Sale of a business for many people is the largest tax event they will ever realize over the course of their lives. In this article we’ll talk about how to minimize the impact of tax when selling a business using charitable giving structures such as Donor Advised Funds.
Before we get started, we are a financial advisor for business owners in Utah and across the country. We’ve written these blogs on business owner finance and investing topics; please check them out if you’d like before you dive in to the rest of this article!
Don’t forget the impact of tax when selling a business!
In the excitement of a business sale, it’s easy to focus on factors such as the sale price, timing of payment, cultural fit, and others. Those are the tangible qualities that are evident. Taxes are paid after the fact, so they’re not as apparent during the deal negotiation stage.
The impact of tax when selling a business can be huge, especially if you are in one of the top tax brackets. Also, the transaction may result in your being “pushed” into a higher bracket. You’ll pay tax on the difference between the cost basis of your business, or what the value of your assets were when you started or acquired it, and the market value that you sell it for. This is called capital gains tax.
Business sale capital gains tax: hypothetical example
Let’s say that you started your business in the year 2000 with a total cost basis of $10,000. Over the years, the business grew to be a mid-size company with 20 employees and $1.5 million of revenue annually. The business’s value upon sale is estimated to be $3.5MM.
That’s a huge capital gain! $3,500,000 – $10,000 = $3,490,000
This would put you in the 20% long term capital gains bracket, assuming you’ve held the business for over a year. You’d pay 20% of $3,490,000 in taxes, or about $690,000 dollars!
We repeat: do not overlook the impact of tax when selling a business!
How to minimize tax burden
Fortunately there are some strategies you can use to cut down the amount of tax you pay when selling a business. Just as a word of caution, we are not providing any recommendations specific to your situation. For suggestions that are applicable to you, please consult a tax advisor.
#1 Sell over a period of time
You can arrange to sell the business over a period of time. This may potentially allow you to reduce the amount of tax you’d have to pay in any one given year. Because you are only recognizing part of the sale in a single year, you may avoid being bumped up into a higher tax bracket.
#2 Sell to employees
You could sell the business to your employees by setting up what is called an Employee Stock Ownership Plan, or ESOP. There are tax benefits that come along with this.
#3 Recognize the value by assets not enterprise value
You have the option to recognize the value of the business based upon the value of all assets involved with the business. This includes equipment, furniture, real estate, patents, trademarks, website domains, equipment, etc.
This is a decision to consider carefully as the details matter. Most likely the tangible assets have depreciated over time. But other assets such as intellectual property may have run up considerably.
#4 Donate some of the proceeds to charity
At Rock House Financial, we believe that charitable giving is a beautiful thing and we are committed to helping our clients integrate this into their financial plans, should they do desire. Clients are often surprised to learn that they can get a tax break and donate to charity at the same time by donating some of the proceeds of their business sale.
One of the vehicles utilized in this strategy is called a Donor Advised Fund, or DAF. As there is quite a bit of detail that goes into discussions about DAFs, we’ll make that the focus of the next section.
What is a DAF and how do I use it to minimize taxes when selling a business?
Let’s talk about DAFs!
- DAFs are separate accounts that are offered by an administrator.
- The funds placed in a DAF are gifted to a nonprofit of your choice (it must be a 501c(3) organization).
- There are additional costs that come along with investing in a DAF, which vary according to which provider you choose.
- When you donate assets to a DAF, you are essentially transferring ownership to the charity. You no longer control the assets.
The benefits of using a DAF are:
- You receive a tax deduction that year for the amount donated to the DAF, just as if you had donated to charity in that year.
- You won’t be charged a capital gain or ordinary income tax on any of the appreciation in the assets you donated.
- The proceeds are strategically allocated to a charity of your choice to make your giving more meaningful and thoughtfully planned!
When you sell your business, you can donate part of all of the business interest to a DAF. However, you must itemize your taxes for that year instead of taking the standard deduction.
How to structure a business sale using a DAF
Who would be the parties involved if you were to choose to use a DAF to reduce taxes when selling a business?
- A DAF provider. They will invest the funds you place into a DAF and manage your donations. This is essentially the party that holds the DAF account. As mentioned before, there are additional fees that come with setting up such an account and they should be clearly disclosed by whatever provider you choose to work with.
