Succession planning is an important process for any business to undertake, but it is especially important for closely held businesses. Inevitably, closely held business owners seek to pursue other ventures, retire, or become physically unable to continue in their current roles. Advance strategic planning is necessary to identify future leadership and have a process in place to ensure that the transition is smooth and mitigates the risks of disruption brought about by change. If part of the plan includes selling the business, advance planning is also critical to address an individual’s tax and estate planning objectives. This article discusses several income and estate tax planning tools which may be used when the sale of a closely held business or the owner’s stock in the business is part of a succession plan. These tools and their application to a particular person or business are nuanced and require a careful review of the specific facts and objectives of each situation. Professional legal and accounting advice should be sought prior to selecting and implementing these tools.
INCOME AND CAPITAL GAINS TAX PLANNING
There are several tools which may be used to mitigate income and capital gains tax liability when selling a closely held business, including: (1) exclusion of gains on the sale of Qualified Small Business Stock (QSBS); (2) outright gifts to public charities; (3) Charitable Remainder Trusts; and (4) Charitable Lead Trusts. The following section briefly examines each of these tools.
Qualified Small Business Stock Gain Exclusion
Under Internal Revenue Code (IRC) §1202, closely held business owners may have the ability to exclude the taxable gain on the sale of the company’s stock. For example:
- For shares issued after September 27, 2020, a stockholder may exclude 100% of the gain, up to $10M of gain;
- For shares issued between February 17, 2009 and September 27, 2020, a stockholder may exclude 75% of up to $10M of gain ($7.5M);
- For shares issued between August 10, 1993 and February 17, 2009, a stockholder may exclude 50% of up to $10M of gain ($5M); and
- Trusts funded with Founders Stock are also eligible for the exclusion with each Non-Grantor Trust[1] owner gifted Founders Stock being able to exclude a separate (up to) $10M gain (although multiple trusts must not be identical or for the same beneficiaries).
To qualify for the exception, the stock must be acquired from a domestic C corporation (S corporations, limited liability companies, and partnerships do not qualify). In addition, the assets of the corporation at the time the shares are issued must be less than $50M and during the time that the individual holds the stock, at least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses identified in IRC §1202. Many service-oriented businesses like those providing health, legal, accounting, financial, brokerage, engineering, and architecture services do not qualify. Original issuance shares (Founders Stock) may qualify but must be purchased directly from the issuing C corporation and not on a secondary market and must be acquired in exchange for money, property, or services. Finally, the QSBS must be held by the owner for at least five (5) years.
[1] The terms “Grantor Trust” and “Non-Grantor Trust” are used throughout this article. A Grantor Trust is one in which the person who created the trust (the Grantor) maintains some level of control over the trust like the ability to revoke the trust, add beneficiaries, and make certain financial decisions for the trust. A Non-Grantor Trust is one in which the Grantor has no control over the trust or its assets. The distinction can be important when analyzing the Grantor’s tax liability.
Outright Gift to a Public Charity
Another option when seeking to minimize tax obligations from the sale of a closely held business is to make an outright gift of the owner’s stock to a public charity, such as a church, school, hospital, or private operating foundation, prior to the sale. Importantly, the public charity does not pay tax on the gain from the subsequent sale of the corporation. The donor’s charitable deduction is limited to the cost basis in the stock. The total amount of the deduction per year is limited to 50% of the donor’s adjusted gross income (AGI). When the charitable contribution exceeds 50% of the donor’s AGI, the excess contribution may be carried over and deducted in the same way as it was in the first year for each of the next five (5) tax years up to the amount of the gift. It should be noted that S corporation stock cannot be gifted to a public charity.
After the sale of the corporation, it is also possible for an individual to donate cash proceeds in the year of the sale to a qualified charity. The seller may then receive a charitable income tax deduction for the donation up to 60% of the donor’s AGI. When the charitable contribution exceeds 60% of the donor’s AGI, the excess contribution may be carried over and deducted in the same way as it was in the first year for each of the next five (5) tax years up to the amount of the gift. The deduction may help offset the donor’s taxable gain on the sale of the business.
The seller may also choose to donate cash proceeds from the sale of the business to a donor-advised fund (DAF). A DAF is a charitable investment account which is used to support charitable organizations of the donor’s choosing. Donors receive a tax deduction for a cash donation in the year of the sale up to 60% of the donor’s AGI. When the charitable contribution exceeds 60% of the donor’s AGI, the excess contribution may be carried over and deducted in the same way as it was in the first year for each of the next five (5) tax years up to the amount of the gift.
Charitable Remainder Trusts
Another tool for managing tax liability is the creation of a Charitable Remainder Trust (CRT). The business seller may donate assets, such as cash or stock, to charity by putting assets in a CRT while the seller also receives income for a set time. More specifically, a CRT is defined as a trust in which: (a) during the trust term, one or more individuals (the donor and donor’s spouse) receive(s) each year either (i) a fixed amount (annuity trust) or (ii) a fixed percentage of the fair market value of the trust property, determined annually (unitrust); and (b) one or more charitable organizations receive(s) the trust assets upon termination of the trust.
