Deferring Capital Gains Taxes on Business Property

The tax deferred exchange provides real estate owners with one
of the last true tax breaks and the only method of deferring tax
on the sale of investment and business property. Most
taxpayers know they can exclude the gain on a sale of their
personal residence. Unfortunately, many business and
investment property owners fail to capitalize on the benefits of
another type of tax-deferred exchange, under Internal Revenue
Code Section 1031.

Far too many business owners sell their business and
investment property and pay capital gain taxes because they are
unaware of provisions in the tax code that allow for deferral.
Internal Revenue Code Section 1031(a)(1) states in part that
"no gain or loss shall be recognized on the exchange of
property held for productive use in a trade or business or for
investment if such property is exchanged solely for property of
like kind which is to be held either for productive use in a trade
or business or for investment." Examples of property types that
typically qualify are vacant land, office buildings, warehouses,
farmland, single-family rental units and shopping centers. Even
leases with 30 or more years remaining are considered real
property and can be traded for other real property.

How does one get started? The procedure is fairly simple as
Treasury Regulations issued in April of 1991 provide a
guideline for taxpayers to follow. Once a buyer for the property
to be sold (the "relinquished property") has been found, a
phone call to a selected "qualified intermediary" to assist with
the Section 1031 exchange is all it takes to begin the process.
The qualified intermediary will produce the necessary legal
documentation required to facilitate the exchange process.
Once the closing of the relinquished property has occurred, the
taxpayer has 45 days from the date of closing to identify in
writing to the intermediary the possible replacement properties.
Due to significant restrictions, it is usually best to identify no
more than three replacement properties. The final step is to
close on one of the identified properties within 180 days from
the date of closing of the relinquished property.

Although the 1031 tax code section is very liberal, various
modifications over the years have resulted in a few additional
restrictions. Partnership shares, notes, stocks, bonds,
certificates of trust cannot be exchanged. A taxpayer who holds
a partnership interest or shares in a corporation that owns real
estate cannot trade that interest for similar share interests.
Business owners should consult a tax expert or legal advisor in
this situation.

With the reduction in capital gains tax rates, taxpayers were
given a rare break. However, this break was not as generous as
originally proposed. Most taxpayers are aware of the new
capital gains tax rate of 15 percent, lowered from the previous
28 percent rate. This is applicable for gain generated from the
sale of capital assets held for more than 12 months. At the last
minute, however, Congress altered the tax rate for recapture of
depreciation taken on real estate to be taxed at 25 percent. This
higher rate is applicable for all depreciation taken after May 6,
1997. Combining the 25 percent depreciation recapture rate
with state and federal tax rates could cost a taxpayer who sells
business real estate over to 40 percent or more of their profit.
On the other hand, a property owner who chooses to perform
an IRC Section 1031 tax deferred exchange can defer taxes on
the all of the capital gain! This leaves the prudent exchange or
with the entire amount available for reinvestment.

Many business owners are unaware that personal property used
in a business, such as a medical practice, can be exchanged as
well. The major difference between a real property and
personal property exchange is what the Internal Revenue
Service considers "like kind" property. I.R.C. Section 1031
defines like kind as "...property held for productive use in a
trade or business or for investment." Like kind as it applies to
real property is very broad in definition. Determining whether
personal property is like kind to other personal property
requires a much narrower scope. The Internal Revenue Code
does not define "like kind." The IRS has published regulations
that can be used to decide if an exchange involves like-kind
properties. The Treasury Regulations distinguishes between
two types of personal property: depreciable tangible personal
property (DTPP); and other personal property (OPP), which
consists of intangible and non-depreciable personal property.
DTPP can only be exchanged for other DTPP. These properties
must be of a "like class" or "like kind." In determining whether
DTPP is of a like class the Treasury Regulations designate 13
general asset classes. These classes combine particular types of
personal property into a certain class group. Some examples of
these groups are office furniture and fixtures, information
systems, airplanes and helicopters, automobiles and taxis, and
buses.

The Regulations also designate that personal property can fall
within product classes contained in the North American
Industry Classification System. These numeric codes can be
used as an alternate method to define the characteristics of a
particular property.

OPP is difficult to classify as like kind to other OPP. It does
not fall within the like class safe harbor available to DTPP.
Intangible personal property, such as a lease or copyright, can
be considered like kind to similar intangible property. The
determining factors are the nature and character of the rights
involved and the nature and character of the underlying asset.
Selling a business can create more than one personal property
group in which to exchange. The IRS looks at the sale of a
business as an exchange of each asset to be transferred, and not
the exchange of the business as a whole. The underlying assets
of a business (e.g., lease value, covenant not to compete,
equipment and fixtures) will need to be analyzed in respect to
their comparable replacement property. Each asset is placed
into the proper exchange group. An exchange group is a
subgroup of the total assets exchanged. Every exchange group
will either have a surplus (trading up in value) or a deficiency
(boot). When the total fair market values of the properties
exchanged are different, the value equal to that difference is
called the residual group. The property in the residual group
will consist of cash and other property that does not fit into an
exchange group.

An example of a business exchange would be the exchange of
one medical practice for another. The relinquished medical
practice value consisted of: (1) the medical equipment (x-ray
machines, etc.) and office fixtures; (2) a covenant not to
compete; (3) lease value for the below market lease of the
office; and (4) client patient lists and files. The medical
practice acquired will generally have similar components of
value. To balance this exchange each separate component is
matched up with its like kind counterpart. A surplus in one of
the exchange groups is not taxable as the Regulations allow for
trading up in value. Any deficiency - going down in value -
would be taxable as "boot."