- A tax advisor or CPA. When selling a business there is the possibility to incur a sizeable tax liability. It’s best to have a CPA or tax advisor overseeing the transaction, from point of sale to helping ensure the charitable donation, should you decide to make one, is handled properly.
- A financial advisor. A financial advisor’s role in helping you sell a business is multi-faceted. They may help you negotiate the deal price or the terms of the transaction, assist you with selecting a DAF provider, or even managing the assets in a DAF. A financial advisor can help you determine how giving fits in your overall financial plan.
- An estate attorney. As a DAF is a charitable vehicle that will potentially live on past your lifespan, an estate attorney can help you ensure that your will and legal documentation properly account for all charitable accounts.
What if the business isn’t yours?
All of this can be complicated if you are handling a business interest that belongs to a husband or wife who passed. The impact of taxes when selling a business that does not belong to you, however, is just as important. For more details about the role that these parties play in such a business sale, refer to our article on selling a business after the death of a spouse.
We’ll discuss this in the second case study below.
Case study: Selling a business with a large capital gain
Jeff owned an HVAC company for 40 years. Most of his retirement was dependent on selling the business so that he and his wife, Linda, could live off the proceeds. He had other retirement accounts, but the sale of the business would help them live without a tight budget and be able to travel more in their retirement. Jeff and Linda donate regularly to their church and like to give to other charities like cancer research and humanitarian fund when they are able. He received a great offer for his HVAC company – but when his CPA estimated the taxes on the sale, it was a little shocking.
The team at Rock House Financial helped Jeff and Linda donate ownership of part of his business before the sale went through to a donor-advised fund, approximately $250,000 of the business’s worth. Jeff and Linda were not taxed on the gains for the portion of the business that was donated. And they were able to claim a $250,000 charitable deduction. This strategy saved them approximately $140,000 in taxes.
They will use the DAF to pay their tithing to their church throughout their retirement. They are putting the tax savings towards their travel fund. They love having a fund dedicated to charity so they can give freely from that account. They portioned $50,000 of their donor-advised fund as the family charity account, and their grandkids pick a charity each year to donate to. This strategy helped them meet their goals to travel and be charitable while also teaching their family to give.
Case study: selling a rental property business using a DAF
Ann and Kurt had slowly accumulated several rental properties. They were generating enough cash flow that Kurt retired from his desk job at 55, while Ann kept working as a fundraiser in healthcare. Kurt ran the rental properties and was very handy, so he did most repairs and upkeep himself, which kept their profits high.
When Kurt died unexpectedly in a car accident at 62, Ann felt overwhelmed taking over the rental business; this had always been Kurt’s project. As she dealt with the grief and rebuilding her life, she was ready to simplify things.
She wanted to retire in a few years, but the cash flow from the rentals would not be enough for her living expenses. The real estate market was very high and the properties had appreciated quite a bit. Selling could help support her retirement.
The big issue with selling the properties were the taxes on the gains in the properties. Working with the Rock House team, she donated one property to a donor-advised fund and then sold it in the DAF. The tax savings from donating that property helped offset the taxes from selling the second property.
Ann could finally breathe a sigh of relief, as selling those two properties helped reduce the work involved with the rental business. She was able to reinvest the money in an investment account with the flexibility and liquidity to support her upcoming retirement. Best of all, the donor-advised fund allowed her to manage her giving to charities she was passionate about.
Concluding thoughts on taxes and selling a business
At Rock House Financial, a fee-only financial advisor in Farmington, Utah, we are charitable giving tax mitigation specialists. We work with families, business owners, and individuals who wants to make an impact through giving.Please subscribe to our newsletter for future updates.
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Foster, Sarah. (7 April, 2022). Bank Rate. 2021-2022 tax brackets and federal income tax rates. https://www.bankrate.com/taxes/tax-brackets/
Case studies presented are based on actual clients, however, the information has been changed or altered for anonymity. These studies are provided for educational purposes only. Similar, or even positive results, cannot be guaranteed. Each client has their own unique set of circumstances so products and strategies may not by suitable for all people. Please consult with a qualified professional before implementing any strategy discussed herein.
No portion of these case studies is to be interpreted as a testimonial or endorsement of the firms’ investment advisory services.
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