 to limited to 10 times the basis of the stock sold in year 2. This is helpful for investors who invested cash for the originally issued stock.
There are some other interesting things you can do with 1202 such as gifting and GRATs, but I’ll leave that for a longer piece on the subject.
Section 1045 (Rolling gain into a new start-up)
After you’ve sold Section 1202 QSB stock, if you reinveest that cash into another Section 1202 QSB within 60 days you can defer the recognition of gain. This is important if you have Sec 1202 gain that you can’t exclude due to the limits above. Your 1202 QSB gain that you can’t exclude can be reinvested in another QSB and that gain can be defered.
NING's or DING's (Using trusts to save on state income taxes)
A “NING” is a “Nevada Incomplete Gift Non-Grantor Trust”. A “DING” is the same thing, except the D stands for Delaware. Here’s how they work. If you sell your company in California, you’ll end up paying California state income tax (with a maximum of 13.3% tax rate).
In this strategy, you first set up an irrevocable trust in Nevada. (It could be Delaware, but Nevada is commonly used for this). Then, you transfer your business interest to the trust prior to sale. Since Nevada doesn’t have a state income tax, the trust doesn’t pay state income tax when the business is sold. YOu would still pay Federal income tax, but you would at least avoid paying state income tax at the time of sale.
A few things to keep in mind. The transfer to the trust is set up as an “incomplete” gift, meaning you don’t use any of your estate/gift tax exemption. The funds in the trust could be invested according to your investment plan. However, distributions from the trust back to you or to your beneficiaries may be subject to state income tax if you/they are California residents.
Bottom line: a NING trust can be used to at least defer state income taxes. This technique currently works in California, though New York has passsed a law blocking it. There is a proposal issued by the California Franchise Tax Board to block this technique, but for the moment it still works. Keep an eye out on this area. And definitelty refer to your tax or legal professional.
Installment Sales
A structured installment sale may provide an efficient option for controlling your total tax liability upon selling your business. An installment sale is exactly as it sounds: the buyer gives the seller a note and pays the seller periodic payments over time. Your total capital gain would be spread out and paid as part of each payment.
The tax benefit from doing this comes from spreading out your income so you don’t pay the maximum capital gains tax all at once.
There are actually three long term capital gains taxes . Single taxpayers pay 0% on gain up to $40,400 ($80,800 for Married Filing Joint). Above the 0% bracket, single people pay 15% on gain up to $445,850 ($501,600 for MFJ) and 20% for gain above $445,850 ($501,600 for MFJ).
If you received all the sales proceeds in one year you might end up paying the maximum 20% rate. But spreading out the gain over a number of years, maybe even 15 or more, could keep you in the lower tax brackets.
Charitable Trusts
A Charitable Lead Annuity Trust (CLAT) is another way of reducing burden. Technically, this one isn’t about reducing your capital gains taxes, but it does provide a charitable deduction. Here’s the idea. Part of your interest can be transferred to the charitable trust, and the trust will pay out an annuity to a charity for the duration of the trust. Whent eh trust expires, its assets will be tranferred to your beneficiaries. The benefit is that you get a charitable deduction up front, and if the assets appreciate greatly you can keep them in your family after the trust expires.
Estate Freezes (Bonus)
This category technically is not about reducing your capital gains taxes as much as it is about reducing your estate tax exposure and ensuring your beneficiaries are taken care of. GRATs (Grantor Retained Annuity Trusts) are frequently used. Here’s how they work. Prior to selling your business, you transfer all or part of your interest in the business to a trust. Then, when the business is sold, sale proceeds corresponding to that interest go the the GRAT. Any increase in the value of that interest over the pre-sale valuation gets transferred tax free to your selected beneficiaries (or to a trust for their benefit).
GRAT’s often last somewhere from 2 years to 10 years. If your business is sold during that time, the proceeds are invested until the GRAT expires and the proceeds are transferred to yoru beneficiaries.
Another estate freeze concept called an IDGT’s (intentionally defective grator trusts) performs the same function but is more flexible than a GRAT. There’s much more detail here, but we’ll leave that for a longer piece on the subject.