The Regulations provide the non-yielding rule that goodwill
and going concern value in one business can never be like in
kind to goodwill and going concern value in another business.
In the example of the medical practice exchange, the client
patient lists and files would probably be viewed by the IRS as
goodwill, and should not be included in the exchange. A
prudent tax planner would attempt to allocate value to the
depreciable or amortizable personal property, such as the
medical equipment and office fixtures, to avoid this problem.
Additional personal property not eligible for exchange
treatment is inventory. The inventory of a business is held for
resale and does not fall within the definition of Section 1031
property.

Anyone considering deferring tax under IRC Section 1031
should obtain competent tax/legal advice before proceeding
with a transaction. A mistake can be costly.

Business Incorporation and Disincorporation

Incorporation and disincorporation are two key decisions to be made at different times in a business life cycle. This article covers the merits of each.

Should I incorporate?

There are too many different permutations of income and individual circumstances to be definite as to which structure is better.

You need to do the projections for both structures. Losses are more effectively utilised when a sole trader and usually it is better to start as a sole trader. Then, once into profit, incorporate to gain the commercial protection offered to the owner by the limited status.

There are income tax advantages to higher rate taxpayers together with national insurance savings.

Transfer of business to a limited company

If you decide to transfer your business to a company:-

Your sole trade will cease on the date of transfer.

The trading stock will be transferred at market value subject to you being able to elect to substitute the greater of cost or the price paid by the company if that would give a lower figure.
Similarly the cessation will give rise to a balancing charge or allowance but you can elect within two years to transfer the assets at tax written down value.
Any unused trading losses cannot be transferred to the company but you can relieve them against income received from the company e.g. salary, fees or dividends.
The chargeable assets of your trade that are transferred to the company give rise to capital gains tax. The computation of liability can be made in either of two ways. (Sections 162 and 165 TCGA 1992).
Stamp duty must be considered; it is not payable on stock, plant or goodwill but SDLT is payable on any transfer of the premises.

You will need to consider whether the company should be registered for VAT and whether the business is to be transferred as a going concern.

Should I disincorporate?

Trading stock

If the trade goes back to the original shareholders and as they are connected with the company, the stock will be transferred at market value. This is subject to an election to substitute the actual transfer value.

Capital Allowances

Balancing adjustments will need to be made taking the actual value at transfer again subject to the election to transfer at the tax written down value.

VAT

There should be no trouble as the transfer will be of a going concern.

Assets

These will give rise to the biggest problem. Substantial capital gains could arise and this will need careful attention with the appropriate professional advice.

Trade ceases

If it is decided to disincorporate, for corporation tax, the trade is treated as ceasing even though the actual trade may continue.

Accounting date

The accounting date ends on the date of disincorporation.

Losses

Unlike when a business is incorporated where any losses are carried forward, on disincorporation any losses are "lost."

Reduce Capital Gains Tax in the Sale of a Business

Hopefully, before selling a business, you meet with a CPA or tax accountant and get an estimate on how much of your proceeds will be going directly to Uncle Sam if you pay them in a lump sum at time of sale. You don't want to save this surprise for after all is said and done, because not only will it most likely be a shock, but you will have given up your chance to do anything about it.

Planning is everything. For this article I will assume you are not doing a 1031 business exchange, that is selling your business and buying another similar business taking into consideration all the IRS guidelines and timelines. It's pretty rare to see this, but it can defer all of your capital gains tax if done correctly. A 1031 Exchange is more commonly implemented with real estate.

Depending on how the business is sold, the gains may be taxed as long term capital gain, short term capital gain, ordinary income, etc. and if you are selling an asset in a C-Corp you may face double taxation. So, the idea is to minimize your tax bill and maximize your proceeds no matter what situation you are in.

One option is with a Self Directed Installment Sale. The structure must be in place before the buy/sell agreement is signed. The gist is to receive the sale proceeds in installments and only pay capital gains tax as you receive the income. This has the effect of allowing the majority of money you would have paid immediately in taxes to continue earning compounded interest for you for many years, thus increasing your bottom line by a significant amount.

The details are a bit too complex to fully outline in a short article, but both an LLC and a Trust are created for you and set up meet IRS criteria for favorable taxation of installment sales. Your asset gets transferred to the LLC prior to sale, and your buyer purchases from your LLC. The trust buys the shares of your LLC from you via an installment agreement and you pay taxes on your gain only as you receive the payments.

You, the seller, are able to control when the payments begin and how long they will be spread out. This allows for maximum flexibility to control your income, and plan for future tax savings as well. Since your buyer paid cash in exchange for your property, you are not dependent on them to make the installment payments and you have transferred the risk of refinance or default. This is done by using an independent third party administrator and your money is safely invested in a principle protected insurance product to be used solely for the purpose of paying the installments.

If you pass on before receiving all of the payments due, the remainder of the installment payments pass to the beneficiaries of your choice.

Seeing an example of a taxed sale vs. a Self Directed Installment Sale side by side will show you how much of a difference in overall return this strategy will provide. This can make the process of the sale more palatable and provide a dependable income stream for retirement.

