Before the Sale: Tax Planning for Business Owners

Catherine H. Hines
Counsel, Tax Department
Published: MA Society of CPAs' newsletter and NH Society of CPAs' newsletter
August 14, 2015

As the baby boomers age, we are witnessing what many have described as the largest transfer of wealth from one generation to another. Much of the wealth is in the form of closely-held, often family, businesses; and the owners of these businesses will typically sell their companies with the hope that the proceeds from the sale will support them and their families for years to come. What they often do not appreciate is the significant negative impact that taxes will have on their plans.

Long before negotiations on the sale of a business begin in earnest, a company’s financial and legal advisors can add value by identifying strategies to produce estate and income tax savings. We describe a selection of these strategies below. Significantly, most of them are best implemented well before a purchase agreement or even a letter of intent is signed.

1. Estate Planning Strategies

If no estate planning has taken place before a sale, 40% federal estate tax will likely apply to sale proceeds transferred to the next generation that exceed the exclusion amount (currently $5.43 million per person and $10.86 million for a married couple). For Massachusetts residents, the state exclusion is only $1,000,000 and a tax of up to 16% applies to amounts above that. After the federal deduction for state tax is applied, the top federal and Massachusetts combined rate is nearly 50%. Below we describe two commonly-used vehicles (“GRATs” and “CRUTs”) that can facilitate the transfer of sales proceeds to family members at significantly reduced estate and gift tax cost.

a. Trusts for the Benefit of Family.  In the low interest rate environment of the past several years (and in all likelihood the year to come), strategies that take advantage of these low rates, like grantor retained annuity trusts (“GRATs”) and intentionally defective grantor trusts, have become particularly effective. A GRAT, for instance, is a trust into which an individual transfer assets in return for annual annuity payments over a fixed number of years. At the end of the GRAT term, the remaining assets in the GRAT pass to the grantor’s designated beneficiaries.  The GRAT can be structured so that the gift deemed to be made to the beneficiaries is minimal. Such GRATs are called “zeroed-out” GRATs. Specifically, the annuity amount – expressed as a percentage of the initial fair market value of the property transferred to the GRAT – is set so that the present value of the amount to be paid to the grantor over the annuity term equals the amount transferred into the GRAT plus an assumed rate of return established by the IRS.  This results in the grantor being treated as having made little or no taxable gift to the ultimate beneficiaries of the GRAT because, in a present value sense, the grantor will receive back everything he puts in. Appreciation in the trust assets in excess of the IRS assumed rate of return will eventually pass to the beneficiaries gift tax-free.

A GRAT will be effective so long as two conditions are met. First, the assets held by the GRAT must grow faster than the IRS’s assumed rate of return. With interest rates remaining low, however, it should, by historical standards, be relatively easy for a growing business to pass this threshold. Second, the grantor must outlive the term of the GRAT lest its assets revert to his estate. Some of the mortality risk inherent in the GRAT strategy, however, can be mitigated by a “rolling GRAT” strategy in which a series of short-term GRATs are created.

The savings from a GRAT can be magnified by the use of discounting. For instance, if the asset transferred into the GRAT is a minority stake in a closely-held business, the valuation of the shares may be discounted for lack of marketability and minority interest status. These discounts increase the value that can be passed on to beneficiaries gift tax-free by reducing the value to which the assumed growth rate is applied. And the more time that passes between the transfer to the GRAT and the execution of a letter of intent to sell the shares, the easier it is to justify a lower valuation for the shares transferred to the GRAT.

b. Trusts for the Benefit of Charity. Some business owners may wish to use a portion of their wealth to achieve charitable goals, particularly when sales proceeds substantially exceed family needs. For these business owners, a charitable trust may provide a tax efficient way to achieve their goals. For instance, the period leading up to a sale of highly appreciated property is an opportune time to consider contribution of a portion of the property to a charitable remainder trust (“CRT”).  The gift to the CRT is subject to the grantor’s retained interest in either an annuity payment or annual payment of a fixed percentage of the CRT assets’ market value; and the assets remaining in trust at the end of the term pass to a charity of the grantor’s choosing.

A CRT generates both estate and income tax savings. The value of the gift to the charity is as a general rule not subject to gift tax and is removed from the grantor’s estate. With respect to income tax, although the CRT will realize the gain attributable to the company’s appreciation upon sale of the assets, since the CRT is itself tax-exempt, it pays no income tax on the sale. The capital gains are retained inside the CRT and must be taken into the grantor’s income only to the extent annual payments from the CRT distribute the gains to him in future years.

The grantor also receives an income tax deduction for the value of the remainder interest given to charity in the year of the gift. In order for the grantor to avoid being taxed on the full amount of the company’s appreciation when the sale occurs, the transfer of the interest in the company to the CRT must occur before the grantor acquires a right to the income from a specific sale of the company. The IRS has adopted the position that, if property is transferred to a charity and the charity is legally bound at that time to sell it to a third party, the sale will be attributed to the donor and the donor will be taxed on the gain recognized from this sale.

2. Income Tax Strategies.

Federal and state income tax can also take a large bite out of sales proceeds. A sale of a C corporation, for instance, will have a combined federal and Massachusetts income tax rate of up to nearly 28% for a stock deal and 58% for an asset deal. In addition to the CRUT strategy outlined above, business owners should consider the savings potentially available from entity choice and New Hampshire asset protection trusts.

a. Entity Choice.  The best tax planning is, of course, to choose the right entity at the outset.  As a general rule, sales of “pass-through” entities such a sole proprietorships, partnerships, limited liability companies taxable as partnerships and S corporations will be more tax-efficient than sales of C corporations, which are subject to entity level taxation. Planning for an eventual exit, should take into consideration whether a different choice of entity would be more tax efficient.  Owners of a C corporation should be advised to consider whether the immediate tax cost of conversion to an entity taxable as a partnership or an S corporation would offset the eventual tax efficiency of pass-through taxation in lieu of double taxation upon a liquidation event (in addition to other factors like the preferences of likely investors).  Notably, if conversion of a C corporation to an S corporation takes place more than ten years before the liquidity event, built-in gains on business assets will not be subject to entity-level tax.

b. New Hampshire Asset Protection Trust.  Effective 2009, New Hampshire enacted legislation allowing a person to transfer assets into trust of which he is a beneficiary that shelters trust assets from future creditors. These asset protection trusts may also allow state income tax savings for Massachusetts residents.  A carefully designed trust with a New Hampshire trustee may not be subject to Massachusetts income tax on the sale of stock held by the trust. New Hampshire does not impose a capital gains tax. And because New Hampshire taxes interest and dividends on New Hampshire beneficiaries only, no New Hampshire tax will be due. Massachusetts income tax should be incurred only when distributions are made to the beneficiaries, allowing trust assets to accumulate state income tax-free.

Thus, a wide variety of estate and income tax savings strategies, only a sampling of which are described above, are available to business owners. Thoughtful exit planning should start well before any deal is reached so that interested taxpayers can take advantage of savings opportunities that will be closed off once the purchase and sale agreement has been signed.