Act Now? And How? Tax Considerations Prior to Transferring Your Business Ownership
With federal tax laws potentially changing in the near future, it is more important than ever to review your succession plan and/or exit plan to determine when and if now is the right time to transfer your business ownership. While it is important to not let taxes alone drive how and when to sell your business, you must weigh your options based on when and the type of transfer that best fits your goals for the future of your business.
There are several ways to transfer your ownership interest in a business, each with different tax implications. First, if you are selling your ownership interests, it is important to determine whether it will be a stock sale or asset sale if you are a corporation.
For example, in a stock sale of a C Corporation, generally, if the stock is sold at a gain from the stocks original basis, the gain is taxed at the capital gains rate on the individual shareholder level, not at the business level. The capital gains rate is generally always lower than an individual’s ordinary income rate and also allows the shareholders and business to avoid a “double tax” effect as described below. Currently, the 2021 federal long-term capital gains rate is between 0% and 20%, depending on the tax bracket of the taxpayer. The federal long-term capital gains rate ceiling is much less than the ordinary federal income tax rate of an individual that can go as high as 37% in 2021. This type of sale therefore benefits the Seller from a tax perspective.
In contrast to a stock sale, if the sale is structured as an asset sale, any gains due from the sale of assets will cause the following tax events: (i) the business to be taxed at the ordinary federal corporate tax rate and (ii) each shareholder with pay the ordinary federal income tax rate when the business is liquidated after the assets are sold. This creates a “double tax” effect that disadvantages Sellers, but allows for Buyers to enjoy more immediate tax benefits like an increase in basis and potential immediate write offs by way of depreciation.
So what is the right move? While it seems that in the Seller’s perspective from purely a tax lability standpoint that a stock sale is more beneficial than a asset sale, other factors, including, purchase price, state tax implications, the type of entity, the type of business and proposed federal tax changes may affect your decision. For example, current proposed federal changes include potentially doubling the federal long-term capital gain tax rates for taxpayers with more than $1 million of adjusted gross income. If the proposed federal changes were implemented, the scale weighing the benefits and burden of a stock sale versus an asset will shift. Further, if the entity is taxed as an S Corporation or partnership, different tax events may occur which can also tip the scales.
A second type of transfer to consider in a family situation is gifting the ownership interests. Based on your succession plan and the proposed federal changes to gift and estate taxes, you may choose to start transferring your ownership interests yet this year. Under current federal law, gift transfers during your life and after your death are both taxed at 40% unless an exemption or exclusion applies to protect the transfer from taxation. The current annual exclusion of gift tax is $15 thousand per recipient without incurring a gift tax. Additionally, the lifetime gift tax exemption is $11.7 million for a single donor and $23.4 million for a married couple. Gifts made in excess of the $15 thousand annual exclusion will first consume the lifetime exemption amount. When the lifetime exemption amount is fully consumed, a donor would then owe gift tax on any amount in excess of the lifetime exemption. These gift tax exclusions and exemptions are scheduled to drop almost in half, to approximately $6.3 million per person ($12.6 million per couple) beginning in 2026, with the potential to change sooner. Additionally, rate increases for gift and estate tax are also being discussed.
For example, if a couple owns a $15 million business, and has yet to use their $23.4 million exemption amount, they could transfer their ownership in the business to their children in 2021 (or a trust for the benefit of their children) free of gift tax, because they would have enough exemption to cover the gift. In contrast, if the couple waits to make the gift, and the exemption amount drops to $12 million per couple, then the $15 million gift after the tax change will result in a $1.2 million gift tax (i.e. [$15,000,000 – $12,000,000] x 40% = $1,200,000).
All in all, if you are looking to sell or gift your business, it is always important to factor in the current tax regulation climate into your decision. Understandably, it is hard to make a decision based on “possible” tax changes, but in the ever-changing tax world, it is something that cannot be ignored. It is always better to be proactive in your approach, so when the time is right, consult accounting and legal professionals to guide the way.