The tax benefit of this approach is similar to your 401K or IRA account. You reduce your current income by the amount of your annual contribution and thus defer the tax you would have paid on that income amount. Those funds are invested in stocks and bonds and grow in value, sometimes dramatically, for the period before you retire and start taking distributions. When you start distributions, the amount is treated as ordinary income and you are taxed at your much lower (you are no longer working and earning a big salary) income tax rate at the time.

The Self Directed Installment Sale allows you to similarly defer your capital gains tax from the sale of your business. Instead of paying all of your capital gains at time of sale, you set up your SDIS to pay out your sale proceeds over time. If you pay all of your capital gains tax at time of sale, that money is gone forever. However, with this vehicle, you spread your receipt of the sales proceeds out over, 15 years for example. When you receive your distribution, you are then taxed for the portion of that distribution that is attributed to the capital gains - generally about 15%.

The difference in after tax proceeds are dramatic and are demonstrated by a complex analysis called an illustration. I will try in an abbreviated fashion, however, to demonstrate the potential impact. If you sold your business and you had a capital gain of $3.46 million, your lump sum capital gains tax payment at a 15% rate would be $519,000. In the SDIS you would keep the entire sale proceeds of $3.46 million and take distributions over a 20 year period or whatever period you chose. You receive an annual payment over 20 years, that would consist of 1/20 of the principal, 1/20 of the capital gains, plus investment returns.

If we did an illustration of this case and compared selling the business and paying all the capital gains up front and invested the remaining proceeds in a 6.85% compound growth portfolio versus the SDIS paying 1/20 of the capital gains annually, you would gain an $831,000 advantage in after tax proceeds. Not to bad for a little advanced planning.

Selling Your Business - Deal Structure and Taxes

The purpose of this article is to demonstrate the importance of the tax impact in the sale of your business. As an M&A intermediary and member of the IBBA, International Business Brokers Association, we recognize our responsibility to recommend that our clients use attorneys and tax accountants for independent advice on transactions.

As a general rule, buyers of businesses have already completed several transactions. They have a process and are surrounded by a team of experienced mergers and acquisitions professionals. Sellers on the other hand, sell a business only one time. Their "team" consists of their outside counsel who does general business law and their accountant who does their books and tax filings. It is important to note that the seller's team may have little or no experience in a business sale transaction.

Another general rule is that a deal structure that favors a buyer from the tax perspective normally is detrimental to the seller's tax situation and vice versa. For example, in allocating the purchase price in an asset sale, the buyer wants the fastest write-off possible. From a tax standpoint he would want to allocate as much of the transaction value to a consulting contract for the seller and equipment with a short depreciation period.

A consulting contract is taxed to the seller as earned income, generally the highest possible tax rate. The difference between the depreciated tax basis of equipment and the amount of the purchase price allocated is taxed to the seller at the seller's ordinary income tax rate. This is generally the second highest tax rate (no FICA due on this vs. earned income). The seller would prefer to have more of the purchase price allocated to goodwill, personal goodwill, and going concern value.

The seller would be taxed at the more favorable individual capital gains rates for gains in these categories. An individual that was in the 40% income tax bracket would pay capital gains at a 20% rate. Note: an asset sale of a business will normally put a seller into the highest income tax bracket.

The buyer's write-off period for goodwill, personal goodwill, and going concern value is fifteen years. This is far less desirable than the one or two years of expense "write-off" for a consulting agreement.

Another very important issue for tax purposes is whether the sale is a stock sale or an asset sale. Buyers generally prefer asset sales and sellers generally prefer stock sales. In an asset sale the buyer gets to take a step-up in basis for machinery and equipment. Let's say that the seller's depreciated value for the machinery and equipment were $600,000. FMV and purchase price allocation were $1.25 million.

Under a stock sale the buyer inherits the historical depreciation structure for write-off. In an asset sale the buyer establishes the $1.25 million (stepped up value) as his basis for depreciation and gets the advantage of bigger write-offs for tax purposes.

The seller prefers a stock sale because the entire gain is taxed at the more favorable long-term capital gains rate. For an asset sale a portion of the gains will be taxed at the less favorable income tax rates. In the example above, the seller's tax liability for the machinery and equipment gain in an asset sale would be 40% of the $625,000 gain or $250,000. In a stock sale the tax liability for the same gain associated with the machinery and equipment is 20% of $625,000, or $125,000.

The form of the seller's organization, for example C Corp, S Corp, or LLC are important to consider in a business sale. In a C Corp vs. an S Corp and LLC, the gains are subject to double taxation. In a C Corp sale the gain from the sale of assets is taxed at the corporate income tax rate. The remaining proceeds are distributed to the shareholders and the difference between the liquidation proceeds and the stockholder stock basis are taxed at the individual's long-term capital gains rate.

The gains have been taxed twice reducing the individual's after-tax proceeds. An S Corp or LLC sale results in gains being taxed only once using the tax profile of the individual stockholder.

Selling your business - tax consideration checklist:

1. Get good tax and legal counsel when you establish the initial form of your business - C Corp, S Corp, or LLC etc.

2. If you establish a C Corp, retain ownership of all appreciating assets outside of the corporation (land and buildings, patents, trademarks, franchise rights). Note: in a C Corp sale, there are no long-term capital gains tax rates only income tax rates. Long-term capital gains can only offset long-term capital losses. Personal assets sales can have favorable long-term capital gains treatment and you avoid double taxation for these assets with big gains.

