Selling Your Business - A Tool To Reduce Capital Gains Taxes

"I would rather expire at my desk than to sell myof time to coincide with the owner's need to receive
business and pay Uncle Sam one dime in taxes." Howthese payments, lets say, for example, ten years
many owners that have paid their fair share of taxesDuring those ten years the trust's investments or a
for twenty years of building their business feel thiscommercial annuity grow without incurring a tax bite
way? The tax bite is the single biggest factor in anfor the business sale.
owner's reluctance to sell his/her company.When the annuity payments start, the owner is taxed
I have previously written articles discussing variousat his then current tax rate for the portion of the
aspects of transaction structures to minimize taxes.annuity payment attributable to the capital gains, his
As a result, I am often contacted by a panicked sellerbasis (no tax), and depreciation recapture from the
that is a week from closing his business sale as hesale, and the income produced from the annuity. The
looks in disbelief at his accountant's spreadsheetannuity pays the owner and spouse this annuity
detailing the tax burden of his impending sale.payment until last to die or until the annuity investments
Recently, the seller of a Sub Chapter S Corporationrun out. If the owner and spouse die, any remaining
with an $8 million transaction value contacted me. Theassets are transferred to the beneficiaries outside of
tax basis was below $200,000 and $4 million of theestate tax liability.
transaction value was the assumption of debt. WhenIf your investments perform at the rate used in the
the dust settled, he was looking at a capital gains taxannuity calculation and the last to die lives to their
liability of a staggering $965,000 while only receivingexact life expectancy, theoretically the trust value will
the remainder of proceeds after the assumption ofbe whatever the gift portion (7% of the selling price)
debt. The assumption of debt is considered as part ofhas grown to. However, if the investments do very
the capital gain for tax purposes.well and you outlive the life expectancy tables, you
The owner sent his accountant's spreadsheet to mecould receive payments well in excess of the original
and since I am not a tax accountant, I sent it to my taxannuity face value. Those excess payments would be
wizard at BDO Seidman. He found a few smalltaxed at your then current income tax rate.
tweaks, but said that there was not much that couldIf the investments do well and the value grows above
be done from an accounting standpoint for this owner.the required annuity reserve amount, the excess can
When I reported this back to the seller I could feel hisbe distributed to the beneficiaries as income.
disappointment and frustration.In the simplest of views, this acts like an IRA. You are
So I began my quest for a better solution. Afternot currently taxed on the amount you put in, it grows
several dozen phone calls to my professional network,tax deferred and you pay taxes upon distribution,
I was directed to a little known vehicle called a Privatehopefully at a far more favorable tax rate. In the case
Annuity Trust. This vehicle has passed the scrutiny ofof the frustrated seller from above, what if he
the IRS and the Tax Court. It is not a way to avoid thedeferred all payments by ten years on the full sale
payment of taxes, rather a method of deferring themprice and the $965,000 in capital gain taxes owed? He
with substantial economic benefit to the owner'shad a life expectancy of 20 years beyond the start of
beneficiaries.the distributions. The $965,000 that he did not pay in
Below is a simplified description of the process. As thetaxes grows at 7% to $1,939,323 by the time
owner contemplates the sale of his business (or anydistributions start.
highly appreciated asset for that matter) he "sells" it toEvery annuity payment contains a portion of the
a trust PRIOR to its ultimate sale. This trust purchasescapital gain or 1/20th of the total capital gain annually.
the asset at FMV and exchanges an annuity paymentTherefore, the bulk of the resulting investment value of
stream complete with IRS life expectancy tables andthe capital gains tax deferral provides huge returns for
interest rates. The trust then sells the company to theyears to come.
buyer to fund the annuity.If it seems too good to be true, remember it is tax
The transaction is accompanied by a gift to the trust indeferral and not tax avoidance. The owner has sold
the amount of 7% of the face value of the annuity.his business first to the trust in return for an annuity
This is so it qualifies as a trust by creating an entitypayment stream. The owner cannot control the trust.
with economic value. Remember, the private annuity isTo the extent that the owner wants immediate
viewed as having zero economic value because theaccess to some of the sales proceeds, he would pay
asset minus the obligation theoretically equals zero.all taxes in proportion to the amount he is receiving. In
The trust is in the name of the owner's beneficiariescases like the one above, this tax deferral tool can
and all aspects of the trust are controlled by thehave a dramatic impact on the financial status of the
trustees/beneficiaries and not by the owner. The trustowner and his heirs by allowing the tax deferred funds
for the benefit of the heirs owns the assets and ownsto compound for many years before their ultimate
the annuity payment obligation. The trust can bedistribution and the payment of any tax.
structured to defer the annuity payments for a period