Minimize Tax Implications with Estate and Tax Planning

Published on: Feb 25, 2022 by Daniel Glomski, CPA, ABV, CVA, MST

Updated on: November 13, 2024

Exit Planning is Not a Short-Term Strategy

It is a long-term view of the future of your business and how you will transition to retirement or another professional endeavor. Exit planning involves time and understanding what your goals and objectives are.

From a business owner’s perspective, it’s critical to plan early because the closer in time you are to your exit date, the number of strategies and techniques, and their impact, becomes less and less.

Every business owner’s situation is different, but what’s not different for everyone is the need for a long timeframe that provides adequate planning and thus an equitable payout.

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It's Not All About Taxes

As you proceed through your exit strategy and start planning for retirement from your business, tax consequences are not the only important aspects to consider.

Financial Security:

What are your lifestyle expectations?
Does the monetization of your business valuation fully support your desired retirement goals (or do you need to build more value or scale back retirement goals)?
Investment structuring and planning should be done before any exit – this will smooth the transition from accumulating wealth to protecting it.

Personal Goals:

Decisions such as where you choose to live can have significant financial impacts (i.e., cost of living and the tax structures).
Most owners’ personal goals change in retirement and these personal goal activities need to be assessed from a financial perspective (i.e., travel, philanthropy, new business opportunities, etc.).

New Lifestyle:

What will fill your time? Hobbies, activities, and relationships can have financial considerations.
How is your health?

There are a variety of things that need to come into this planning process that are not tax-related, but it all works into the process.

EXIT PLANNING: THE OFFICIAL GUIDE

The Desire to Have a Tax-Efficient Transfer

The tax expense is only one component when calculating the net proceeds from the sale of a business. Other components are debt, working capital, and transaction expenses. So how you structure the transaction can have an impact on how much you pocket from the sale of your most valuable asset.

Structure of the Deal (asset or stock):

Sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation (and because some tax of an asset sale is at ordinary rates due to recapture rules).
Buyers generally want an asset sale to maximize future depreciation write-offs via the ability to write-up tax basis in assets.
The seller should consider seeking a gross-up payment from the buyer for additional tax costs.

Structure of the Business (C or S (pass-through)):

C (asset): Gain subject to entity-level corporate income tax and shareholder-level (dividend/capital gain).
C (stock): May qualify for 1202 gain exclusion and/or long-term capital gain exclusion (requirements).
S (asset): Gain passes through to seller subject to one layer of tax.
S (stock): 338(h)(10) election available to treat as a deemed asset sale.

Structure of the Purchase Price Allocation:

In an asset sale or deemed asset sale, the purchase price allocation can have big tax consequences for both parties.
Both parties submit matching allocations of purchase price across different classes of assets. This affects how the seller determines gain/loss and depreciable basis in assets for the buyer (any write-up for buyer results in some depreciation recapture to seller).

Installment Sale - A sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business’s performance. An installment sale also may make sense if the seller wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT (Net Investment Income Tax) or the 20% long-term capital gains rate.

But beware of potential unintended consequences of an installment plan such as an increase in tax rates, portion of proceeds not eligible, or default.

The Role Estate Planning Plays in Your Exit Plan

A considerable number of people are under the misconception that estate planning is something you're planning for when you die. However, your estate is typically considered your financial wherewithal as it is today, including life insurance and every asset you own.

ESTATE PLANNING BASICS: WHEN, WHY, AND HOW

The fact of the matter is you might become disabled or incapacitated to a point that you can't run the business so your estate plan documents would incorporate the provisions for what would happen in the case of your disablement or in the case of your passing.

Also, understand that you need to control and plan for things and provide for what would happen with the business:

Who would run it?
How would they run it?
What would happen if it sold?
Where would the money go?
Who would get the money?
In what way, shape, or form would there be a trust involved? Would they get it outright?

These are all considerations that are part and parcel of an estate plan that should be embedded in your exit plan.

The Intersection of Exit and Estate Planning

There is an important duality of this planning but exit and estate planning are interrelated. Both have separate issues they address, but common themes to both are determining your goals and objectives, understanding business value, selecting the successor(s), and protecting the business.

estate-planning-and-exit-planning-go-hand-in-hand

ESTATE PLANNING & EXIT PLANNING GO HAND IN HAND

The intersection of both concepts also addresses how business interests will be transferred. Here are examples of how the two can intersect:

If business interests will be disposed of through an estate plan but there are plans to sell to a third party in a few years, might you consider voting/nonvoting interest splitting and minority transfer to family members now to take advantage of valuation discounts available with certain gift and estate planning techniques?
If a business interest is to be transferred to a child and the owner has charitable interests, might a charitable lead trust provide optimal gift tax and charitable planning?

Exiting a business provides an excellent opportunity to engage in estate planning transactions to help accomplish the business owner’s financial and personal goals.

Popular Estate Planning Technique: Intentionally Defective Grantor Trust (IDGT)

If you are considering transferring your business interests to a family member, how you structure the transaction can have a meaningful impact on the success of the transfer. Making a transfer in trust can reduce many risks and concerns that the person making the transfer may have. A popular technique to implement in this situation is an intentionally defective grantor trust (IDGT).

THE WHAT, WHY, AND HOW OF TRUSTS

An IDGT is an irrevocable trust that is structured so that any transfer into the trust is excluded from the grantor’s estate for estate tax purposes because the transfer is treated as a completed gift. Therefore, the business owner is able to pass ownership to the family while, at the time of the transfer, “freezing” the value of the ownership interest that was transferred and passing it outside of his or her estate for estate tax purposes.

The IDGT then holds the ownership interest in the business in trust, according to the terms of the trust instrument, for the benefit of the designated beneficiaries. Generally, the grantor makes an initial transfer of an up-front “seed” gift. Then the IDGT and the grantor enter into an agreement through which the grantor sells all or a portion of the ownership of the business to the IDGT, with the remainder of the payments evidenced by a promissory note given to the grantor.

THE DEFINITIVE GUIDE TO BUSINESS TAX CREDITS AND DEDUCTIONS

Next Steps

An estate plan is not an exit plan, but an exit plan is not complete without an estate plan. Even if you take 5% of your time and spend it on the business, instead of 100% in the business, you will be better off for it. You will monetarily reap the rewards on the transaction and in your estate plan if you do that as part of your business planning.

An advisory team can help you with this process. You’ll need a team of advisors to guide you on strategies, tactics, and all the documentation you’ll need for a successful transition. SVA strives to help business owners identify and prioritize their objectives with respect to their business, their employees, and their family. If you are ready to talk about your goals for the future and get insights into how you might achieve those goals, we’d be happy to sit down and talk with you. Contact us today.

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Biz Tip Topic Expert: Daniel Glomski, CPA, ABV, CVA, MST

Dan is a Principal with SVA Certified Public Accountants. He helps clients understand financial information to improve their company’s profitability and protect their interests. He does this by taking the time to understand the client, external influences and personal objectives of the owners. He works closely and proactively with the clients, emphasizing customer service and being available for his clients. This approach results in supporting clients with timely information and strategies to move them and their businesses forward to help them reach continued success.

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