3. Look first at the economics of the sales transaction and secondly at the tax structure.

4. Make sure your professional support team has deal making experience.

5. Before you take your business to the market, work with your professionals to understand your tax characteristics and how various deal structures will impact the after-tax sale proceeds

6. Before you complete your sales transaction work with a financial planning or tax planning professional to determine if there are strategies you can employ to defer or eliminate the payment of taxes.

7. Recognize that as a general rule your desire to "cash out" and receive all proceeds from your sale immediately will increase your tax liability.

8. Get your professionals involved early and keep them involved in analyzing various bids to determine your best offer.

Again, the purpose of this article was not to offer you tax advice (which I am not qualified to do). It was to alert you to the huge potential impact that the deal structure and taxes can have on the economics of your sales transaction and the importance of involving the right legal and tax professionals.

Impact of the Capital Gains Tax Increase on the Sale of a Business

Business owners and management teams that are contemplating a sale of their company are now evaluating the impact that the 'timing of sale' has on the net proceeds received, as a result of the upcoming 33% capital gains tax increase. Many business owners have seen a decline in revenue and profit over the last several years and are expecting an improvement in the future. Since most business valuations are derived, largely in part, by the earnings the company generates, the general consensus is that a higher value will be obtained by delaying the sale. Achieving the highest business valuation is often the sole concern with little consideration to the net after tax dollars. Many business owners are now re-evaluating this thought process given the significant capital gains tax increase that will take place on January 1, 2011.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 was signed into law on May 28, 2003. Among other things, this 2003 tax law created lower dividend and capital gains rates for all investors. Under this Act, the maximum net capital gains tax for assets held for more than one year was lowered from 20% to 15% (and from 10% to 5% for taxpayers in the 10% or 15% tax bracket). The Tax Increase Prevention and Reconciliation Act of 2005, which extended the 15% capital gains tax rate, "sunsets" on January 1, 2011. The term sunset is a time phase-in provision which means that without further Congressional action, the previous law, including the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), will go back into effect. Therefore, the top 15% capital gains rate will revert to its former pre-May 6, 2003 level of 20%, effectively a 33% increase.

This tax increase should be one of many factors that are considered when evaluating the optimal time table for a business sale. For those owners or management teams that do not plan to sell for 5-10 years this event should not become an inducement to rush out and sell the company. For those owners that are considering a sale over the next few years, the impact that this tax increase has on the after tax dollars received in a sale could be very significant and therefore, a thorough evaluation should be performed by the owner to assess the actual effect between selling a business now or years in the future. By analyzing the net after tax proceeds from a business sale in years 2010 thru 2013, the business owner or management team will recognize that even with a 10-15% growth per year, and maintaining consistent earnings with a constant exit multiple, the incremental value attributed by the growth in income and revenue, in most cases, would be completely negated by the increase in capital gains taxes. Therefore, while the value of the business is anticipated to be higher in years 2011 and beyond, the net after tax proceeds, could be considerably less.

There are many considerations involved in the sale of a privately held business and this article is written with the intention of helping business owners understand the potential impact that the 2011 capital gains increase will have on the sale of their privately held business. Understanding the effect of the impending capital gains tax increase enables business owners to make informed decisions as it relates to maximizing the net after tax dollars through the intelligent structuring and timing of the business sale transaction. The tax implications will vary for every business based upon the type of assets being sold and the structure of the transaction and it is strongly recommended that a business tax advisor be involved in the process.

Deferring Taxable Gain on the Sale of Your Business Or Real Estate Assets

Business owners who sell a business, assets held or used in their business, or real estate used in their business operations can face significant capital gain taxes.  These capital gain taxes due from the sale of your company, assets or real property can be minimized or even eliminated with the proper tax deferral or tax exclusion planning in conjunction with your legal and tax advisor. 

There are numerous tax deferred and/or tax exclusion strategies available for the sale of businesses, assets and real estate.  It is critical that careful tax planning be a priority in order to properly deal with the potential capital gain taxes that will be generated by the sale of your property.

The 1031 Tax Deferred Exchange May Not Be Suitable

Owners of real or personal property, such as a business interest, assets used in a business or real property that have been held for rental, lease, investment or used in a trade or business, frequently structure tax-deferred exchanges pursuant to Section 1031 ("Section 1031") of the Internal Revenue Code ("Code") in order to defer the payment of their taxable gains.

However, tax-deferred exchanges pursuant to Section 1031 are not always feasible, suitable nor appropriate for taxpayers when they are selling their company, assets used in their company or real property used in their business operation. 

Section 1031 Exchange transaction structures require business or property owners to exchange equal or up in net sales value by acquiring one or more replacement properties that are of like-kind.  Locating suitable replacement properties to be acquired as part of the Section 1031 Exchange in order to replace the relinquished property (business) can be extremely challenging, very stressful, and virtually impossible in some cases. 

The taxpayer may have absolutely no wish to reinvest his or her net sale proceeds into another business operation of like-kind, or any kind, for that matter.   Taxpayers may just wish to "cash out" and pay their taxes. 

Taxpayers may have reached a point in their life when they merely wish to sell, cash out, pay the taxes, and absolutely not reinvest in another business, assets or real estate. They may not even want to see another business as long as the live.  Some taxpayers may opt to sell and pay their capital gain taxes in the current year, but many would prefer to implement some kind of tax deferral or tax exclusion strategy that would allow them to defer the payment of their taxable gains over a period of time of their choosing rather than get hit with them all in the year of sale.

