Tax changes alone shouldn’t dictate a business owner’s decision to sell. That said, certain tax proposals under President Biden’s American Families Plan are now playing a significant role in exit planning. Most salient are (1) the proposal to nearly double the top long-term capital gains tax rate to 39.6% (or 43.4% if you include the net investment income tax), which would be the highest long-term capital gains tax rate in 100 years, with the appreciated value of unsold assets taxed at the owner’s death, and (2) the proposal to eliminate the step-up in basis on unrealized gains at death. These proposals are changing the tax calculus and upending long-embraced strategies for tax planning efficiencies.
Consider, for example, a business owner planning to make a bequest of ownership interests in the family business to his or her children at death. The owner could see that bequest treated as if it were a sale for income tax purposes, taxable at the 43.4% capital gains rates, with no basis step-up tax benefit from holding those assets until death (subject to a $1 million per person exemption, and including possible options to defer payment of the tax until the family no longer owned the business). Moreover, this tax would be independent of the gift and estate tax, currently assessed at 40% on amounts gifted or bequeathed in excess of $11.7 million per person.
Normally, the time to begin thinking about your exit strategy is at the formation of your business. Initial entity structure and ownership allocation could significantly impact the success of your exit (for example, whether your entity qualifies for Section 1202 tax treatment). It’s also wise to take steps 3-5 years before sale of the entity to leverage pre-exit gifts, sales, and funding of trusts before a firm value for the entity is set. For example, discounts to fair market value for lack of marketability and lack of control at transfer can maximize the increase in value of those assets outside of the owner’s gross estate.
However, more often than not owners don’t have the luxury of scripting the timing and path between formation and exit. When external forces (such as current market conditions) drive a sale earlier than expected, an owner can still take steps to implement an effective estate plan.
3 Proactive Steps Business Owners Can Still Take Before a Sale in 2021
1) Put governing documents in order. Be sure your Operating Agreement, Voting Agreements, Shareholders’ Rights Agreements, Buy-Sell Agreements, and the like are current and complete. Consider whether any provisions are stale and in need of an update (such as a valuation formula in a buy-sell agreement). Confirm all necessary signatures are on file and ownership information is up-to-date. Because time kills deals, eliminating potential hiccups in the due diligence phase is even more critical now as all parties are watching the tax law changes and seeking to close before year-end.
2) Leverage Estate Planning and Generational Gifting. If the sale of your business will create a taxable estate, advance planning on wealth transfer is important. There is incredible leverage pre-sale to gift and sell interests in the business prior to a market value being set by an outside buyer. Business owners can take advantage of lack of marketability and lack of control discounts for minority, non-voting interests ranging from 25-35%, depending on the circumstances. Typically, owners should complete any gifting long before signing the LOI with the buyer. The IRS has taken the unofficial position that the execution of an LOI sets a price. Pre-LOI, owners can maximize lifetime gifting planning by removing business interests from their estates at the discounted value. Any increase in value at the time of sale, along with future appreciation on the business interests, would occur outside of the owner’s estate.
If the owner simply hasn’t had time to focus on estate planning until after the LOI is signed, all is not lost. The owner may still be eligible for discounts “before the deal is done,” based on uncertainties inherent in any deal. For example, discounts for the time value of money held in escrow, probabilities of hitting earnout targets, and risk arbitrage regarding whether a deal will happen at all provide a basis for taking discounts on the value of business interests that are gifted or sold pre-sale, potentially in a range of 12-13%.
3) Leverage Charitable Gifting. If you are charitably inclined, charitable gifting prior to the sale can help you achieve your goals and at the same time yield tax efficient results. The period prior to sale of highly appreciated assets is a perfect time to consider a contribution of such property to a charitable remainder trust (CRT). An owner can gift an interest in the business to a charity and retain an interest in a periodic payment (such as an annuity) for the specified term. At the end of the term the remaining assets would pass to the charity. Tax benefits are three-fold: [1] there would be no gift tax on the gift to the charity; [2] as a tax-exempt entity the charity would pay no income tax on the sale of the interests (notwithstanding the gain on the appreciation of the company’s assets at the time of sale), and [3] the owner would receive an income tax deduction for the value of the assets given to charity in the year of transfer. IRS Section 7520 interest rates, used to calculate the annuity amount that is paid to the owner, remain low, making this a good time to consider a CRT.
The duration of seller-favorable market conditions and the final tax law changes remain uncertain. That said, advance planning is always a wise strategy. If your goal is to close on the sale of your business before year-end, it’s not too late to take steps that could have a meaningful impact.
Maribeth Younger is an attorney in Williams Weese Pepple & Ferguson’s Estate Planning and Administration group.
