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Thursday, May 2, 2024
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Case Studies |
A Tax-Effective Way to Sell a Closely Held Business
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Case:
Daniel and Lorraine White, both age 60, started a comprehensive financial planning business over 30 years ago. With hard work and a lifelong commitment to building the business, they now have over 30 employees who serve many of the high net worth clientele in their city. Over the years, Daniel and Lorraine have branched out into a number of financial areas, one of which is online investing. This aspect of the business has done extremely well and the company has grown substantially over the past three years. The net worth of the company is now projected to be over $5.5 million.
Daniel and Lorraine feel the time has come for them to slow down, since they have been working 50+ hours per week on average for most of their lives. They were recently offered $5.5 million for their "C" corporation stock and another $1.5 million for a three year consulting arrangement and a five-year non-compete agreement. The $1.5 million would be paid in equal installments over the three year period. After discussing the terms of the sale with their financial advisors over the past several months, Daniel and Lorraine feel that this is a very fair sales price. They like the idea of retirement but are not willing to quit working entirely. Therefore, a three year consulting arrangement is very appealing to them.
The main obstacles to selling their business are the income and capital gain tax consequences. Their tax attorney, Rebecca Ramsey, stated that the capital gain taxes on the sale alone would be $1 million, since their basis in the stock is close to zero. Then, in addition to capital gains taxes, the ordinary income taxes on the consulting and non-compete agreements are projected to be about $600,000. Daniel and Lorraine were taken back by the amount of these taxes and questioned Rebecca about recommendations she may have to reduce this tremendous tax. Her response was, "It depends."
Question:
Daniel and Lorraine were both very curious as to what she meant by the "it depends" statement. Rebecca knew that they were moderate donors to several charities. They had explained to her that they felt that they had been fortunate and would like to "give something back" to the community. In fact, their feeling is that they would like to do something very significant for the community where they have lived their entire lives. They have considered making a contribution to the local community foundation but do not want to sacrifice their lifestyle or retirement security. Also, Daniel and Lorraine would like to make a meaningful bequest to their children upon their passing.
Solution:
Rebecca then went on to explain what she meant by "It depends." Knowing their objectives, she stated that it depends how much they would like to give to charity and how much in tax they would like to save. Daniel and Lorraine responded by stating, "a significant amount and as much as possible!" Rebecca said she had a planning strategy that would work well to fulfill their objectives of giving back to the community and taking care of their children.
First of all, the Whites would create a charitable remainder unitrust and transfer $3 million of the company stock to the trust. Rebecca suggested a payout rate of 5% which would yield an income tax deduction of over $870,000. Then, $500,000 of the stock would be transferred to the community foundation to fund a Donor Advised Fund. The other $2 million in stock would be retained and sold for cash. This $2 million would be subject to capital gains tax, but the unitrust and gift deductions would reduce the net tax payable.
Lastly, the Whites would create an irrevocable life insurance trust (ILIT) for their children. By contributing approximately $20,000 to the trust each year for about eight to ten years, the ILIT should be able to purchase a second-to-die life insurance policy well in excess of $1 million. When Daniel and Lorraine pass away, the insurance will pass to the children gift and estate tax free. Also, this will preserve their lifetime exemption equivalents. They may still use their estate tax exemptions to transfer additional sums to the children free of estate tax.
By creating the charitable remainder trust and the Donor Advised Fund, no capital gain taxes will be due on the sale of $3.5 million of company stock. The charitable deductions generated by these two charitable transfers will result in significant tax savings. These savings would significantly reduce the tax on the sale of the retained stock and the income received from the consulting/noncompete agreement. Daniel and Lorraine retain control over which charities will receive the unitrust assets upon their passing (projected to be over $6.8 million based upon their life expectancy and an overall trust return of 8%). Also, by creating the Donor Advised Fund, they have the ability to give to various charities during their lifetime. Finally, as a result of choosing a 5% unitrust payout rate, they will receive $150,000 per year from the trust which will continue to increase throughout their lifetimes.
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