Structures to Consider Before You Sell Your Business
Planning an optimal business sale requires careful consideration and understanding of various sale options and structures, as well as a thorough understanding of the transaction’s effect on the business owner’s personal financial planning. Many owners leave money on the table during a sale while they stay focused on growing their business or on finding the right buyer. Effective exit planning involves many moving pieces and may be a multi-year process which is why it is crucial for business owners to prioritize their personal goals alongside the business’s exit planning readiness. By familiarizing themselves with the range of financial planning and tax strategies, entrepreneurs and business owners can significantly enhance their chance of success in a business sale.
Capital Gains Versus Ordinary Income
One important aspect to consider is the distinction between capital gains and ordinary income. When negotiating a sale, owners often focus solely on the headline gross number without considering the tax implications. This can be a costly mistake, as different types of sale proceeds can result in significant variations in tax liability. For instance, sale terms with long-term consulting contracts or deferred compensation may offer compensation taxed at ordinary income rates, which can be as high as 37% plus payroll taxes and state taxes. Bracket tax rates could be even higher in 2026 if the 2017 Tax Cuts and Jobs Act isn’t renewed. On the other hand, capital gains rates can range from 0% to 23.8% at the federal level. The difference between ordinary income tax rates and capital gain tax rates can be profound, so any offer should be evaluated on an after-tax basis. Moreover, timing differences in long-term versus upfront compensation should also be adjusted to the present value when negotiating.
In certain situations, deferred compensation agreements can be very efficient tax-wise. If the payments are received over time during retirement, the recipient can benefit from having those amounts being taxed in potentially lower tax brackets. Also, since many deferred compensation agreements are immediately vested, the FICA taxes could be due upfront based on the present value of the future deferred compensation payments. While that may sound disadvantageous, the business owner is likely already hitting the maximum taxable income for Social Security ($168,600 in 2024) so they could avoid future Social Security taxes of 12.4% by being liable for them upfront. Of note, is that sometimes the buyer of the business won’t prefer deferred compensation arrangements given that it creates a liability on their balance sheet, which could be unfavorable with lenders.
Stock Sales Versus Assets Sales
There are a significant number of implications and motivations when it comes to structuring a business sale as an asset sale versus a stock sale. While the business entity type and individual circumstances matter greatly, purchasers usually want to structure the sale as an asset sale, while stock sale transactions tend to be more optimal for business owners and their personal financial planning.
Buyers prefer an asset sale because it allows them to deduct the depreciation on their newly purchased assets and consequently reduce their tax liability going forward. Furthermore, opting for an asset sale instead of acquiring the entire entity could potentially enable the buyer to avoid unforeseen liabilities.
On the flip side, an asset sale could result in double taxation to the selling business owner. The assets sold would be taxed to the corporation, and then the proceeds would potentially be taxed again when the entity dividends out the proceeds to the business owner or the entity is liquidated. Moreover, there could be substantial depreciation recapture liabilities arising from the sale of the asset.
Stock sales, on the other hand, allow the business owner to get favorable long-term capital gains rates and avoid double taxation. Buyers generally do not like stock purchases since the assets within the company carry over their basis after the transaction is completed. If the purchaser sells those assets in the future, they could end up with a substantial capital gain. Additionally, a stock sale exposes the buyer to the debt and potential liabilities of the business being sold.
Section 1202 Qualified Small Business Stock
Another potentially material consideration in the asset sale versus stock sale discussion involves the use of Section 1202 qualified small business stock (QSBS). QSBS is one of the most compelling financial planning techniques available to business owners. After meeting a five-year holding period, Section 1202 allows owners of qualifying C corporation stock to exclude capital gains taxes on gains of the higher of 10 times the stockholder’s basis or $10 million ($5 million for married filing separately). Some states like New York also allow the QSBS exclusion, while others like California do not. QSBS also potentially makes stock sales relative to assets sales for owners even more attractive, since an asset sale essentially wastes the QSBS benefit.
There are a host of potential planning opportunities for business owners to maximize the benefits of QSBS. For business owners with pass-through entities that are expected to be sold for large capital gains, long-term planning around converting to a C corp may make sense. For a lot of business owners, starting as a pass-through entity could be beneficial since this initial structure can allow more start-up expenses to be deducted and losses can be passed through to the owner. Since 80% of a corporation’s assets have to be used in a qualified business to be QSBS eligible, entrepreneurs raising capital for a new venture but taking several years to deploy it into business operations should also consider starting the company as a pass-through entity. Given that a conversion of a pass-through’s assets can convert at fair market value and that consequently results in higher basis, this could result of an even higher exemption given the 10X basis rule.
Another issue to be mindful for business owners is holding no more than 10% of the C corp’s assets in real estate, which could dismantle QSBS eligibility. We’re not big fans of C corporations holding real estate generally, given that step in basis is more easily achieved in pass-through entities if the business owner were to pass away or sell the business.
One significant aspect of qualified small business stock is that gifted stock retains the grantor's holding period, and most interpretations of the regulations suggest that each recipient of QSBS can benefit from a separate $10 million capital gains exemption. A business owner who anticipates significant future capital gains and has several children may consider establishing separate trusts for each child. This will enable them to utilize their lifetime gift exemption to transfer shares to each trust, thereby potentially multiplying the number of $10 million capital gain exemptions. Although entrepreneurs and their advisors should be mindful that the IRS could aggregate trusts if they are substantially similar through Section 643(f).
