Tax Considerations in Your Business Succession Plan

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by Advice Chaser
by Advice Chaser

The time comes for every business: the day when the original founder hands the company down to someone else. With luck, it can be the beginning of a new era for the company. But it can also create a massive taxable event. Will the value of your life’s work be eroded by taxes? It takes careful planning to hand on your business while also minimizing tax burden.

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Taxes from the Sale of Your Business

When you sell your business, the proceeds will be taxed. This can have a large impact, especially if you receive the amount as a lump sum. That large sum can bump you into a much higher bracket than usual, causing you to have to pay a higher percentage in taxes.

How exactly your business will be taxed depends on your corporate structure. If it’s a sole proprietorship, business income is the same as personal income and will be taxed based on your personal income tax bracket. But if it’s a C-corporation, you can expect to pay the corporate tax rate. Selling shares that have appreciated will have you paying capital gains tax.

Since these tax rates change all the time, it’s hard to say which structure will result in the lowest taxes at the time you sell. When you are thinking about selling, talk to a tax professional to work out your options.

In some cases, you may be able to structure the sale so that you get paid a portion of the proceeds each year. This can spread out the income and keep you in a lower tax bracket. Plus, receiving the money more slowly can allow you to live on that income for a while.

Estate Tax on Businesses

If, instead of selling your business, you leave it to your successors as part of your estate, it may be liable to estate tax. Currently, estates under $12.92 million are exempt from estate tax. But this limit is set to revert to a lower level in 2025.

Can you give away your business before your death instead? Yes—but the gift tax exemption and estate tax exemption are combined under the same limit. So if you give away a certain amount to your successor before your death and the rest in your will, the amount you gave away counts against your estate tax exemption. Still, by giving assets away now, you lock in the current favorable estate tax exemption level. That is one reason why you might want to start handing down your business sooner rather than later.

However, there’s one other consideration. When you give a gift of appreciable assets like shares in a business, the giver has the same cost basis for these assets as you had. So, for instance, if you give your niece shares you bought at a dollar a share, and they appreciate to three dollars a share by the time she sells them, she will have to pay capital gains tax on two dollars a share. That’s the amount the stock has appreciated since it was purchased—even though you were the one who purchased it.

When appreciable assets pass through an estate, however, they receive a step up in basis. This means that the new cost basis of the assets is what they are worth at the time the heirs inherit them. So leaving your niece stock worth three dollars a share in your will means that she won’t have to pay capital gains tax unless it then appreciates to more than three dollars a share.

Selling Your Business to a Partner

When your business is a partnership, one member can leave while the other takes over full ownership of the business. There are a number of ways to arrange this with minimal tax impact.

If your partner is your spouse, you have no worries. You don’t pay taxes when transferring assets to your spouse, and after your death they pass to your spouse without estate tax.

Otherwise, you’ll have to sell your business interest to your partner. You can do that at any time, but it’s wise for partners to plan ahead with a buy-sell agreement. This sets up the process for the purchase as well as containing agreements about the purchase price. Sometimes, the payment happens over years. This allows the remaining partner to finance the purchase and the selling partner to avoid entering a higher tax bracket.

However, what happens if you die and your partner isn’t ready to buy out your estate? Your heirs want their half of the business’s value, but your partner doesn’t want to sell the company to pay your heirs. A good solution to this is for each partner to buy life insurance on the other. That way, when one of you dies, the other can use the insurance money to buy the deceased partner’s share of the company.

Of course, taxes still come up. The selling partner or their estate will have to pay taxes on the proceeds. The purchasing partners may not have to pay anything. If they fund the purchase with life insurance, they won’t have to pay taxes on the life insurance payout. And, depending on the structure of the agreement, they may receive a step-up in basis on the larger share of the company they now own.

How to Reduce Your Tax Liability

It can be difficult to navigate all the different considerations involved in your business succession plan. For instance, the tax mitigation strategies you would use in a sole proprietorship aren’t the same as what you’d use in a corporation. And, as tax laws change, a strategy that once minimized taxes might now mean you owe more.For this reason, you need individual guidance based on your particular business when drafting your succession plan. This plan should also be updated regularly to ensure it’s up-to-date with current laws and tax rates. A business financial advisor can help you work out the best succession plan that minimizes your taxes. We can connect you with the right advisor for your business when you contact us.

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