Planning opportunities don’t automatically end for business owners once their business has sold. That’s especially true for younger entrepreneurs who may not prioritize succession planning or wealth transfer like those nearing retirement. If you’re like them, you’re probably already thinking about your next venture—while also looking to minimize taxes when selling your business.
That was a major goal for Mike and Molly, a 38-year-old couple who received an $80 million offer for their business from a private equity firm. The deal consisted of $55 million of cash up-front and $25 million of rolled equity. While initially excited, the couple were concerned about the $15.95 million tax bill on the up-front cash.1 To minimize the burden, we explored several post-transaction tax mitigation strategies, including:
- Pass-Through Entity (PTE) Tax election
- Qualified Opportunity Fund (QOF)
- Donor-Advised Fund (DAF)
Pass-Through Entity (PTE) Tax
The state Pass-Through Entity (PTE) Tax election was designed to eliminate the adverse impact of the $10,000 State and Local Tax (SALT) deduction cap for partnerships and S corporations. To date, it’s been an effective way for pass-through entities to deduct a portion of state income taxes paid against federal income.
Since Mike and Molly’s company was structured as an S corporation, they were able to deduct the amount paid for state taxes on the sale. This reduced their federal taxes owed by $990,000, netting them 2.54% of savings.
Qualified Opportunity Fund (QOF)
While the PTE Tax was beneficial, Mike and Molly wanted to look for other ways to minimize taxes when selling their business. Though its benefit has diminished slightly, a Qualified Opportunity Fund (QOF) remains available for deferring previously realized capital gains through reinvestment.2 The strategy offers additional tax benefits by allowing investors to potentially receive tax-free income during the life of the fund. And if the investor holds their investment for 10 years, any gains within the fund itself will also be avoided.
By deploying $1 million of their eligible gains into a QOF, Mike and Molly further reduced their tax bill by deferring federal and state taxes on this amount, which ultimately would have cost them $290,000.3 Coupled with the PTET election, this move provided them with total tax savings of $1.26 million, or 3.23%.4 Already, they were further ahead than if they’d done no planning at all.
Donor-Advised Fund (DAF)
Since they’d always been charitably inclined, Mike and Molly also decided to make a $1 million gift to a donor-advised fund. They did not have any existing highly appreciated assets, so they used cash from their deal.5 The gift provided them with a $1 million tax deduction that could offset some of the taxes on their business sale. By combining the charitable gift with the PTE Tax and QOF, they saved a total of $1.46 million. While seemingly small, this additional 3.74% in wealth would help defray other costs, such as funding attorney or banker fees.
Tax-Loss Harvesting
When aiming to minimize taxes when selling your business, keep in mind that not all taxes hit at once. For instance, to help Mike and Molly prepare for future taxes in 3 to 5 years when the rolled equity sells, we recommended that they invest some of their cash proceeds in an active tax-loss harvesting portfolio. The strategy is designed to achieve a pre-tax return that is similar to its benchmark while outperforming on an after-tax basis. Knowing the couple faces a substantial tax liability in the future, banking these losses during the interim period would go a long way toward funding this looming obligation.
With our thoughtful analysis and tax reduction strategies, Mike and Molly were able to pave the way for additional planning opportunities. This includes allocating funds toward future children’s higher education expenses and developing a strategic investment plan aligned with their goals. Ultimately, by minimizing taxes when selling your business, you can use the savings toward the future success of your next venture.
- Elizabeth Sohmer, CFA
- Associate Director—Institute for Executives and Business Owners
- Andrew Bishop, CFA
- Director—Wealth Strategies Group
1 Assumes business sale was structured as an asset sale where the initial cash proceeds received were taxable at a capital gains rate of 29% (20% federal + 9% state). Therefore, after-tax proceeds, absent any planning, would be $39.05 million.
2 The deferral lasts until the earlier of the date on which the investment into the QOF is sold or exchanged, or December 31, 2026.
3 Assumes the entity (as opposed to the individual investor) made the QOF investment.
4 Benefit is overstated due to the tax liability being deferred, as opposed to eliminated entirely.
5 Giving shares of a company to a DAF prior to a sale will have a higher benefit since the units owned by the DAF will not be subject to capital gains taxation at the time of the sale, further reducing the effective cost of the gift. Note: The pre-transaction charitable deduction is based on the fair market value of the units on the contribution date, as determined by a qualified independent appraisal. (IRC §170(e)(1) and Treas. Reg. §1.170A-1(c)(1)). The appraisal value may be subject to valuation discounts, reducing the value of the deduction. Additionally, the DAF may earn income that is taxable to the charity as unrelated business taxable income. Furthermore, the IRS may deem the capital gains tax unavoidable to the donor depending upon the timing of the pre-transaction contribution. A post-transaction contribution of cash or appreciated marketable securities avoids these potential issues.