When you have built a business from the ground up, selling it would not be just any transaction! It is your legacy and there are many aspects you would be taking into consideration when selling it.
Putting emotions aside- if you are not prepared when selling your business, you may even end up incurring losses. One such aspect in this regard that many business owners overlook is capital gains tax. If you are not prepared, it can take a massive bite out of your proceeds.
So why do most business sellers end up paying it in full when capital gains tax deferral options are available? If you are planning your exit, it may help to learn how you can avoid a massive tax bill.
Let’s learn how!
- Overview of Capital Gains Tax Explained
If you are selling your business at a profit, the IRS will be coming for a share! The profit that you earn from sale- the difference between what you sell it for and your original investment- is classified as a capital gain.
Now, depending on how long you have owned the business and the structure of the sale, your tax could range from 15% to 30% when you include federal, state and probably even net investment income tax.
For instance, if you sell your company for $5 million and your cost basis is $1 million, that $4 million gain could result in over $800,000 in taxes- money that would vanish from your earnings just like that! That is the money you could have invested somewhere, used for your retirement or passed on to your heirs.
Yet, unfortunately, many business owners go into a sale with zero capital gains tax planning, which means they usually leave hundreds of thousands or even millions on the table!
2. Introduction to Deferred Sales Trust (DST)
What many business owners do not know that there is a legal, IRS-sanctioned tool that allows you to defer those taxes and take more control over your financial future- the Deferred Sales Trust, or DST.
A DST is essentially a business sales tax strategy that leverages IRS Code Section 453 (installment sale rules). It lets you defer capital gains by not receiving the full sale amount upfront. Instead, you are paid over time through a trust.
However, do not worry as this does not mean you are giving up your money. In fact, you can earn interest, reinvest the proceeds and probably pay far less in taxes over time.
If you are considering selling your business, knowing about DST may save you from paying an exorbitant amount in the name of taxes.
3. How a Deferred Sales Trust Actually Operates
Here is a simple explanation of how a deferred sales trust works.
- Setting Up a Trust
Before you sell the business, work with legal and financial professionals to set up a deferred sales trust- an independent, irrevocable entity.
- Selling the Business to the Trust
You sell your business to the trust in exchange for a promissory note. This is a legally binding agreement where the trust agrees to pay you over time.
- Trust Sells to the Buyer
Then, the trust sells the business to the actual buyer for the same price that was agreed upon. Since the trust technically owns the asset at the time of the sale, you do not receive the full proceeds upfront- and that is what enables capital gains tax deferral.
- You Receive Installment Payments
Over time, the trust pays you based on the terms you set- monthly, quarterly, annually- that is up to you! And because you did not receive the full sale proceeds all at once, your capital gains tax is spread out, usually at a lower rate.
This is how you do a tax-efficient business sale!
4. Key Advantages of a Deferred Sales Trust
Now that you know how it works, let’s talk about why smart business sellers are employing DSTs
- Defers immediate capital gains tax- This is the main benefit! Instead of writing a massive check to the IRS the year you sell your venture, you get to keep more of your proceeds. You can then make them work for you- invest the money to earn returns and grow your wealth.
- Flexibility in income timing- You can structure the payments to meet your personal cash flow needs- hence, making it ideal for business exit financial planning. Whether you want income for ten years, life or for your heirs, it is customizable according to your needs.
- Investment growth inside trust- The trust is not only holding your money- it can reinvest in real estate, private equity, securities or back into your own ventures. This way, you get investment flexibility without triggering immediate tax.
- Estate Planning benefits- DSTs can be tied into your estate plan, which reduces estate exposure and helps you pass on more wealth. In some cases, if it is combined with an irrevocable life insurance, it can eliminate capital gains and estate entirely.
- Peace of mind and control- This is probably one of the best benefits for sellers. You are not relying on buyer financing. You are not bound by a standard plan. You have legal and financial professionals structuring that deal with your best interests in mind.
5. Final Thoughts
Most business owners do not implement a DST for one of three reasons:
- They do not know it exists.
- They assume it is too complicated
- They find out too late about it
But the good news is, now you know!
If you are planning to sell your business within the next 6 to 24 months, this is the time to explore your business sale tax strategy options. Also keep in mind that DSTs are not something you can set up after the sale and have to be structured before you sign a purchase agreement.
When you get a jump on your capital gains tax planning, you can transform a one-time sale into a durable source of income, lower your taxes and give yourself more freedom when you retire or start your next business adventure.
So, if you are considering your exit strategy, talk to a tax-savvy advisor who understands how to structure a tax-efficient business sale using advanced tools like DSTs. You are not only avoiding taxes, but also maximizing your finances for the future.
You have put in so much effort and time into your business. After all the years, late nights, risks, wins and losses; you deserve to walk away with more than what the IRS says you can keep!
Keep an eye for more latest news & updates on Buzz Telecast!
