Exit Planning Tax Strategies: Maximizing Your Business Sale
The sale of a business marks a significant life transition. Make the most of this liquidity event with proper planning and perspective—setting yourself up for success in your next chapter. Exit planning tax strategies are key.
Start the planning process early
Bringing in professionals from different disciplines (e.g., tax, legal, investment, estate planning, etc.) allows you to develop a holistic plan — ideally before a sale is even on the horizon. The goal is to create a vision for life after the sale, think through how you’ll replace the business income stream, and fulfill other long-term goals. Perhaps start with a one-stop shop for all your financial needs.
Establish residency in a lower-tax state
Establishing residency in a lower-tax state like Texas or Nevada before the sale can generate huge savings for those willing to relocate. Just be aware that when a state looks at your residency, they’re not just looking at how long you were there. They’ll also look to voter registration, driver’s license, and legal mailing address—there’s more to establishing residency than spending half a year in a state.
Don’t relocate just for lower taxes if it will disrupt family life. If you’re going to move, consider doing so 18 months in advance of a transaction. Ideally, look to have a couple of tax years that show that state’s Department of Revenue that you’re a committed resident of that state with all the evidence to support it.
Qualified small business stock (QSBS)
To qualify for QSBS, which provides favorable tax benefits, you must be a C Corp—you can’t be an S Corp, a partnership, or a sole proprietorship. When the stock is issued or capitalized, you need to have a capitalization value—essentially gross asset value—of $50 million or less. If you meet that threshold and other requirements, upon a future sale, you would be exempt from up to 100% of the tax on the gain up to $10 million. The 100% number is predicated on the stock issued after September 27, 2010 (Before that year, the exempt percentage is less).
It’s worth noting that a lot of states don’t respect QSBS. If you were to have a transaction in California and realize $10 million of gain, the amount would be exempt for federal purposes. However, California state taxes would still apply.
How Can You Benefit From Investing in Qualified Small Business Stock?
Charitable planning with donor-advised funds (DAF)
A DAF is really just a 501c3 charity that an individual can direct toward charitable purposes. It can be a valuable planning tool for a business owner with a pending sale. For example, by moving half a million dollars of company stock into a DAF, you may receive up to a $500,000 charitable deduction on your tax return, ideally in the year the sale occurred. The key point is to make the move pre-transaction but after the price has been established through a legally binding contract. If you wait until after the transaction, you will miss out on the key benefits of this strategy. If all is executed properly, you end up with a half-million-dollar charitable deduction, the transaction occurs, and shares in the donor-advised fund are converted to cash. And now you have $500,000 you can direct to worthy causes over whatever time period you deem appropriate.
Delay capital gains taxes with Qualified Opportunity Zones (QOZ)
A founder may realize a million-dollar gain on the sale of their business and not want to recognize all the gain in one year. One option is to take a portion, say $250,000, and reinvest it back into a QOZ. (Bear in mind – if you take the $250,000 and roll it into a QOZ, you must do so within 180 days of realizing the gain). The IRS has defined hundreds of areas throughout the country that would benefit from additional capital investment because of being previously underserved or underprivileged. If you invest in a QOZ fund, current tax policy incentivizes you from a tax perspective to invest capital in these specific areas.
The major benefit from a QOZ is the long-term capital gain exemption on the gain from the QOZ fund investment. For example, if you invest $250,000 in a QOZ, hold it for ten years (the requirement is a 10-year hold), and the value doubles to $500,000, upon sale, 100% of the $250,000 gain is exempt from tax.
These investments tend to be real estate-oriented. Examples include student housing, multi-family housing, or commercial property. Diversifying from what was once a concentrated business asset into a more diversified asset can help with cash flow and create the opportunity for long-term capital appreciation. You’re deferring the initial capital gains tax that would have been paid upon sale and exempting future gains from tax as a result of the investment.
Don’t let the tax tail wag the dog
While saving on taxes is crucial, align strategies with your personal goals and desires. For example, only pursue charitable giving if you’re genuinely charitably inclined, not just for the deduction. Your fulfillment and specific needs should take priority over minimizing taxes at all costs. With the proper perspective, you can optimize taxes while staying true to your goals.
Build an investment portfolio to replace the business income stream
Shifting to a liquid investment portfolio from a steady business income can be psychologically jolting. Market volatility and other elements out of your control replace what felt like a more controllable income stream from your business. To ease the transition, limit how often you check balances, maintain a long-term perspective, find non-market purpose through volunteering or passion projects, allocate plenty of fixed income to protect your near-term needs, and diversify income streams. Though you’ve given up control, you’ve gained freedom. Stay focused on maximizing your freedom while letting advisors handle the volatility.
Create benefits like long-term consulting gigs that provide ongoing income.
Consider factors other than the sale price listed in the headlines when structuring your sale. Negotiate additional benefits that can provide steady income over time. For example, structure a 5-year consulting agreement to advise the new owners for a set fee; negotiate to keep company-paid health insurance for a period post-sale; and maintain retirement plan contributions through a service contract.
Get creative with the deal terms to supplement the lump payment with an income stream. This can provide peace of mind by replicating the steady cash flow you relied on pre-sale.
Take time to celebrate
Selling a business marks a massive achievement that caps years or decades of hard work. Take time to acknowledge your achievement and celebrate! Work through some items from your bucket list, travel, or take a step back to appreciate reaching this milestone through your dedication and perseverance. You’ve earned it!
Partner with a financial advisor
Collaborating with seasoned advisors like Brighton Jones on exit planning tax strategies can provide a holistic approach, ensuring a smoother transition to managing investments and alternate income streams. Remember, it’s essential to prioritize personal fulfillment over tax optimization and to negotiate benefits beyond the sale price to sustain a steady cash flow. Don’t forget to relish the fruits of your labor and reward yourself for the dedication and perseverance that led to this significant milestone.
