Viewpoints

Smart Owners Reduce Retirement Tax Bite

Eileen Semmler

Originally Published In:
BUSINESS STRATEGIES MAGAZINE
June 2006
Author: Eileen Semmler, CPA

There are more than 12 million business owners in the United States, many of whom are over 50 years old and will leave their companies within the next ten years.   Yet, the majority will have done little or no advance planning for their eventual exit.
Advance planning can mean the difference between leaving on your own terms with your personal and financial goals met or having to liquidate assets in a “fire sale” with less than ideal income tax consequences.

Business owners tend to focus their efforts on creating a profitable and growing company.  But attention must also be paid to creating value that is saleable and preserving that value even after your retirement, as it is likely that your company will be the funding mechanism for your payout.  Some things to consider in planning your exit include: the timing of your retirement; a reasonable estimate of the value of the company and the cash flow you will require from it; how your expertise and talents will be replaced; who you would like to run the business and their capabilities; the financing of the deal; and of course, the tax consequences.

Sale To An ESOP

If you desire is to sell your business to your employees, consider an employee stock ownership plan (ESOP) – a qualified plan adopted by the business to invest primarily in employer securities.  In a closely held business, an ESOP provides a buyer for the owner’s stock, which may not otherwise exist.

In general terms, the ESOP would borrow the money required to affect the purchase and employer contributions are made in an amount necessary to amortize the ESOP loan.  The corporation receives a tax deduction for the contributions, which may be limited based on compensation of employees plus the interest paid on the loan.
The shareholder may defer gain on the sale of stock to an ESOP if he reinvests the proceeds in publicly traded stocks and bonds.  Under current tax law, if the seller holds the replacement securities until death, his heirs will get a step up in basis to fair market value and the gain on the disposition of the business interest will never be taxed.

Attention must be paid to creating and preserving value even after your retirement, as it is likely that your company will be the funding mechanism for your payout.
Use of an ESOP is a complicated transaction, but the tax benefits can be substantial.  This strategy may allow a sale to employees that would otherwise be personally unable to fund the purchase.

Sale To A Charitable Remainder Trust

If you are planning on selling the stock in your business to an outside party, you might avoid the individual capital gain tax by using a charitable remainder trust (CRT).  In fact, a CRT can also be used to yield a current income tax deduction, but the trust must be created and the business must be transferred to the trust before the owner has a binding obligation to sell the business to a third party.

The tax savings on the transfer allow you, as trustee, to invest the entire proceeds within the trust to producce more income to fund your living expenses in retirement.  You can even use the tax savings from the charitable deduction to fund a life insurance policy to replace the asset for your heirs – a win on any level, particularly if you desire to make a substantial charitable contribution anyway.

Sale to A Grantor Trust

A grantor trust is a trust where the grantor (generally the person who contributed the assets) is treated as owning the assets for income tax purposes.  For this reason, transactions between the grantor and the trust, including sales, are not recognized for income tax purposes.  However transfer to a properly structured grantor trust are recognized for gift and estate tax purposes.

This technique is particularly useful if you expect your business to experience significant growth after the transfer.  The business interest transferred to the trust will not be included in your gross estate and there will be no taxable gift if the grantor receives fair market value of the transferred interest.

Properly structured, you may be able to transfer most of your business interest (and its future appreciation) at a significant discount while retaining control over the business throughout your lifetime.

Disclaimer: The Bonadio Group provides the information in Viewpoints for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in Viewpoints are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.