Tax-Efficient Exit Strategies Every Business Owner Should Know

Ken Hargreaves, CFP®, AIF®, AWMA®, CRPC®

Running your own business comes with numerous tax breaks: deductions for expenses, healthcare premiums, and retirement plan contributions, to name just a few. In fact, they’re so numerous that many business owners don’t take full advantage of them. Even more challenging is looking ahead to reducing your tax bill when the inevitable happens: exiting your business. In this article, we’ll discuss how everything comes together: your business structure, how you sell the business, the timing of your sale, and even how your business is evaluated. Also, keep in mind that it’s vital to meet with a tax advisor to ensure you understand all the implications and opportunities available to you.

How You Sell Your Business

When it comes to selling your business, most transactions are structured as asset sales rather than stock sales, especially in small-to-medium-sized businesses. This is because buyers prefer asset sales for two major reasons:

Tax Benefits: When buyers purchase assets in an asset sale, they acquire those assets at their fair market value (the price they paid). This step-up in tax basis is important because it allows buyers to write off depreciation or amortization over the applicable period, reducing taxable income.

Liability Protection: When someone purchases company stock, they might inherit any legal issues, tax debts, or other liabilities tied to the company. In an asset sale, assets such as business equipment, goodwill, and intellectual property are generally transferred free of the company’s liabilities.

So, what you are most likely stuck with is an asset sale. However, that’s not the end of the world, as your business structure can still provide significant tax advantages. 

How to Structure Your Business

Your business structure directly impacts how much money you keep from every dollar earned, especially during your eventual exit. 

Pass-Through Entities (S-Corps, LLCs, Partnerships)

Pass-through entities, such as S-Corps, LLCs, and Partnerships, offer significant tax advantages when you’re planning to sell your business. One of the most critical aspects of pass-through entities is that your income is only taxed once, at the personal level and not at the corporate level. That single taxation continues to apply when you sell your business.  

When you sell a pass-through entity, you’ll only pay tax once at your personal rate versus getting hit twice with corporate tax plus personal tax in a C-Corp sale. 

Beyond just avoiding double taxation, pass-through entities give you more control over how you sell your business. For example, you can use installment sales to spread gains over multiple tax years, helping to avoid paying significant taxes on a lump sum of cash and allowing you to time the installments for the years you predict you’ll have a lower income. 

S-Corps

Profits and losses pass directly to the owner’s personal return, and when selling the business, owners can sell either stock or assets. Buyers typically prefer asset sales for tax benefits, and S-Corp sellers don’t face additional taxes whether the sale involves stock or assets. If you’re thinking about converting your C-Corp to an S-Corp to dodge double taxation, it’s not that simple, as conversions made within the past five years may trigger the Built-In Gains Tax on any asset appreciation during that time.

LLCs

Unlike S-Corps, LLCs don’t have stock. Instead, owners sell (or gift) membership interests or assets. Like S-Corps, taxes are paid only once, at the personal level. LLCs also offer more flexibility in allocating profits and losses among owners, even if those allocations don’t exactly align with ownership percentages.

Fine-Tuning Your Exit Strategy 

Let’s imagine you’ve determined the ideal structure for when it comes time to sell your business, but that’s not the end of the end of the story. Below are additional strategies to help you get the most out of your sale, many of which can be used in combination. 

Installment Sales

Imagine you find a buyer for your business, you agree to a sale (let’s say, $3,000,000), the funds get into your account, and during tax time, you’re hit with a massive tax bill. While paying your fair share of taxes is inevitable, you likely don’t have to take the gains of your sale all at once. Instead, you might be able to spread that income over several years to lower your annual tax bill and help fill in lower-income years with more of your gains. However, the buyer will have to agree to your payment schedule and also owe interest on the installation payments. Yes, that interest goes to you, but you’ll also owe ordinary income tax on it.  

Valuation Discounts

Typically, a business’s value is determined based on things such as its assets, earnings, and market potential. However, when gifting shares or transferring interests in a family business or partnership, your business is likely to be valued less than if you were selling stocks of a publicly traded company on the open market. 

The reason is twofold: if you’re selling a minority stake in the business, the recipient won’t receive full control of the company or perhaps even a vote on how things are operated. Basically, they’d have a difficult time selling that interest if such a sale is even legal. Secondly, even if the recipient of the interest can sell it, it will be exceedingly difficult to do so because of the private nature of family businesses. So, since this interest is less likely to be purchased by an outside party, it’s determined to have a lesser value. All of this means you can start passing down more of your business in a tax-efficient manner than you otherwise could due to annual and lifetime gift tax exemption limits. Valuation discounts come in especially handy when used in conjunction with family-limited partnerships and trusts. 

Employee Stock Ownership Plans (ESOPs)

If passing your business to family members or charitable organizations isn’t your preferred exit path, an ESOP offers its own tax advantages. Like with installment sales, you can sell a percentage of your shares over time, helping you avoid a lump sum and a sizeable tax bill. Plus, if you have a C-Corp, the principal of the loan taken by the company to fund the stock purchase and its interest could be tax deductible. You can even borrow against your QRP without triggering taxes, creating liquidity without losing the tax deferral. 

In Conclusion

Exit planning isn’t just about finding a buyer. You also need to think about the structure of your business, timing your sale, and incorporating the proceeds into a tax strategy that doesn’t leave any money than necessary to the IRS. Fortunately, we have a multitude of tools at our disposal, such as valuation discounts and ESOPs, that can help us make the most out of your exit. However, the most effective exit strategies often take years to implement properly.

If you’re thinking about your eventual exit, start by clicking the number below so we can analyze your current structure and run the numbers on different scenarios. It’s never too early to start, and waiting too long may risk missing opportunities.

Disclosures

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author/presenter as of the date of publication and are subject to change and do not constitute personalized investment advice.

A professional advisor should be consulted before implementing any investment strategy. WealthGen Advisors does not represent, warranty, or imply that the services or methods of analysis employed by the Firm can or will predict future results, successfully identify market tops or bottoms, or insulate clients from losses due to market corrections or declines. Investments are subject to market risks and potential loss of principal invested, and all investment strategies likewise have the potential for profit or loss. Past performance is no guarantee of future results.

Please note: While we strive to provide accurate and helpful information, we are not Certified Public Accountants (CPAs). The information in this article is intended for informational and educational purposes only and should not be interpreted as tax advice. It is crucial to consult with a CPA or tax professional to discuss you

Author

  • A Florida native, and full-time Sarasota resident, Ken founded WealthGen Advisors, LLC after spending more than fourteen years in the financial advisory industry. Ken holds multiple industry designations, as well as a master's degree in Financial Planning. Prior to founding WealthGen Advisors, Ken spent almost a decade in New York and then Texas as Vice President at The Capital Group, a $2T global investment manager serving institutional clients and pension funds.

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