Deferring Capital Gain Taxes Without a 1031 Exchange

There are a number of tax deferred and tax exclusion strategies available that a taxpayer can use to defer the payment of taxable gains, so it is important that the taxpayer meet with his or her tax advisor to review all of their tax strategies. The following are the two most common tax-deferral strategies available for the sale of businesses, assets used in your business or real estate:

Seller Carry Back Note (Seller Financing)

The taxpayer could structure the sale of his or her business operation by carrying back a note, which is often referred to as seller financing or a seller carry back note. Seller financing is merely an installment note or promissory note where the buyer of the business entity or assets/property makes periodic payments to the seller. Depreciation recapture taxes, if any, are due and paid in the year the business, assets or real estate were sold. The capital gain taxes are partially or fully deferred over the term of the note and are taxed as principal loan payments are made to the taxpayer.

The installment note or promissory note strategy has positive and negative features. The obvious positive is that you can sell your business, asset or property and defer the payment of your taxable gains by structuring a seller carry back note.

However, the risk of buyer default on the installment note is a considerable negative. The process to foreclose or otherwise take back the business or asset/property can consume significant amounts of time and money and the business, asset or property may have been irreparably damaged during the buyer's ownership and management.

Deferred Sales Trusts or DSTs

Deferred Sales Trusts or DSTs are highly effective tax-deferred strategies, similar to the installment sale or seller carry back note, but without the risk of buyer default.  The Deferred Sales Trust receives all of the net cash proceeds from the buyer at the closing of the sale transaction, thus removing the buyer from involvement in the Deferred Sales Trust  transaction.  Deferred Sales Trusts can provide other great tax and estate planning strategies as well.

Deferred Sales Trusts are drafted pursuant to Section 453 of the Internal Revenue Code, just like the installment sale note or promissory note in seller financing. The capital gains tax is realized or triggered, but not recognized or paid, because it is deferred over a period of time selected by the taxpayer.

The capital gains tax liability is partially or fully tax deferred over the term of the installment sale note created within the Deferred Sales Trust account, which you will negotiate in advance directly with the Trustee of the Deferred Sales Trust. 

Selling Your Business - A Tool To Reduce Capital Gains Taxes

"I would rather expire at my desk than to sell my business and pay Uncle Sam one dime in taxes." How many owners that have paid their fair share of taxes for twenty years of building their business feel this way? The tax bite is the single biggest factor in an owner's reluctance to sell his/her company.

I have previously written articles discussing various aspects of transaction structures to minimize taxes. As a result, I am often contacted by a panicked seller that is a week from closing his business sale as he looks in disbelief at his accountant's spreadsheet detailing the tax burden of his impending sale.

Recently, the seller of a Sub Chapter S Corporation with an $8 million transaction value contacted me. The tax basis was below $200,000 and $4 million of the transaction value was the assumption of debt. When the dust settled, he was looking at a capital gains tax liability of a staggering $965,000 while only receiving the remainder of proceeds after the assumption of debt. The assumption of debt is considered as part of the capital gain for tax purposes.

The owner sent his accountant's spreadsheet to me and since I am not a tax accountant, I sent it to my tax wizard at BDO Seidman. He found a few small tweaks, but said that there was not much that could be done from an accounting standpoint for this owner. When I reported this back to the seller I could feel his disappointment and frustration.

So I began my quest for a better solution. After several dozen phone calls to my professional network, I was directed to a little known vehicle called a Private Annuity Trust. This vehicle has passed the scrutiny of the IRS and the Tax Court. It is not a way to avoid the payment of taxes, rather a method of deferring them with substantial economic benefit to the owner's beneficiaries.

Below is a simplified description of the process. As the owner contemplates the sale of his business (or any highly appreciated asset for that matter) he "sells" it to a trust PRIOR to its ultimate sale. This trust purchases the asset at FMV and exchanges an annuity payment stream complete with IRS life expectancy tables and interest rates. The trust then sells the company to the buyer to fund the annuity.

The transaction is accompanied by a gift to the trust in the amount of 7% of the face value of the annuity. This is so it qualifies as a trust by creating an entity with economic value. Remember, the private annuity is viewed as having zero economic value because the asset minus the obligation theoretically equals zero.

The trust is in the name of the owner's beneficiaries and all aspects of the trust are controlled by the trustees/beneficiaries and not by the owner. The trust for the benefit of the heirs owns the assets and owns the annuity payment obligation. The trust can be structured to defer the annuity payments for a period of time to coincide with the owner's need to receive these payments, lets say, for example, ten years During those ten years the trust's investments or a commercial annuity grow without incurring a tax bite for the business sale.

When the annuity payments start, the owner is taxed at his then current tax rate for the portion of the annuity payment attributable to the capital gains, his basis (no tax), and depreciation recapture from the sale, and the income produced from the annuity. The annuity pays the owner and spouse this annuity payment until last to die or until the annuity investments run out. If the owner and spouse die, any remaining assets are transferred to the beneficiaries outside of estate tax liability.

If your investments perform at the rate used in the annuity calculation and the last to die lives to their exact life expectancy, theoretically the trust value will be whatever the gift portion (7% of the selling price) has grown to. However, if the investments do very well and you outlive the life expectancy tables, you could receive payments well in excess of the original annuity face value. Those excess payments would be taxed at your then current income tax rate.

