With proper planning, time, and consideration of all contingencies, you can get the most out of prospective merger and acquisition (M&A) transactions as there are plenty of tax opportunities to protect and maximize business value. Achieving optimal tax outcomes begins with having a firm understanding of available strategies that defer, exclude gains, leverage deductions, and tactics for attaining preferred tax rates or double tax benefits when opportunities present themselves.
Why defer taxes on transactions?
Deferring taxes on M&A transactions can provide different benefits depending on the situation and the goals of the owner. In certain cases, deferring taxes allows the business to pay taxes at a later date when it is more agreeable to business strategy or can lead to a lower rate. Tax deferral can also permit full reinvestment of gains or transfer of ownership for other assets without realizing gain today.
- Installment sale: By accepting payment for the sale of business stock or certain assets over time, gains can be reported in the year payments are received instead of the year of the sale.
- Like-kind exchange: Real estate gains can be deferred if sale proceeds are held for future investment or put to productive use for your business when reinvested into qualifying replacement property.
- Tax-free exchange: Exchanges of securities, capital assets or stock can be made for stock in another corporation without recognizing gain. Similarly, a corporation can exchange its own stock for property or services under the same tactic.
- Sale of C-corp stock to an Employee Stock Ownership Plan: Shareholders can elect not to recognize the gain on the sale of stock to an ESOP if the proceeds are reinvested into a security issued by a domestic operating corporation.
- S corporations that sell stock to an ESOP can avoid tax entirely on the income allocated to the ESOP. Plan participants will then pay tax upon distribution of cash at retirement or when they exit from the plan.
How to leverage lower tax rates and brackets
Capital gains by design are taxed at lower tax rates than all other sources of income to encourage the trading of capital assets. Capital gains are commonly achieved any time a security or capital asset is sold at a price higher than its original cost basis. Capital gains take many forms, including the sale of stock, LLC interests, goodwill, intangibles, customer lists, personal goodwill, or options.
The lower tax brackets of families and employees can be leveraged through the gifting of capital assets or by paying them directly for ordinary and necessary business expenses. The idea is to lower the tax burden by providing appreciated assets in lieu of cash.
For example, for an individual earning $40k or less, their capital gain rate is 0%. This means that assets gifted to this individual and then sold would be subject to no capital gains taxes up to a total annual income of $40k including their regular earnings. Above $40k, a rate of just 15% applies for long-term capital gains until the next income tier of $441k.
Consider leveraging existing plans or creating new retirement plans before or after an M&A transaction to be advantageous to all parties involved, including ownership and employees. Retirement plans offer opportunities to shelter income and defer or eliminate taxation.
Achieve a double benefit when gifting appreciated assets
Making a charitable donation to a donor-advised fund in the form of appreciated assets can preserve up to approximately 70% of the asset while serving underprivileged children or any eligible cause of your choosing. By gifting appreciated assets prior to sale, the business can take a charitable tax deduction at ordinary rates based on the fair market value of the asset donated. Then, when the asset is ultimately sold, taxes on the gain are fully excluded.
Double benefit: 40% savings on contribution and 30% exclusion on the gain.
Another example of a double benefit
LLC/partnership interests offer an additional opportunity to provide the best of both worlds – benefits for the buyer and the seller. By allocating the purchase price, a buyer can receive depreciation/amortization for stepped-up assets in the business while the seller receives preferential capital gains treatment.
Qualified Small Business Stock
Qualified Small Business Stock (QSBS) that meets specific criteria can be sold for a gain with 50%-100% exclusion up to $10 million or 10 times the basis, depending on the issue date. C-corporation stock must be held for more than five years and be issued after August 10, 1993, to qualify. In addition, the rollover of gain can be deferred when reinvested in another QSBS.
Now is the time to execute your estate tax plans
If you are anticipating a future sale of your business, you may want to consider one of the many ways to gift company stock as a means of using your eligible gift and generation-skipping tax exemptions. While the current gift, GST, and estate tax exemption are $12.06 million, proposals are constantly being considered that could limit these exemptions to be as low as $1 million.
If you do not currently have an estate tax strategy, we can help you design and execute one before any potential new bills are signed into law.
Ideas for deferring or excluding taxes after the sale
After an asset or security has been sold for a capital gain, strategies still exist to defer or exclude taxes by taking advantage of investment incentives. Options include Opportunity Tax Zones, empowerment zones, rural developments, and energy-related credits.
Quest can help you develop a strategy for better tax outcomes even after a capital gain has been realized. Our team is also available to organize a full-fledged M&A transaction game plan to take advantage of as many tax opportunities as are relevant to your situation.