#40 | Tax Questions When Exit Planning For Your Business

Today, Bruce and Jason Hosler dive into the complexities of exit planning and tax issues related to selling a business. We kick off discussing the importance of understanding a business’s structure when preparing for a sale. The structure, whether it’s a sole proprietorship, partnership, LLC, S-corporation, or C-corporation, significantly impacts tax implications. We note that some business owners even change their structure before a sale for better tax treatment.

There are differences between selling business assets and selling stock. Selling assets involves transferring individual business components, while selling stock means transferring ownership of the entire entity. This choice affects tax payments and liabilities. Asset sales might allow for a step-up in basis, reducing capital gains taxes, whereas stock sales can involve fewer transactional steps.

We then explore how to determine a business’s fair market value before a sale. It’s industry-dependent, often involving multiples of EBITDA or gross revenues. It’s important to engage a professional firm for valuation, considering factors like hiring family members or owning vehicles through the business.

Next, we delve into capital gains tax rates and their application to business sales. These rates vary based on income, with different thresholds affecting the percentage of capital gains tax. We discuss the benefits of installment sales in managing these taxes, spreading out capital gain recognition over several years.

For more information about anything related to your finances, contact Bruce Hosler and the team at Hosler Wealth Management.

Call the Prescott office at (928) 778-7666 or our Scottsdale office at (480) 994-7342.

To listen to more Protection & Preserving Wealth podcast episodes, click here.

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Guest Profile

Jason Hosler holds Series 7 and 66 FINRA securities registrations. He brings a technological edge to our firm and helps many of our clients stay current in the fast-moving age of the internet.

Podcast Host

Bruce Hosler Image

Bruce Hosler is the founder and principal of Hosler Wealth Management, LLC., which has offices in Prescott and Scottsdale, Arizona. As an Enrolled Agent, CERTIFIED FINANCIAL PLANNER™ professional, and Certified Private Wealth Advisor (CPWA®), Bruce brings a multifaceted approach to advanced financial and tax planning. He is recognized as a prominent financial professional with over 27 years of experience and a seven-time consecutive *Forbes Best-In-State Wealth Advisor in Arizona. Bruce recently authored the book MOVING TO TAX-FREE™ Strategies For Creating Tax-Free Retirement Income And Tax-Free Lifetime Legacy Income For Your Children. www.movingtotaxfree.com.

In the Protecting & Preserving Wealth podcast, Bruce and his guests discuss current financial topics and provide timely answers for our listeners.
If you have a topic of interest, please let us know by emailing info@hoslerwm.com. We welcome your suggestions.

*2018-2024 Forbes Best In State Wealth Advisors, created by SHOOK Research. Presented in April 2024 based on data gathered from June 2022 to June 2023. 23,876 were considered, 8,507 advisors were recognized. Not indicative of advisor’s future performance. Your experience may vary. For more information, please visit.

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Jon “Jag” Gay: Welcome to Protecting and Preserving Wealth. I’m Jon Jag Gay. I’m joined as always by Bruce and Jason Hosler of Hosler Wealth Management. Gentlemen, good morning.

Jason Hosler: Good morning, Jon.

Bruce Hosler: Jon, good morning. Welcome. A little cool out today.

Jon: Cooler for me in Detroit than probably you in Phoenix, but I’m thawed out and will proceed.

Bruce: Actually, we’re in Prescott this morning and it was a little fresh, 28 degrees this morning.

Jon: 28 degrees would be a heat wave for me right now. I’m looking at 11 as we record this on January 16th. All right, we’re going to take some of the heat out of exit planning tax issues, if you see what I did there today.

Bruce: Ah, there you go.

Jon: Let’s start off by talking about– I’m a business owner, you’re a business owner. At some point, you do end up selling the business. Can you talk about the importance of understanding the business structure when preparing to sell a business in the US?

Bruce: Yes, this topic today of business owners being able to understand the tax implications of selling their business, and the first one is their structure. Whether you’re organized as a different type of entity, whether it’s a sole proprietorship, a partnership, an LLC, an S-corporation or a C-corporation, can have dramatic impact on the tax implications. Certainly, whether you’re selling assets or you’re selling the stock, those are also very important, and I’m sure we’re going to talk about some of that later on here as well, but understanding your structure and how that affects you on the back side of the transaction, where the money comes from and how it pays through the business back to you can have big tax implications.

Jason: Jon, we’ve even seen some owners will change the structure of their business before they move forward with the sale for preferential tax treatment.

Jon: That’s really fascinating. I know in just the day-to-day of running a business, there are so many different rules depending on which of those categories you fall into, but that’s a good point, Jason, that maybe it may behoove you to be classified differently for a tax reason. Gentlemen, what are the key differences between selling the assets of a business and selling the stock or ownership interest?

