Business Brokers: Tax Issues #2
Taxes. What, again?!?
That’s right. Another riff.
But this one is about a somewhat little known method designed to help our clients – the sellers of the businesses we represent – defer taxes on the gains they realize from their work building a valuable enterprise.
Last week’s post discussed the looming threat of significantly higher capital gains taxes in the U.S, Canada, Australia, the U.K. and pretty much every other English-speaking jurisdiction on the planet. This post is about a vehicle that sellers can use to soften that blow.
The vehicle in question is called a Deferred Sale Trust.
A deferred sale trust is a vehicle used to defer capital gains tax when selling certain assets that are subject to the capital gains tax.
Instead of receiving the sale proceeds at closing, the money is put into a trust and only taxed as the funds from the sale are paid out of the trust. This strategy allows the seller to reinvest the money from the sale into investments that may not be allowed by other capital gains tax deferral strategies.
How it Works
Deferred sales trusts were created as a way to work with a tax law that protects a taxpayer from having to pay taxes on money that they’ve not yet received.
In the U.S., it differs from a so-called 1031 Tax Deferred “Like-Kind” Exchange, generally associated with commercial real estate, in that a Deferred Sales Trust does not impose strict – and relatively short – time limits within which the tax payer must act.
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For the purposes of business brokers and how we advise clients, the idea behind a deferred sale trust as it would be used in a transaction whereby a business is sold is for the business owner to sell the business to the trust with the sale being structured as an installment sale.
The trust then immediately – even concurrently – sells the business to the ultimate buyer. The proceeds are placed in the trust without the seller having to pay taxes on any of the capital gains – because the seller has not received any of the proceeds of the sale; the trust has.
Because the trust sells the business for the same amount it paid for it with the installment sales contract, the trust doesn’t face any capital gains tax liability.
The installment sales contract – the vehicle used by the seller to sell and by the trust to buy the business – is exactly what it sounds like; a purchase agreement that allows the buyer – in this case, the trust – to pay for the business over time. The time period can be whatever the seller wants it to be.
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For example, if the gain on the sale of the business is $2 million, that sum can be invested by the trust thereby earning additional gains. The installment sales contract can be structured so that the trust pays for the business in regular “installments” – monthly, quarterly, annually – or on any other schedule the seller wants – for a period of years.
Ya Gotta Follow Da Rules!
A deferred sale trust has to be set up properly, and specific rules must be followed throughout the process in order to enjoy the tax benefits. This means that one of the advisors in a transaction where the seller wants to take advantage of this strategy to defer taxes must be a tax attorney or accountant that has experience in setting up a deferred sale trust.
Simply explained, the process for using a deferred sale trust looks like this:
- A third-party trust is formed that will be managed by a third-party trustee.
- The business is sold to the trust using an installment sales contract; which means the trust pays for the business over time.
- The trust sells the business to the buyer and receives the funds buyer’s funds immediately.
- The third-party trustee invests the funds.
- The third-party trustee distributes installment payments to the seller as outlined in the installment sales contract.
- Capital gains taxes are paid on any principal amount the seller receives from installment payments.
Capital gains taxes are paid when you profit from the sale of a business or investment property. Using a deferred sale trust doesn’t eliminate capital gains taxes, but it does allow them to be deferred while the proceeds of the sale of the business is reinvested – and making more money.
The seller can direct the trustee to invest the funds however the seller wants them invested and can thereby earn income on the sale proceeds while it sits in the trust. The seller – our client – begins paying capital gains taxes only when he or she starts receiving principal payments from the trust.
The Bottom Line
The installment sales contract that transfers the business to the trust is like seller financing – but the seller is financing the purchase of his or her business by the trust not for the ultimate buyer. The buyer buys from the trust purchase price is transferred to the trust at closing.
The installment sales contract can be set up however the seller wants to structure it, with periodic “installment” payments to the seller. From the standpoint of the trust, it’s like paying for a car. The seller can begin receiving installment payments right away – or defer them for several years. Like almost any installment “loan” such payments can be spread out over many years.
When a broker suggests this to a client, it is critical to advise them that experienced talent must be brought in – and not at the last minute – to discuss the structure of the trust and then to set it up. Though the buyer doesn’t need to know the details, the purchase agreement that the buyer is party to must reflect the trust as the seller.
Again, call in the pros.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you agin next Monday. In the meantime, I hope you have a safe and profitable week.