Determining an exit plan for your organization will be one of the most difficult decisions you make as a business owner. You have a lot to consider, including (but not limited to) business continuity; transition plans; the wellbeing of your employees, customers, and vendors; and – of course – taxes. While the future stability of the organization will be out of your hands once the new owner steps in, you can guarantee a certain tax outcome for yourself if you have the right exit plan in place.
The tax implications of your exit plan will vary depending on the strategy you choose. Here are some common exit plans.
If You Sell Your Business
A business sale (or liquidation) can be structured in one of two ways.
As a Stock Sale
If you are a C or S corporation, you can structure your exit plan as stock sale. You will recognize a capital gain or loss on the sale of your ownership shares.
As an Asset Sale
If you decide to sell the assets of your business, you will allocate the sale price to each asset and calculate gains and losses separately. The holding period and character of the gains will be determined by how the assets are used in the business. For example, a car dealership would recognize ordinary income when selling their fleet because their vehicles are considered inventory. For the sale of the dealership’s commercial building, the prior depreciation taken would be a Section 1250 gain taxed at 25%, and the sale of the dealership’s land would be a Section 1231 gain generally taxed at capital gain rates.
If You Use Your ESOP
If your company has an employee stock ownership plan (ESOP), your exit plan will look a little bit different. In general, owners will recognize capital gains from the sale of their ownership shares just as they would in a straight stock sale. However, C corporation owners have the option of deferring their gains by reinvesting their proceeds in securities of other domestic companies. This can allow owners to defer taxes for years or even decades, and if those replacement shares are held until death, the gains will be permanently excluded.
Owners of ESOP companies – both C and S corporations – will have the option to sell their shares back to the company over several years, enabling them to gradually exit the business. This will not eliminate capital gains taxes, but it will spread out the gain recognition.
If You Transfer Ownership to Family Members
Owners of closely held businesses often want to transfer ownership to the next generation. There are a few ways you can do this.
If you transfer ownership shares or business interest to family members while you’re still alive, you will need to file a gift tax return. When you file your gift tax return, you have the choice of paying gift tax now or reducing your lifetime gift/estate tax exemption, which is currently $11.58 million. Unless the value of your business is more than the lifetime gift/estate tax, you will not owe gift taxes. Reducing your gift tax exemption will also reduce the available estate tax exemption you can apply to the assets you bequeath at death.
Transfer at Death
Some business owners draft their will so business interests are transferred to their heirs when they die. If your business and other assets in your estate exceed the gift/estate tax exemption, your estate will owe taxes on that transfer. In 2020, the estate tax exemption is $11.58 million, but this amount has changed drastically over the years, and there is no guarantee it will stay at such a high number.
Transfer Over Time
To reduce your reliance on the gift and estate tax exemption, you can transfer your business interests into a trust during your lifetime. For example, if your business is an S corporation, you can transfer your shares into a Grantor Retained Annuity Trust (GRAT). With a GRAT, you can control the assets until your death, receive annuity income from those shares during your lifetime, and transfer the remaining interest to your heirs. The GRAT will be excluded from your estate and only future incomes will be taxable to your heirs. There are many other trusts that can hold your business interest, so talk to your business advisor to select the one that’s right for your business and for your long-term goals.
Creating an Exit Plan
Be familiar with the tax consequences of your exit plan. If you have questions about your current plan or want to create a more thorough strategy, please reach out to us. Our CPAs would love to help you develop a plan that is right for you. Contact us today to learn more.