Article Written by Ryan Cave with Sunbelt Business Broker of South Florida
Business brokers help clients find a current market for the business, or help them find ways to enhance their position.
Business brokers bring clients pre-approved and pre-qualified buyers.
Business brokers also sometimes fall short, though, allowing their clients — and potential buyers for their client — search for tax help on their own. And sometimes, clients may choose not to sell their business after learning how much they’d net after all fees, commissions and taxes are paid.
As trusted advisors, business brokers can help their clients by partnering with specialists that can help them defer, reduce or even eliminate some taxes when they sell. By partnering with someone who would offer a no-cost consultation, brokers can add a value to the service they provide their clients.
Here are some potential tax strategies clients can take advantage of when they sell their business.
1400z Opportunity Zones
Created as part of the Tax Cuts and Jobs Act of 2017, 1400z Opportunity Zones allow people to defer, reduce and eliminate capital gains taxes. This federal program allows people to separate basis and gain capital.
For example, from a $2 million business sale, the seller can separate the $1 million they invested into the business and the $1 million in profits for tax purposes. Then, they only have to reinvest the gain capital to take advantage of tax benefits, which creates liquidity in the process.
If a seller holds the investment he made with the gain capital for five years, they’ll get their deferred zero basis capital gain stepped up to 10%.
To understand the potential tax benefits more clearly, it’s best to look at an example. Let’s first assume the following factors:
- Capital gains from a business sale of $1 million
- Long-term capital gains tax rate of 23.8%
- State tax of 4%
- Traditional portfolio with a simple annual return of 9%
- A Qualified Opportunity Zone (QOZ) simple annual return of 9%
In a traditional taxable investment, the seller would have to pay the full amount of taxes ($278,000) at the time of sale, leaving them with $722,000 for capital investment. With the QOZ, the seller would have the full $1 million available.
Projecting out the investments to 2027 — when taxes would be due for a QOZ executed in 2020 — the traditional taxable investment would be worth $1,438,630. The QOZ investment, meanwhile would be worth $1,992,563.
Taxes would have to be paid on the QOZ at this point, but they would be reduced by 15%. This means the total tax bill would be only $236,300 compared to the $278,000 for the traditional investment. What’s more, the investment itself would create the liquidity to pay that tax.
Projecting this example out to 2030 — the maximum holding period for a QOZ of 10 years — the traditional investment would be worth $1,863,068. After paying taxes that totaled $317,217 at the time of sale, the net would be $1,545,851. And, in the end, the total tax paid on this traditional investment would be $595,217 — based on the tax paid at the time the business was sold and the tax paid now when the investment is sold.
By comparison, the QOZ investment would be worth $2,580,426 when it was sold in 2030 — and no new taxes would be due. In all, the difference in two investment strategies would be a whopping $1.03 million.
Delaware Statutory Trust (DST)
Formed in Delaware law in 2004, the DST can be used as an exchange in a 1031 replacement. This can be extremely profitable for people who are selling physical real estate and don’t want to go into another active real estate investment.
They can instead opt for a passive real estate investment that meets the 1031 exchange requirements, deferring capital gains tax in the process.
The DST is a great way to acquire a potentially high-quality property by pooling your money with other investors. It’s also great for estate planning, as your heirs can sell this real estate investment and pay no taxes under today’s tax laws. Further, this passive investment means you can reap all the financial benefits of owning real estate without having to worry about the nitty-gritty of property management.
This tax strategy under Section 453 involves the disposition of a property or business interest where at least one payment is received by the seller after the tax year in which the disposition occurs.
In this case, a seller would decide they wouldn’t need access to all the proceeds from the sale of their business, so they’d stretch out those payments for tax purposes. As these proceeds are distributed to the seller, they’re taxed before being disbursed.
The key to this tax strategy is a plan must be put in place before the business closing. That’s because contract language must be set at properly at the time of sale.
Essentially, the seller will sell the asset to an intermediary at fair market value. The dealer then sells that asset to the buyer at that same value. The seller will obtain a loan from a third-party lender equal to 95% of the net sales proceeds.
The seller and dealer make loan payments on their respective notes. The dealer’s installment payments fund the seller’s payment on a limited recourse loan, meaning the dollars become washed.
While the seller defers the tax on the sale, inflation during the contract terms acts in the seller’s favor, allowing them to pay the future tax bill in depreciated dollars.
The Broker Can Add Value for Their Clients
Business brokers today can add value to their clients by doing more than determining valuation and bringing qualified buyers. They can partner with specialists who can help their clients prepare for life after the sale by putting them in the best tax situation possible.