If the investments do well and the value grows above the required annuity reserve amount, the excess can be distributed to the beneficiaries as income.

In the simplest of views, this acts like an IRA. You are not currently taxed on the amount you put in, it grows tax deferred and you pay taxes upon distribution, hopefully at a far more favorable tax rate. In the case of the frustrated seller from above, what if he deferred all payments by ten years on the full sale price and the $965,000 in capital gain taxes owed? He had a life expectancy of 20 years beyond the start of the distributions. The $965,000 that he did not pay in taxes grows at 7% to $1,939,323 by the time distributions start.

Every annuity payment contains a portion of the capital gain or 1/20th of the total capital gain annually. Therefore, the bulk of the resulting investment value of the capital gains tax deferral provides huge returns for years to come.

If it seems too good to be true, remember it is tax deferral and not tax avoidance. The owner has sold his business first to the trust in return for an annuity payment stream. The owner cannot control the trust. To the extent that the owner wants immediate access to some of the sales proceeds, he would pay all taxes in proportion to the amount he is receiving. In cases like the one above, this tax deferral tool can have a dramatic impact on the financial status of the owner and his heirs by allowing the tax deferred funds to compound for many years before their ultimate distribution and the payment of any tax.

Capital Gains Deferral in a Business Sale

The sale of business is a challenging and difficult transaction with several complicated aspects. Whether it's the complete sale of a business or simply the sale of a partial ownership interest in a company, one of the most troubling issues created by this disposition is the manner in which capital gains and other taxes are addressed. There are not many options available to a business owner, and the few that are come accompanied by complex rules and regulations. There are also restrictions that can increase future risk and possibly trigger IRS penalties.

We are always looking for ways for our business sellers to maximize their transaction proceeds while keeping as much possible through the use of intelligent tax planning and deal structure. I asked Dan Carroll from Brook Hollow Financial to explain a unique way to defer capital gains taxes that are the result of a business sale.

Large Tax Bill Due upon Sale

Capital Gains, Depreciation Recapture and even Income taxes may be levied against the proceeds of the sale of the business. Depending on the initial amount invested and how much the business has grown, these taxes can consume much of the sale price. Currently the Federal Capital Gains Tax stands at 15%. Most states have a Capital Gains Tax as well, with the total amount often exceeding 20% of the gain. We believe that these rates will have near term upward pressure caused by the need for the Treasury Department to make up for the $800 billion shortfall that will result from the repeal of the Alternative Minimum Tax. Other taxes, particularly if held in a 'C' Corp., can exceed 60% of the transaction.

Loss of Regular Income

When a business is sold, the owner's cash flow stops as well. Therefore, the amount of money that was being produced needs to be replaced. Without this regular income, former business owners are left with a significant gap in what they receive each month and must alter any plans or budgets accordingly.

What to do with the Proceeds

Another major challenge that a business owner will face is what to do with the proceeds of any sale. There are many ways to put this money to work for you, but this often means accepting significant risk and investing in markets without much experience. Alternatively, sellers might mitigate risk, but only at the cost of getting a very low return. Either way, inadequate returns and potential loss of capital are serious risk factors that must be considered.

Need to Mitigate Future Risk

Among the challenges presented by investing the new capital is that there may be different goals for the individual at this stage of his or her career. If the sale is prompted by a desire to move away from daily management and responsibility, or simply to cash out at a good time in the market, the owner may want to revisit his or her goals. A review of the financial needs and expectations may reveal a requirement for total investment certainty. While these alternatives do exist, most do little to provide a reasonable return and can make planning more difficult with these limited resources. The need and desire to mitigate future risk should play an important role in any decisions about your investment plans.

The Traditional Business Sale - Cash Transaction

The cash transaction option is fairly straightforward. The seller is paid cash from the buyer. After any loans or other debts are paid, the funds are then made available to the seller. At this point, the seller must pay federal and state taxes on the proceeds, and then the remaining balance is left to invest. This drastically reduces the principle and lowers any future returns. The stock market and other liquid investments carry very significant market risk, and the individual could lose some or all of the money. On the other hand, the individual could place the money into a guaranteed investment such as a certificate of deposit, but the returns will drastically lag other possible alternatives. Investing on your own requires some planning and active management of the portfolio, but more importantly, it may provide for unpredictable future income necessary to manage and care for an investor and his or her family.

Another Approach - The Installment Sale

The Installment Sale is a mechanism that has been available since the 1930's. In this type of transaction, the buyer of a business agrees to pay the seller a certain amount of money over a fixed period of time. Under this approach, the IRS has ruled that only the amount of distribution in any given year is subject to any applicable taxes in proportion to the total due. The problem here had been reliance upon the buyer to continue to make the payments promised. Often times the business is run poorly and is no longer producing enough revenue to make the promised payments. There has always been recourse in these transactions, so that if the buyer did not live up to his obligation, the seller could foreclose and reclaim ownership of the business. However, this offered little protection if the business has not been run properly or the value lowers for other reasons, since the original seller would now reclaim a much less valuable business.

An Improved Approach - The Installment Sale with Guaranteed Annuity Payments

There is a way to ensure that these types of transactions could still be utilized while eliminating the possibility of default. The transaction takes place as described above, only there is a second transaction that occurs simultaneously. At the time of closing, the buyer purchases an annuity from an A+ rated Annuity company. Therefore the seller receives a guarantee that regardless of the future strength of the business, the payments will be made as agreed upon, and all of the tax deferral benefits remain intact.

