You’ve built a thriving business and poured your heart and soul into it, and now it’s time to sell and reap the rewards. Congratulations! That’s a monumental step, not just in terms of the immediate financial windfall but also for your long-term financial health. It’s an exhilarating, albeit slightly nerve-wracking, phase. 

But before you pop the champagne and sail off into the sunset, let’s talk strategy, specifically tax strategy. Yes, I know “tax” isn’t the most thrilling word in our vocabulary, but stick with me because Uncle Sam has his eye on a piece of the pie. 

Selling a business can trigger a significant tax bill, leaving you feeling like you just worked hard for someone else. Understanding and leveraging tax-deferred opportunities can significantly impact how much of that sale you get to keep and grow over time. 

What Does Tax-Deferred Mean?

Tax-deferred means you can delay paying taxes on investments and their earnings until you withdraw the money. This allows your money to grow tax-free, potentially leading to significant savings. Often, when money is withdrawn during retirement, you will be in a lower tax bracket.

Here’s an example: Imagine you sell your business for $1 million, resulting in a $500,000 capital gain. If you were to pay taxes on that amount right away, it could leave a hefty dent in your pocket. But by utilizing a tax-deferred strategy, you can hold onto that money and invest it, allowing it to grow tax-free until you withdraw it later. The longer you leave it untouched, the more it can compound, leaving you with a much larger sum.

Tax Strategies for the Savvy Seller

There are several tax-deferred opportunities available that can help you minimize your tax burden. Let’s explore some options you might want to consider.

1. Seller Financing

Have you ever thought about being the bank? In seller financing, you extend credit to the buyer to purchase the business. The buyer pays you back over time with interest. The catch? You don’t get all your money upfront. Still, it can spread the tax burden over several years, potentially keeping you in a lower tax bracket and reducing the immediate tax hit.

Pros:

  • Spreading sale proceeds over several years minimizes annual capital gains taxes for tax benefits.
  • Seller financing can speed up the closing process since there’s no waiting on the bank’s loan approval.
  • Offering seller financing widens the potential buyer pool.
  • Sellers may command a higher sales price because they’re offering financing.
  • Seller financing generates consistent interest income for sellers.

Cons:

  • One of the most significant risks for sellers is the buyer defaulting on the loan. 
  • Deferred full payment to sellers.
  • Crafting a seller financing agreement requires legal assistance to ensure the contract protects both parties. This can add to the transaction’s costs and time.
  • Sellers manage loans and address payment issues.

2. Installment Sales

Similar to seller financing, installment sales allow you to defer taxes by receiving the proceeds over time. You only pay taxes on the portion of the gain you receive each year. This can be a great way to manage your tax liability and keep more money working for you over the sale period.

Pros:

  • Pay tax only on received installment profits, deferring tax liability.
  • Installment sales enhance buyer accessibility beyond traditional financing.
  • Earn interest on financed amounts for additional income.

Cons:

  • Risk of buyer loan default.
  • Delayed full payment of sale proceeds.
  • Potential for lower future income if interest rates rise.
  • Possible decline in property value over time, complicating resale after default.

3. Qualified Opportunity Funds (QOFs)

This program was established by the federal government in 2017 and designed to spur economic development in specific areas. If you reinvest your capital gains into a QOF operating in a designated Qualified Opportunity Zone (QOZ), you can defer paying taxes on those gains until you sell your investment, or until December 31, 2026 — whichever comes first. 

You must reinvest your capital gains within six months of selling your business. If you hold the investment for at least five years, you can exclude a portion of your original capital gains from taxation. If the investment is held for at least ten years, any capital gains from the future sale of the investment are returned to you tax-free.

Pros:

  • Defer taxes on QOF gains until Dec 31, 2026, or upon sale/exchange.
  • 10% gain exclusion for QOFs held over 5 years; 15% for over 7 years.
  • After 10 years, QOF investments can grow tax-free.
  • QOF investments boost distressed areas with new jobs and development.
  • Opportunity to make a positive impact in at-need communities.

Cons:

  • As with any investment, there’s no guarantee of a return, and investing in distressed areas may carry higher risks.
  • There are strict regulations to qualify for the tax benefits, including how and when funds are invested and managed.

4. Real Estate 1031 Exchange

If your business includes real estate, a 1031 exchange allows you to defer capital gains taxes by reinvesting the proceeds from the sale of your property into the purchase of another property. Also known as a “like-kind” exchange, the IRS lets you sell one property and reinvest the proceeds in another similar property while deferring taxes on your gain. 

With careful maneuvering, real estate investors can use 1031 exchanges to keep deferring taxes indefinitely through strategic property swapping.

Pros:

  • Defer capital gains taxes on the sale.
  • By deferring taxes, investors can potentially acquire larger or more valuable properties, allowing their portfolio to grow.
  • Properties exchanged through 1031 may be inherited with a stepped-up basis, negating capital gains tax.

Cons:

  • The rules governing 1031 exchanges are complex; failing to adhere to them can result in a significant tax liability.
  • Strict timing pressures quick decisions, risking less favorable choices.
  • Not all real estate transactions qualify for a 1031 exchange. 

5. Charitable Remainder Trust (CRT)

Feeling philanthropic? A CRT allows you to contribute a portion of your business sale proceeds to a trust, which then pays you (or another beneficiary) a stream of income for a term of years or for life. After the term ends, the remainder goes to your chosen charity. This strategy can offer immediate tax deductions and reduce estate taxes while supporting a cause close to your heart.

For example, let’s say you sold your business for $5 million and contributed $2 million in proceeds to a CRT. The CRT could then pay you a set percentage of $2 million yearly, say 5%, equaling $100,000 annually. After your death, the charity of your choice would receive the remaining assets in the CRT.

Pros:

  • Claim an immediate tax deduction in the year you set up the trust and transfer assets into it.
  • If the CRT is funded with appreciated assets, assets within the trust can be sold without incurring capital gains tax at the time of the sale. This allows the full value of the assets to be reinvested by the trust, potentially increasing the income generated for the beneficiaries.
  • CRTs provide an income stream for the beneficiaries. 
  • Beyond the financial benefits, you can support causes and organizations important to you.

Cons:

  • CRTs are irrevocable; beneficiaries or terms of the trust cannot be changed.
  • Setting up and managing a CRT can be complex, requiring legal and financial expertise.
  • Income received depends on the trust’s investment performance. Poor investment performance can reduce the income stream and the ultimate charitable donation.

Let Five Pine Wealth Help You With Tax-Deferral Strategies

Smart tax planning is crucial, and every situation is unique. It’s essential to carefully evaluate your options and seek professional advice before making any decisions.

Remember, navigating the complexities of tax law can be tricky. Five Pine Wealth Management has experienced advisors who can help you determine the best tax-deferral opportunities for your situation. To schedule a meeting, send an email or give us a call at 877.333.1015.

Selling your business is a considerable achievement and the start of a new chapter. Celebrate your success, explore your options, and make informed decisions to maximize the rewards of your entrepreneurial journey.