Planning with the End in Mind: Tax & Financial Considerations Before You Sell Your Business
Building a successful business doesn’t happen overnight and neither should preparing for an intentional exit. Many business owners start out with the goal of an eventual sale, but daily management and operations crowd out strategic planning until deal day dawns. It is usually at this time that our firm receives a call from the business owner, requesting a valuation and tax advice. While consulting a professional is certainly highly recommended, we would shout from the rooftops that owners should consult the relevant advisors earlier in the process to increase value.
Even if the sale of the company is not currently in your strategic plan, keep in mind that, most likely, a significant portion of your net worth may be tied up in the business and measuring the risk and return of that investment is time well spent.
Two important factors to consider now, rather than later, are the gap between current value and desired value and tax structure of the entity.
Measure the Gap
Many owners do not consider how they are using the funds received from a transaction until the deal is complete—in other words, they negotiate blindly. Regardless of whether you plan to roll the funds into a new venture or sail off into retirement, it is critical to know what value you need out of the business before agreeing upon a sales price.
In coordination with a financial advisor, walk backwards and determine how much after-tax proceeds you need to fund retirement or the next investment goal. This desired value should then be compared to the current value of your business to determine if there is a gap. A valuation professional can measure the current value and walk you through the asset and income approaches. A good valuation specialist also is a great resource to weigh in on how to build value and close the gap. For example, if your EBIDA is higher in service line A than line B, consider funneling more marketing dollars toward A.
By evaluating your company’s entity structure now, rather than at the deal table, you have more options available to increase after-tax proceeds. The sale of a business is typically structured as either the sale of the individual assets or the stock of the company. The deal structure determines the tax consequences and whether the proceeds will be taxed at the current preferential capital gains rates or at the individual’s ordinary income tax rates.
With a Democratic regime in Congress and constant discussion of potential tax rate increases, the value of advance tax planning is growing steadily.
For example, there are significant benefits available for Qualified Small Business Stock (QSBS). Section 1202 of the Internal Revenue Code was created to encourage investment in certain small businesses by allowing investors to avoid tax on some or all of their gain from the sale of QSBS if held for at least five years. To qualify as QSBS, the company must:
- Be a domestic C corporation with aggregate gross assets that do not exceed $50 million—the entity can be converted to a C corp prior to the transaction and qualify if the holding period and aggregate asset threshold are met
- Have stock issued after August 10, 1993
- Have stock acquired by taxpayer directly from the company in exchange for money, property, or services
If eligible, each stockholder can avoid paying federal tax on gains up to the greater of $10 million or 10 times your tax basis. Please see planning opportunities for QSBS stock here.
Tax Deferral or Gain Exclusion
In addition to considerations such as entity design, asset versus stock structure, electing in or out of installment sale treatment, and optimal allocation of purchase price, there are other strategies to defer or reduce the tax cost of a transaction.
Investing the sale proceeds in an opportunity zone (OZ) business, property, or fund allows for deferral of tax payment on the gain and even partial exclusion of the gain. An OZ is an economically distressed area, defined on this map. There are multiple benefits of investing in an OZ business, piece of property, or fund, not only the deferral of capital gain recognition until the earlier of sale of the OZ investment or December 31, 2026, but also exclusion of up to 15 percent of the original deferred gain if held for more than seven years and permanent exclusion of tax on gains resulting from post-investment appreciation if held more than 10 years.
For the charitably inclined, there are a number of opportunities available ranging from gifting appreciated stock to the more sophisticated vehicles, such as a charitable remainder trust. The proceeds can be donated to a charitable remainder trust, generating a tax deduction and stream of annual revenue for the donor during their lifetime, while the remainder of the trust goes to the designated charity at death.
Depending on the amount of proceeds received, an owner also may need to consider estate and gift planning. Currently, an individual can give away during life or at death up to $11.7 million, without incurring estate or gift tax at the 40 percent rate. This level of exemption is set to expire in 2026 and various members of Congress have regularly introduced legislation to significantly cut the lifetime exemption and increase the estate tax rate prior to the sunset date. Working with a competent estate planner can help you increase the transfer of wealth from one generation to the next.
Planning with the end in mind brings to light a number of considerations that may be foreign, uncomfortable, and even surprising to an owner who may only enter into an exit strategy once in a career. BKD Private Client’s team of professional advisors holistically considers the business succession, transaction and personal tax considerations, and estate and wealth planning. We guide our clients through the process from beginning to end and provide our experience and technical knowledge to help business owners develop appropriate goals, avoid pitfalls, and land gracefully.
For more information, contact your BKD Private Client™ trusted advisor or submit the Contact Us form below.