There are several advantages to using a Charitable Remainder Trust to address income tax liability. For instance, the donor may take a charitable income tax deduction of the present value of the charity’s interest when the stock is gifted to the CRT. Moreover, the CRT is exempt from income taxation, so the charity does not pay tax when the company is sold and can reinvest the proceeds of the sale. In addition, the tax gain from the sale is deferred until distributions to the donor of the annuity or unitrust payment.
To qualify for these tax advantages, no sale agreement or letter of intent may be executed for the sale of the business at the time the stock is gifted to the CRT; or, if a sale agreement or letter of intent has been executed, the CRT remains subject to one or more material contingencies at the time the stock is gifted to the CRT.
Charitable Lead Trusts
An individual may wish to transfer stock to a Charitable Lead Trust (CLT) to mitigate tax liability. A CLT is defined as a trust in which (a) during the trust term a charitable organization receives each year either (i) a fixed amount (annuity trust) or (ii) a fixed percentage of the fair market value of the trust property, determined annually (unitrust) and (b) a noncharitable beneficiary (such as the donor’s children or trusts for the donor’s children) receives the trust assets upon termination of the trust. One of the advantages of a CLT is that it may be used in the year of the sale, even if the sale agreement or letter of intent has already been executed. In addition, if structured as a Grantor Trust, the seller may take a charitable income tax deduction equal to the value of qualified income interest in the year the gift is made which can be used to offset some of the gain on the sale. The charitable deduction is limited to 30% of the donor’s AGI. When the charitable contribution exceeds 30% of the donor’s AGI, the excess contribution may be carried over and deducted in the same way as it was in the first year for each of the next five (5) tax years up to the amount of the gift. The future gift to the remainder beneficiaries (the donor’s children or trusts for their benefit) is discounted to present value and the assets of the trust are excluded from the donor’s estate for estate tax purposes.
Estate Tax Planning
There are several estate planning tools which may also be used to mitigate estate tax when the sale of a closely held business or an individual’s stock is part of a business owner’s succession plan, including: (1) gifting stock to a Spousal Lifetime Access Trust; (2) gifting stock to an Irrevocable Trust for Children; or (3) selling stock to a Grantor Trust. The following section briefly examines each of these tools.
Spousal Lifetime Access Trust
A Spousal Lifetime Access Trust (SLAT) is an irrevocable trust for the benefit of the donor’s spouse. A donor may transfer assets, such as stock in a closely held business, out of the donor’s taxable estate at a lower value before a sale or public offering is completed. The donor’s spouse is the beneficiary of the trust, so the spouse has access to the trust funds if needed, effectively allowing the donor to have indirect access to the funds. Moreover, the stock’s appreciation after the date of the gift is not included in the taxable estate. SLATs are usually Grantor Trusts, so they would not qualify for QSBS; but, they can be structured as Non-Grantor Trusts. For stock to be valued at a lower value for purposes of a SLAT, the stock must be transferred to the SLAT before the sale agreement or letter of intent is executed. If a sale agreement or letter of intent has already been executed, the SLAT will be subject to one or more material contingencies at the time the stock is gifted to the trust.
Irrevocable Trust for Children
An Irrevocable Trust for Children (ITC) can be a useful tool where the individual has a larger estate, does not need access to funds, or is unmarried but has children. A trust donor may transfer assets such as stock out of the donor’s taxable estate at a lower value before the sale of the business or public offering is completed. Any stock appreciation after the date of the gift is not included in the donor’s taxable estate. An ITC can be either a Grantor Trust (all income taxable to the grantor) or a Non-Grantor Trust (income taxable to trust).
Sale of Stock to a Grantor Trust
The sale of stock to a Grantor Trust, also commonly referred to as an Intentionally Defective Grantor Trust (IDGT), may be useful for limiting estate tax liability, particularly where the seller has already maxed out allowable gift tax exclusions, but seeks to transfer more assets out of his or her estate prior to the sale. The IDGT purchases the seller’s stock at a discounted value in exchange for a promissory note. As a result, the IDGT is treated as the grantor for income tax purposes, so there is no gain on the sale. IDGTs are typically structured using the Applicable Federal Rate (AFR) of interest with interest-only payments required on the promissory note for a term of years with a balloon payment at end of the term. To the extent stock appreciation exceeds the interest paid on the note after the date of the gift, such appreciation is not included in the seller’s taxable estate.
Careful advance planning is required when an individual plans to sell a closely held business or their stock in the business as part of a succession plan. There are many tools which an individual may be able to use to mitigate tax liability in these situations, but they require professional assistance and advice which is tailored to the specific individual’s assets, liabilities, goals, and objectives.
Our Team
BHGR’s Trusts, Estates, Probate, and Tax Group advises local, national, and international, high-net-worth individuals and families in all aspects of sophisticated estate, tax, asset protection, and business planning. Our attorneys also counsel clients on the use of trusts and other estate planning tools to mitigate taxes when selling closely held companies, selling business equity, or other types of liquidity events.
This article is informational only. The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information. Readers of this website should contact their own attorneys to obtain advice with respect to any particular legal matter. No reader, user, or browser of this site should act or refrain from acting based on information on this site without first seeking legal advice from counsel in the relevant jurisdiction. Only your individual attorney can provide assurances that the information contained herein—and your interpretation of it—is applicable or appropriate to your particular situation. All liability with respect to actions taken or not taken based on the contents of this site are hereby expressly disclaimed. The content on this posting is provided “as is;” no representations are made that the content is error-free.