Minimize the IRS tax bite when selling a business

The amount paid to the IRS when a business is sold is predicated upon the structure of the sale, which in turn is based on the proposed buyer. To minimize the IRS' participation in the sale through the taxes generated, the business owner should frequently receive the least amount of money possible.

This seems counter-intuitive if the owner is relying on the business to provide cash (and lots of it) for retirement, but in certain settings, this is the most prudent way to maximize gain. Depending upon the parties involved and the timing of the sale, there are several different types of taxes that may come into play. They include:

• Income
• Capital gain
• Gift and estate taxes

All of these types of taxes must be considered before the sale is structured.

A lower value for the business will maximize the net money received for the business when the primary objective is to transfer the business to a child, a key employee, or a co-owner. Seeking the highest possible value for an ownership interest generally makes sense only when selling to a third party.

Typically, key employees, children and co-owners do not have any cash to pay for an ownership interest. The purchase price must be paid from company earnings. 

Consequently, the business earns the money resulting in income tax to the business or new owner (tax No. 1). The remainder after payment of tax No. 1 is paid to the selling business owner, who must now pay taxes on the gain realized on the sale (tax No. 2). 

The higher the purchase price, the greater the double tax bite. The greater the tax bite, the greater the difficulty of accomplishing a successful transfer that allows the business owner to get to retirement in style.

Get a valuation

Lowering the purchase price starts with a valuation that uses the "lowest defensible value" for the ownership interest. The IRS will not let the seller choose an arbitrarily low value, and doing so could lead to unintended gift taxes being owed by the business owner. Obtaining a professional valuation from a certified appraiser is the starting point to define value.

Once value has been determined, the next step is to structure the sale so that the company earnings that are used for the purchase are taxed only once. For example, if the owner wants to receive a $1 million purchase price, an outsider could pay the purchase price. The owner pays capital gain tax of approximately 20 percent (state and federal) and nets $800,000. 

For an insider using company earnings, the company must first produce $1.5 million of revenue taxed as ordinary income (assume 33 percent). This leaves $1 million to be paid to the owner who then pays capital gain tax. It took $1.5 million of company earnings for the owner to net $800,000, a 47 percent tax.

There are various planning tools that will achieve single taxation that is deductible to the business. Examples include:

• Deferred compensation. 
• An employee stock ownership plan (ESOP). 
• A grantor retained annuity trust (GRAT), or an intentional grantor trust (IGT).

Determining the best solution for each owner is a joint endeavor by the advisory team consisting of the attorney, CPA and financial adviser.

Remember, to pocket more you sometimes must get less.

Wayne W. Wilson is the principal attorney of Wilson Law Group, LLC, an estate, business and eldercare planning law firm with offices in Madison and Evansville, Wisconsin.