QSBS Rollovers
QSBS business owners can also benefit from Section 1045 rollovers. Following the sale of the business, Section 1045 allows a business owner to use some or all of the sales proceeds to purchase QSBS of another eligible company. Utilizing a Section 1045 rollover would enable the holder of the QSBS to extend their holding period to meet the five year minimum requirement to be eligible for the $10 million exemption. In other cases, this could be helpful in getting a deferral on amounts above $10 million by investing in a new venture. While this strategy can be beneficial, Section 1045 rollovers must be completed within 60 days of the sale. This can make it a challenge to navigate the proper planning involved in selling the first company and establishing a position with the new company in time.
Installment Sales
Business owners who do not need all of the sale proceeds upfront may want to consider utilizing an installment sale as a potential option to reduce their sale tax liability. Since capital gains rates range from 0% to 20%, depending on taxable income, using an installment sale could keep the selling business owner in a lower capital gains tax bracket. Moreover, net investment income tax (NIIT), an additional tax of 3.8%, is assessed on adjusted gross income of $200K for single tax filers and $250K for married filing joint filers. Considering the 0% capital gains bracket at $94,050 and the standard deduction of $29,200 (married filing jointly), a business owner who sells their business in 2024 and realizes a $2 million gain through a 20-year installment sale could potentially end up paying 0% in capital gains. Installment sales may also be attractive to buyers since some buyers may have limited access to favorable financing options.
While installment sales offer advantages, they also come with potential pitfalls as they expose the sale to the credit risk of the buyer. Additionally, if the seller passes away before the final payment, the fair value of any outstanding installment payments will count towards the estate’s value for purposes of the Federal estate tax calculation. This could result in a significant issue for the estate if sufficient liquid assets are not available. Another pitfall for an installment sale that includes sizable real estate assets is that taxes on depreciation recapture are due upfront, while installment payments are received by the owner over time. This asset-liability mismatch could result in a liquidity issue for the seller.
One potentially aggressive strategy that some advisors recommend are deferred sales trusts (“DST”), which have features of installment sales. In this structure, a third party trust buys the business from the buyer, invests the proceeds, then makes installment payments to the seller over time. While the goal of this structure is to get the potential tax benefits of an installment stale and avoid credit risk from the buyer, the DST itself becomes a credit risk to the seller. The installment payments could be at risk if the trust’s investment performance is poor. If investment performance is good, it is retained by the trust. Potentially this may incentivize the DST trustee/provider to take on unnecessary risk in the investment portfolio.
Employee Stock Ownership Plans (ESOP)
ESOPs can provide business owners an opportunity to gradually obtain liquidity for their shares over time, offering an alternative to relying solely on the valuation of a future sale as part of their personal exit plan. An ESOP can allow an owner to get some liquidity and still receive potential upside on their remaining shares in the future. Since shares sold to the ESOP are managed by a trust, the owner can potentially continue to exert control over the shares sold to the ESOP through the governance structure. Meanwhile, participants can take distributions upon death, disability, retirement, etc. Given that an ESOP provides broad company ownership, incentives are aligned to increase the profitability and value of the shares over time. Companies that are good candidates for ESOPs usually have strong cash flow, a solid succession management team in place, and believe the company’s value can be increased through employee ownership and productivity.
Depending on the structure of the plan and the type of business, several tax-saving strategies are potentially available by utilizing an ESOP:
S corporations can attain tax-exempt status.
Owners of C corporations enjoy preferential capital gains rates.
Pre-tax funds can be utilized to acquire owners' shares.
Both the principal and interest used for purchasing the owner's shares are tax-deductible.
Despite the advantages, ESOPs may not be suitable for every business owner due to potential drawbacks. Given that a trust manages the share purchase, the owner can only obtain fair value for their shares upon sale. However, a sale to an ESOP creates a market for the initial sale of company shares, establishing a put option that serves as a minimum price for an external buyer. Additionally, the company will need to have sufficient debt capacity in order for the trust to finance the purchase of the shares.
Charitable Strategies
Entrepreneurs that are planning to sell their business with significant interest in charitable giving should consider various charitable strategies. These strategies can not only amplify their philanthropic impact but also potentially reduce their liability for capital gains taxes, income taxes, state taxes, and/or estate taxes. For example, a selling business owner can leverage charitable remainder trusts (CRT) as a strategy by donating shares to a CRT ahead of the transaction. This approach offers:
An upfront tax deduction that can help offset the significant tax liability resulting from the business sale.
An income stream through an annuity after the sale in exchange for the funds going to charity at the end of the annuity term. The remainder given to charity must be at least 10% of the initial deposit to the trust.
Deferred capital gains taxes can be reduced as the capital gain tax on the sale is only assessed when the owner receives annuity payments, leading to potential savings. Potentially, a business can receive the annuity capital gains at rates of 0% or 15% over time instead of the 23.8% upfront capital gains rate without this type of structure.
If the owner is in good health and the owner receives annuity payments for a period longer than the expected IRS mortality tables predict, the value of the amount received through the annuity could more than offset any remaining amount given to charity.
A simpler charitable strategy would be to eliminate capital gains and receive an upfront charitable deduction on shares that are donated to a donor advised fund (DAF). Some DAF providers, like Fidelity Charitable and Schwab Charitable, can receive shares of privately-held companies and the donor can “advise” the DAF to distribute the funds to the charity of their choice at any time in the future. Until the funds are distributed, the funds can be invested and consequently potentially increase the magnitude of giving impact.
By considering these comprehensive strategies and working closely with a team of attorneys, CPAs, bankers, and financial planners, business owners can align their personal and financial goals while enhancing their preparedness for a successful business sale.
David Flores Wilson, CFP®, CFA, CEPA is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.