Recently, the seller
of a Sub Chapter S Corporation with an $8 million transaction value
contacted me. The tax basis was below $200,000 and $4 million of the
transaction value was the assumption of debt. When the dust settled, he
was looking at a capital gains tax liability of a staggering $965,000
while only receiving the remainder of proceeds after the assumption of
debt. The assumption of debt is considered as part of the capital gain
for tax purposes.
The owner sent his
accountant’s spreadsheet to me and since I am not a tax accountant, I
sent it to my tax wizard at BDO Seidman. He found a few small tweaks,
but said that there was not much that could be done from an accounting
standpoint for this owner. When I reported this back to the seller I
could feel his disappointment and frustration.
So I began my quest
for a better solution. After several dozen phone calls to my
professional network, I was directed to a little known vehicle called a
Private Annuity Trust. This vehicle has passed the scrutiny of the IRS
and the Tax Court. It is not a way to avoid the payment of taxes, rather
a method of deferring them with substantial economic benefit to the
owner’s beneficiaries. Below is a simplified description of the
process. As the owner contemplates the sale of his business (or any
highly appreciated asset for that matter) he “sells” it to a trust
PRIOR to its ultimate sale. This trust purchases the asset
at FMV and exchanges an annuity payment stream complete with IRS life
expectancy tables and interest rates. The trust then sells the company
to the buyer to fund the annuity. The transaction is accompanied by a
gift to the trust in the amount of 7% of the face value of the annuity.
This is so it qualifies as a trust by creating an entity with economic
value. Remember, the private annuity is viewed as having zero economic
value because the asset minus the obligation theoretically equals zero.
The trust is in the
name of the owner’s beneficiaries and all aspects of the trust are
controlled by the trustees/beneficiaries and not by the owner. The
trust for the benefit of the heirs owns the assets and owns the annuity
payment obligation. The trust can be structured to defer the annuity
payments for a period of time to coincide with the owner’s need to
receive these payments, lets say, for example, ten years During those
ten years the trust’s investments or a commercial annuity grow without
incurring a tax bite for the business sale. When the annuity payments
start, the owner is taxed at his then current tax rate for the portion
of the annuity payment attributable to the capital gains, his basis (no
tax), and depreciation recapture from the sale, and the income produced
from the annuity. The annuity pays the owner and spouse this annuity
payment until last to die or until the annuity investments run out. If
the owner and spouse die, any remaining assets are transferred to the
beneficiaries outside of estate tax liability.
If your investments
perform at the rate used in the annuity calculation and the last to die
lives to their exact life expectancy, theoretically the trust value will
be whatever the gift portion (7% of the selling price) has grown to.
However, if the investments do very well and you outlive the life
expectancy tables, you could receive payments well in excess of the
original annuity face value. Those excess payments would be taxed at
your then current income tax rate. If the investments do well and the
value grows above the required annuity reserve amount, the excess can be
distributed to the beneficiaries as income.
In the simplest of
views, this acts like an IRA. You are not currently taxed on the amount
you put in, it grows tax deferred and you pay taxes upon distribution,
hopefully at a far more favorable tax rate. In the case of the
frustrated seller from above, what if he deferred all payments by ten
years on the full sale price and the $965,000 in capital gain taxes
owed? He had a life expectancy of 20 years beyond the start of the
distributions. The $965,000 that he did not pay in taxes grows at 7% to
$1,939,323 by the time distributions start. Every annuity payment
contains a portion of the capital gain or 1/20th of the total
capital gain annually. Therefore, the bulk of the resulting investment
value of the capital gains tax deferral provides huge returns for years
to come.
If it seems too good
to be true, remember it is tax deferral and not tax avoidance. The
owner has sold his business first to the trust in return for an annuity
payment stream. The owner cannot control the trust. To the extent that
the owner wants immediate access to some of the sales proceeds, he would
pay all taxes in proportion to the amount he is receiving. In cases
like the one above, this tax deferral tool can have a dramatic impact on
the financial status of the owner and his heirs by allowing the tax
deferred funds compound for many years before their ultimate
distribution and the payment of any tax.
David Kauppi is business broker with Mid Market Capital,
Inc. MMC is a merger and acquisition firm specializing in providing
intermediary services to entrepreneurs and middle market corporate
clients in a variety of industries. The firm counsels clients in the
areas of merger and acquisition, divestitures, succession planning,
valuations, and exit planning. Dave is a Certified Business Intermediary
(CBI), a licensed business broker, a Certified Estate Advisor (CEA), and
a member of IBBA (International Business Brokers Association) and the
MBBI (Midwest Business Brokers and Intermediaries). Contact Dave Kauppi
at (630) 325-0123, email davekauppi@midmarkcap.com or visit our Web page
www.midmarkcap.com.
