Selling your business is one of the most significant financial events you will ever experience. But alongside the excitement of closing a deal and moving on to new opportunities, there's often a looming concern: capital gains taxes. Many business owners find themselves frustrated by how much they stand to lose to taxes when selling an appreciated asset, such as a business they've spent years building.
In my M&A practice, I encounter sellers who hesitate to plan their exit because they're worried about the hefty capital gains tax bill that might follow. But recently, I’ve come across a tool that could help these sellers potentially defer these taxes for years — or even generations: a Deferred Trust. In this post, we’ll dive into how a Deferred Trust can provide a solution to manage capital gains taxes effectively and why it could be a game-changer for business owners looking to sell.
The Basics of Capital Gains Taxes on Business Sales
When you sell your business, capital gains taxes are calculated based on the profit you make from the sale. This is usually the sale price minus your "basis"—the amount you’ve invested in the business. If you’ve held the business for more than a year, you’re generally taxed at the long-term capital gains rate, which is lower than ordinary income tax rates. However, depending on your income level, this can still be a hefty tax, reaching up to 20% at the federal level, not to mention potential state and local taxes.
For example, imagine selling your business for $10 million with a basis of $2 million. This results in a taxable gain of $8 million, meaning you could face a federal tax bill of $1.2 to $1.6 million, and even more depending on where you live. For many business owners, this is a tough pill to swallow.
How a Deferred Trust Can Help Defer Capital Gain Taxes
A Deferred Trust, sometimes referred to as a Deferred Sales Trust (DST), is a legal structure designed to help you defer capital gains taxes when selling an appreciated asset like your business. The strategy works by allowing you to transfer the business into the trust before selling it, thus deferring the capital gains taxes that would usually be triggered at the time of sale.
Here’s how it works: instead of selling directly to a buyer, you first sell your business to the trust. The trust then completes the sale with the buyer, and because you receive a promissory note instead of immediate cash, the gain is deferred. The trust reinvests the proceeds into income-generating assets, which can then provide you with a stream of income. The payments you receive over time will spread out your capital gains liability, potentially lowering your overall tax bill.
Why Consider a Deferred Trust?
1. Tax Deferral
The most significant advantage of a Deferred Trust is the ability to spread out and defer capital gains taxes over time. Instead of facing a massive tax bill all at once, you manage the timing and amount of the taxes you pay as you receive distributions from the trust.
2. Flexibility and Control
With a Deferred Trust, you get more control over how and when you receive the proceeds from the sale. You can customize your payments, which may allow you to stay within a lower tax bracket, helping you optimize your overall tax strategy.
3. Diversification
Once the trust receives the proceeds from the sale, it can invest in a variety of income-generating assets. This allows you to diversify your wealth beyond the sale of your business, spreading your risk across different investments.
4. Estate Planning Benefits
A Deferred Trust can be an excellent tool for estate planning. By using the trust as part of a larger estate strategy, you may be able to reduce estate taxes and pass wealth on to future generations in a tax-efficient manner.
Key Considerations Before Setting Up a Deferred Trust
While a Deferred Trust offers numerous advantages, it’s essential to understand the potential complexities and challenges.
Costs and Complexity: Setting up and maintaining a Deferred Trust requires the involvement of experienced professionals, including attorneys and financial advisors. The costs of creating and managing the trust should be considered as part of your decision-making process.
Ongoing Management: Managing the trust and its investments will require ongoing attention, which could be time-consuming and may come with additional fees.
Investment Risks: Like any investment, there are risks involved. The trust will need to make sound investments to generate returns. Poor performance could reduce the income you receive over time.
IRS Compliance: While Deferred Trusts are legal, they can draw scrutiny from the IRS if not set up and managed correctly. It’s crucial to work with professionals who are familiar with the regulatory requirements.
Who Should Consider a Deferred Trust?
If you're a business owner facing a substantial capital gains tax bill and you're looking for a way to defer those taxes, a Deferred Trust could be worth considering. This strategy may also appeal to those looking for more control over their income after the sale, those interested in diversifying their investments, or those integrating estate planning into their exit strategy.
The Importance of Professional Guidance
While a Deferred Trust can be an excellent strategy for deferring capital gains taxes, it’s not a one-size-fits-all solution. The complexity of tax laws, estate planning, and business sales requires specialized expertise. Consulting with a qualified financial advisor, tax professional, and estate planning attorney experienced in Deferred Trusts is crucial to ensuring you are making the right decision for your specific financial situation.
Conclusion
Capital gains taxes can take a significant bite out of your profits when selling a business, but a Deferred Trust offers a potential way to defer taxes, manage your income, and maintain control over your financial future. If you’re a business owner worried about the tax implications of a sale, it’s worth exploring whether a Deferred Trust could be the right solution for you.
Important Disclaimer: I am not a tax advisor, and none of this information should be considered reliable in your specific financial situation. You must consult with a professional tax advisor and an estate planning attorney familiar with Deferred Trusts to make informed decisions.
Dr. Allen Nazeri, aka "Dr. Allen," boasts over 30 years of global experience as a healthcare entrepreneur. He is the Managing Director at American Healthcare Capital and Managing Partner at PRIME exits. Dr. Allen provides strategic growth consulting to leadership teams of both privately held and publicly listed companies, ensuring their preparedness for successful exits.
He holds a Dental Degree from Creighton University and an MBA in M&A and Investment Banking from the University of Bedfordshire. Dr. Allen is the author of "Value Engineering: Strategies to 10X the Value of Your Clinic and Dominate the Market!" and the brand new book "Selling Your Healthcare Company at a Premium". Dr. Allen offers a free valuation to business owners ready for a partial or complete exit strategy. Dr. Allen collaborates with strategic buyers, private equity firms, and institutional investors, taking direct accountability for the annual successful sell-side representation of nearly $750M in enterprise value.
To have a confidential discussion about your company and receive a free valuation, please email Allen@ahcteam.com or Allen@ahcpexits.com
You can now communicate with Dr. Allen's clone https://www.delphi.ai/drallen
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