The benefits of this type of transaction are as follows:

Seller is able to sell the business without future risk

Tax-deferral creates much greater taxable equivalent return

Flexible planning allows for specific plans tailored to individual needs

Stabilizes future income with certainty for life

Much larger total benefit over time - guaranteed

Payments can continue to pass on to heirs in the event of death

Eliminates need for expensive life insurance

Requires no management responsibility

There are no direct or on-going fees

Expedited closing

A simple way to look at this plan is to compare it to an IRA. With the IRA your investments get to grow on a tax deferred basis for many years and you get the benefit of earning investment returns on the amount not paid in tax. When you draw the funds out of the account, you are then taxed at your then current rate. With the guaranteed annuity installment sale, you may elect to take a portion of the business sale proceeds at close and pay all of the appropriate taxes on that portion.

You then could structure the guaranteed annuity to begin paying you a certain amount starting in 5 years for another 20 years. The investment would be allowed to grow tax deferred for that 5-year period. When you started taking distributions, you would be taxed at the rate you would have been from the original sale transaction. The important thing to remember here is that instead of receiving the entire distribution at closing and paying a huge tax bill up front, you are taking 1/20th of the distribution each year and paying 1/20th of the tax. The remaining portion of the deferred tax stays invested and earns income over the 20-year period. This substantially increases your return on the deferred portion of your sale proceeds.

This mechanism is a great way to secure your proceeds with guaranteed payouts, no ongoing involvement or management responsibility, and beneficial tax treatment. This will ensure the highest possible taxable equivalent return when compared to any fixed-income, guaranteed investment. Remember in a business sale the important number is how much you get to keep.

Australian Taxation - How Long Should Business Records Be Retained?

A case that was recently decided in the Federal Court highlights a problem in relation to the keeping of business records. During the 1988 income year, a unit trust engaged in the purchase of a significant investment. It was not a good investment. Not too long afterwards the investment was worthless and in May 1993 the investment was sold for $1. This resulted in the unit trust incurring a capital loss of nearly $2.5m.

All of the units in the trust were sold from the original owner to a new owner in two tranches. One was in June 1993 and the other was in June 1995.

Capital losses may only be deducted for tax purposes against capital gains. Put another way, capital losses may not be used as a deduction against normal income. Due to this, the capital losses were carried forward by the unit trust until a capital gain was made by the unit trust in 2001.

The Australia Taxation Office ("ATO") raised amended assessments against the ultimate beneficiaries of the trust and would not allow the capital loss of $2.5m to be set off against the capital gain made in 2001. The beneficiaries objected to this and the matter found its way to the Federal Court.

The main argument of the ATO was that the trust had fundamentally changed through some things that happened in 1993. I won't go into the details of that.

However, the ATO also argued that the taxpayers could not prove that the purchase of the investment occurred in 1988 because, among other things, the primary documents that evidence the transaction no longer existed. This was so even though the financial statements of the unit trust showed the acquisition and there was verbal evidence from the people who actually engaged in the transaction. I note that the financial statements were prepared by a reputable firm of Chartered Accountants.

In his testimony before the court, the original owner of the units said that he did not have any of the business records of any of his companies or entities from 21 years ago. I know of few people that would.

So here's the point. Generally, businesses are required to keep their records for a five year period under the Australian taxation law. But when it comes to capital gains tax, you need to keep records of everything that may be relevant to working out whether you have made a capital gain or capital loss. And, according to the ATO publication "Record Keeping For Small Business", "You must keep these records for five years after you sell or otherwise dispose of an asset...". So, you may need to keep the records for a very long time.

You will note in the case I refer to above that the ATO required the taxpayer to produce business records of a transaction that was 21 years old. Further, the disposal of the investment occurred in 1993, so that was 16 years earlier (not five).

The moral of the story is this: if you think that a transaction may have long term significant tax implications, don't (ever?) throw out the primary documents that relate to that transaction. Keeping an electronic (scanned) image is something that you should consider.

Wishing you easier business.

John M. Jeffreys

2011 Capital Gains Tax Increase and the Impact on Business Owners

The last couple of years have been difficult for business owners and financing markets, to say the least. Limited credit, economic uncertainty among businesses and consumers, and poor financial performance across industry sectors contributed to curtailed growth prospects, and have some wondering what their long-term strategy might entail. As we head into 2010, however, there are many reasons for optimism that merger and acquisition activity will increase, including improving economic indicators, cash heavy balance sheets of strategic buyers, better than expected fund raising by private equity groups and Key Take Aways increased confidence in the private and public sectors. For potential sellers, 2010 is also an important time to consider valuation risks now versus future years due to the scheduled increase in the capital gains in 2011.

Originally signed into law in 2001, the capital gains tax rate was reduced as part of President Bush's Economic Growth and Tax Relief Reconciliation Act. Under the reduced rate, long-term capital gains and qualified dividends were taxed at 15% for the lowest two income tax brackets. The lowered rate was set to expire in 2008; however, reduced rate was extended in 2006 under Bush's Tax Reconciliation Act and is scheduled to expire at the end of 2010, at which time the rate will revert to the 2003 rates, which were 20%.

Given the capital gains tax rate increase represents a 33.33% higher effective tax rate, there is significant motivation for owners and shareholders already considering a potential sale in the near-term to consider action in 2010. Beyond avoiding a higher tax rate on long-term capital gains, sellers also need to carefully plan the timing of a potential exit in 2010 in order to secure the most attractive buyer and preserve leverage in the negotiations of the purchase agreement.

