Maximizing Your Profits: Tax Mitigation Strategies for Business Owners

Taxes…an honor, a privilege, and a thorn in our side.

“What???,” You say. Taxes, honor, privilege in the same sentence?

To be a business owner contributing to our community is an honor.

And as I was just explaining to one of my young daughters recently, here in the United States it is relatively easy and low cost to set up a business. Access to capital is abundant and the corporate tax rate is low in comparison to other countries. 

We are privileged to live in a country where entrepreneurship and innovation is highly valued.

With this honor and privilege we have a duty to pay taxes!

Entrepreneurs choose to pour their time, capital, expertise, and sweat equity into building an enterprise. It is risky and the more successful they are, the greater the duty to give a large chunk to the U.S. Treasury every year.

When a business owner exits their business, that liquidity event will most likely be the biggest whopping tax bill they will ever see!

So while it’s our duty and privilege, I’d be hard pressed to find a business owner who volunteers to overpay and there are ways to mitigate the tax impact so not to be raked over the coals.

For example, we have a client whose $32MM deal is scheduled to close on 7/31. The transaction includes a roll-over of equity and the deal is structured as an “F” reorganization for tax purposes. 

An “F” reorg is a deal structure in which an S-corporation is legally converted to an LLC  before selling the business so that the buyer receives a step-up in basis on the assets which increases depreciation and amortization to offset future taxable income. The benefit to the seller is they are able to defer the taxes on the equity roll.

An “F” reorganization is unlike a 338 (h) (10) election that I have previously blogged about which also gives a buyer a step-up in basis but does not give the seller a tax deferral on the equity roll. In this case we negotiate a “gross-up” from the buyer in the purchase price to compensate our client for the increased tax burden.

I know tax planning may sound complicated and confusing but it doesn’t have to be if proper tax planning is done well in advance of a transaction and with people who have the proper expertise.

There are many ways to minimize the tax impact when selling your business.

Tax Mitigation Strategies

Tax mitigation is always a focus as we prepare our clients to sell their business and requires planning well in advance of the transaction. There are a variety of tax minimization strategies and they are categorized into three groups.

1.Estate Freezing and Transfer Techniques – These strategies freeze the value of the business at its current valuation and transfer the asset to the children. When the business sells in the future, after it has appreciated, the gift or inheritance tax is mitigated on the liquidity created from the appreciation.

The most common strategies used include:

Annual Gifting – Transfer up to $16,000 of stock to an individual

Installment Sale to an Intentionally Defective Grantor Trust All or part of the business is sold to an irrevocable trust to benefit the children in exchange for a note. When the business is sold the note is paid off to the seller and the growth in value of the business from the transfer date remains in the trust to benefit the children free of gift and estate tax.

Grantor Retained Annuity Trust (GRAT) – Shares of a business are transferred to a trust in return for an annuity typically equal to the value of the shares. Subsequent appreciation upon sale passes to the beneficiaries free of gift and estate taxes.

Charitable Lead Annuity Trust (CLAT) – Shares of a business are transferred to a trust that pays an annuity to a charitable organization. At the end of the annuity term the remaining value passes to the non-charitable beneficiaries (the children in most cases) and the appreciation of the remaining interest for the family benefit is again free of gift and estate taxes.

2. Rollovers, Exclusions, Tax Deferrals Unlike the previous strategy, which requires the business owner to enter into a transaction and create a special legal entity, the following are just tax code.

 S 1042“Tax Free” rollover from the sale of a business to an ESOP. This strategy defers federal and sometimes state tax on the transaction by rolling proceeds into a qualified replacement property (QRP) – stocks or bonds of a domestic company. The differed taxes are then extinguished at death when the children receive a step-up in basis.

S 1202Capital gains exclusion allows a small business owner to exclude up to 100% of gain capped at $10MM or 10X the basis that is held for 5-years or longer in a qualified small business stock (QSBS), which is a domestic C-Corp with gross asset basis that do not exceed $50MM.

S 1045Rollover of a taxable gain of a QSBS into another QSBS within 60 days, therefore deferring the recognition of gain until the new entity is sold. 

3. Income Tax Mitigation

Qualified Opportunity Zone Investment – Capital gain reinvestment in a QOZ fund within 180 days of the sale of your business will defer your capital gains tax until 12/31/26 if your interest in the fund is disposed of before this date. If the funds in the QOZ remain for 10 years the appreciation on the invested proceeds is excluded from federal capital gains tax.

IC-DISC – Interest Charge Domestic International Sales Corp – An entity is created in order to enable exporters to convert ordinary income from sales to foreign unrelated parties into qualified dividend income so the income is taxed at capital gains rate as opposed to ordinary income tax rates.

INGT – Incomplete Gift Non-Grantor Trust – A trust structure that allows a business owner to shift tax exposure from high tax states i.e.– NY or CA to low tax states – FL or TX. This is designed to be an incomplete gift for gift tax purposes and as a separate taxpayer resident in a state with favorable trust income tax laws for state income tax purposes.

It takes time to develop and implement an effective tax minimizing strategy so be sure to engage in creating your Master Exit Plan well in advance of your anticipated departure from the business.

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