In preparing to sell a business, owners routinely plan to: fix up a plant or property, clean up the company’s books and records, or reduce unwanted inventory. But one area that business owners routinely neglect is tax and estate planning in preparation for a sale. All too often, a buyer has been found, but there is a significant tax liability that could have been reduced or avoided had the business owner or investment banker planned more thoroughly. With time to plan for an S election, or transferring shares out of the taxable estate, business owners can achieve much better tax results.
This article will discuss in summary form certain tax-planning steps that owners of closely held businesses should consider in preparing to sell a business.
1. Selection for pass-through taxation. A sale of C corporation assets typically causes two levels of taxation – a tax on gain at the corporate level and a second tax on distributions to shareholders. Electing S corporation status is a relatively easy but important step for business owners seeking to mitigate this. An S corporation is a “pass-through” entity, so all items of income, deduction, gain and loss pass through directly to the shareholder’s tax return and thus are only taxed once. Following an S election, any built-in gains will be subject to tax for 10 years following the election. However, a business owner can obtain an appraisal to help establish the value of the corporation on the day of the S election, and any appreciation after that date will not be subject to double tax.
2. Recapitalization to voting and non-voting shares. Many business owners seek to reduce their exposure to gift and estate taxes which currently reach 45% of the owner’s taxable estate. One of the first steps in transfer tax planning often is a recapitalization of the company shares to two classes – one with voting rights and one without. The business owner may then transfer non-voting shares to members of his or her family, trusts for their benefit, or other entities. Typically, the transfer of a non-voting, non-marketable interest is valued at a significant discount -- for example, 30% (confirmed by an appraisal). In some cases, the business owner may also wish to transfer voting shares.
3. Gifting program. Under current law, an individual may give away up to $12,000 per beneficiary per year ($24,000 for a married couple) without incurring gift tax. Thus, a business owner can give away discounted, non-voting shares in the business on an annual basis. As a further step, the business owner may choose to use his or her full gift tax exemption amount ($1 million in 2007) to make gifts of shares in the company. These steps need to be carried out carefully as there are risks that the gifted property could still be included in the owner’s taxable estate. But a gifting program can achieve significant tax savings.
4. Sale of company shares to a trust. A business owner also may consider selling shares in the business to a trust for the benefit of family members in exchange for a promissory note. This type of sale has the effect of “freezing” the value of the company in the owner’s estate (at the value of the note received), while allowing all appreciation in the company to accumulate estate-tax free in the trust.
Before taking any of the steps outlined above, a business owner should discuss them with his team of advisors. Most importantly, the business owner and his team should address these issues as early as possible.
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