While owners and shareholders may be hesitant to pursue an acquisition without greater economic certainty, there are multiple indicators suggesting that 2010 is likely the right time to at least consider a potential a sale, given favorable terms. The capital gains tax increase serves as motivating factor; it is by no means the only one.

The following are key points for understanding the impact of the capital gains tax rate increase on M&A activity in 2010:

Consider the overall economic picture.

There are signs at the corporate level that are encouraging to mid-size firms considering being acquired. Over the last three months through January 2010, deal flow is up 16.8% over the same period a year before. Of course, last year was the one of the worst years in our economic history. However, major deals are being completed, which can cause a "bandwagon effect." In addition to corporate confidence, many private equity groups with a strong track record continue to raise money. In 2009, the average fund size raised by private equity groups was $1.5 billion, the second highest on record. This indicates more private equity groups than expected will have cash in 2010 and will need to put it to work. With a return in confidence to the markets and increasing signs of an economic stabilization, 2010 is likely to see a number of buyers enter the market with cash on hand seeking good deals.

Understand your long-term growth realities.

While the economy is expected to undergo further recovery in 2010, many mid-size firms are simply not going to be able to grow at the same rates experienced in the 2003-2008 period. Given modest growth expectations, overall business growth in the next three to five years will not be significantly higher than its current state in 2010.

It is projected that the economy will grow at an average rate of less than 3.5% for the next 3-5 year, which will mimic the growth of most industries. (There are, of course, exceptions to every rule.) Given this outlook, a company should consider a realistic growth projection as part of their calculations for keeping their business or selling it now or five years from now. This is especially so considering what will most likely be a higher capital gains tax rate in 2011 and beyond.

Think critically about timing.

Early in 2010, the market will be more favorable to sellers, who will have a range of potential buyers to choose from. Moreover, the capital gains tax rate increase puts buyers not paying all cash at a disadvantage, since the increased tax rate will apply to deferred payments at the time the payment is made. Deferred payments are likely to continue into 2011 and beyond for non-cash buyers. Therefore, sellers are more likely to find buyers with cash in hand earlier in the year.

In addition to increased choice of buyers, owners are in a better negotiating position earlier in 2010. As potential buyers know that sellers have a range of options and varying deal structures to minimize tax obligations, they are more likely to agree to terms favorable to the seller. As 2010 progresses, the buyer will be able to use the impending tax increase as leverage in deal negotiations, aware the seller has significant motivation to close before 2011. In fact, if negotiations are still ongoing in 4Q10, buyers are likely to try and discount the purchase price by 1% to 5% or seek tougher terms in the purchase agreement, knowing the seller will try and avoid paying the higher tax rate.

While not appropriate for all owners, those considering a sale in the near-term future are likely to experience favorable conditions 2010 as closing before year end avoids paying higher capital gains taxes. Additionally, early movement will prove advantageous for sellers by yielding a greater range of potential buyers and a strong position in deal negotiations. Overall, 2010 is likely to experience a significant revival in M&A activity, attracting a number of interested buyers to the market.

Could Capital Gains Tax Break Encourage Business Incorporation?

There is some interesting legislation surfacing that could fuel business incorporation. President Obama is backing a proposal that eliminates capital gains tax on investments made in 2010 and 2011 on qualifying small businesses. "We should eliminate all capital gains taxes on small business investment so these folks can get the capital they need to grow and create jobs " said Obama at a February Town Hall meeting in Nashau, N.H. "That's particularly critical right now, because bank lending standards are tightened since the financial crisis and many small businesses are still struggling to get loans". The president believes in the proposal and so do the majority of small business owners according to a recent poll. PNC Financial Services Group polled 500 small business owners and 60% believe the proposal would benefit small business.

The tax break does not support all business incorporation or benefit all investors. The tax break applies only to individual "angel" investors who invest in the early stages of small privately held corporations.

Sorry LLCs and S-corps, you can only qualify for the tax break if you invest in a C-corporation with assets of less than $50 million. Other restrictions prevent newly incorporated businesses in fields like farming, accounting and law, restaurants and hotels, or banking and finance from benefiting. The tax break is geared towards corporations in fields that are believed to have high-job growth potential such as manufacturing and technology.

Also, the investor has to purchase "original issue" stock. Original issue is stock purchased directly from the company. Additionally, the stock must be held for at least five years.

What about AMT? The alternative minimum tax (AMT) is a tax structure that is aimed at eliminating deductions from high income filers. Those investors that would have the cash flow to support business incorporation are generally subject to AMT exposure. In this proposal the impact of AMT is eliminated 100%.

Before you form an opinion on the new proposal, let's look at the current law. Under current law, the exclusion for purposes of the regular income tax system of 50% of the recognized gain on the disposition of qualified small business stock (which was increased recently under the American Recovery and Reinvestment Act to 75% for issuances after February 17, 2009) is substantially undercut by the combination of the high 28% rate of tax applicable to the non-excluded portion of the gain under the regular income tax and the AMT rules.

Of course with any legislation there are going to be supporters and skeptics. But small business owners are hopeful that investors will have an incentive to give business incorporation a shot in the arm.

To learn more about how Capital Gains Tax Break Encourage Business Incorporation click here: http://www.ezonlinefiling.com/incorporate-1.php