Jason: Selling the assets means transferring individual business components, while selling the stock means transferring the ownership in the entire entity. That choice affects how the taxes are paid and the liabilities, how they’re handled. Asset sales can allow for potentially a step-up in basis, can reduce your capital gains taxes, and on the other side, stock sales can involve fewer transactional steps to complete the sale.

Bruce: I might add, there’s a lot of professionals that will advise clients against purchasing the stock of a company, if you will. They almost always want to insist on asset sales because of the liability they could be picking up by buying the stock. You’ll see that effect in there, and there’s some different elections that can be made, a 338, different elections like that that affect the taxes. Clients just need to be aware of the difference between selling the assets and selling the actual stock itself.

Jon: Very fair point. Before you sell anything, the obvious question is, what is this worth? How should a business owner go about determining the fair market value of their business before a sale?

Bruce: It depends on the industry that they’re in, and some of those are very different, the metrics on how you value the business. In almost every business, they’re going to use some sort of a multiple of your EBITDA, which is Earnings Before Interest Taxes and Amortization, or they may use gross revenues, a multiple by gross revenues. In almost every case, you should engage some professional firm that does valuations in your industry, that has familiarity with your industry, and engage them to give you a valuation.

And you should do this for multiple years, so that you have a baseline, and you understand where you’re at. Because, until you get to that point, you’re maybe just guessing the best you can based on the industry, and you may have some underlying things that you’re doing that could really affect the value, both either up or down.

Jason: Some of those things might be like hiring family members to pay a salary, having vehicles that are owned by the business. Those types of expenses that business owners often run through their businesses might affect the valuation.

Jon: Yes, sometimes you have to unravel that, Jason. Another piece of it is, if you’re the business owner, particularly if you built the business, there’s so much emotion and personal feeling tied into that business. To Bruce’s point earlier, that may affect the value up or down, where you’re not really looking at it clearly. That’s why you would want to go to a professional firm that does this every day, so you have a better idea of what it’s worth on the market, as opposed to what it’s worth to you in your heart, mind, body, gut, and soul.

Bruce: You know, there’s also the different type of buyers. If you have a strategic buyer, if you have someone that’s just buying it for cash flow, you have a competitor that may be looking at you. There are different buyers that are going to have strategic interests that may value the business very differently than somebody else who’s buying it for another purpose.

Jon: Excellent point. Can you clarify the capital gains tax rates and how they would apply to the sale of a business?

Jason: Sure. Capital gains tax rates can vary based on your income. If you make a certain amount, less than around $80,000, your capital gains rates are actually zero up to that point. Then, around $500,000, they step up from 15% to 20% long-term capital gains rates. It’s important to know what your other income is going to be. Your long-term tax rates most likely apply. Most business owners don’t own a business for less than a year, but you also have to know what your other income is going to be in the year of the sale or in future years if you’re using a strategy such as an installment sale.

Bruce: That’s a big point that I wanted to address using the installment sale because long-term capital gains rates can be very generous. In fact, if you’re married filing joint, you don’t go over 15% long-term capital gains rate until you go above $553,000 a year. Think of that. If you took an installment sale over a number of years, you could keep your capital gain at only 15% as opposed if you took it all upfront, you’re going to have 5% more and go into the 20% range. I think we’re going to talk about net investment income tax here in a minute. There’s some planning around tax rates and capital gains rates that are very powerful.

Jon: I know the two of you in the firm at Hostler Wealth Management spend so much time on minimizing tax burden, even just in a person’s life outside of a business ownership. The same applies here. You want to employ those strategies so that you are minimizing your tax rate for years going forward. Bruce just mentioned the NIIT, the net investment income tax. When does that come into play during a business sale?

Jason: The net investment income tax is a 3.8% tax on certain investment income, which includes capital gains. It’s going to apply to you if you’re single at $200,000 and $250,000 for married couples filing jointly. When you have investment income that’s above that, that net investment income tax is going to be applied.

Jon: The team at Hosler are such experts on all the forms. Let me ask you about Section 1202, the Section 1202 exclusion and its potential benefits for business sellers.

Bruce: This is the qualified small business stock section exclusion and really this only applies to C-corporations. We don’t see this very often because many businesses have elected for S-corp or LLC or something like that. These questions about the Section 1202 only apply to certain stockholders. You have to have held the stock for certain periods of time, but the results could be huge because you can exclude up to 100% of the gain that may be available to certain business owners. Again, depending on the industry you’re in, it affects you as well, but for manufacturing, construction, things like that, some of those owners could benefit from a 1202 exclusion. It’s a very favorable option.

Jon: What about the concept of installment sales? We alluded to this a little bit earlier. When might it be advantageous for a business seller?

Bruce: If you don’t need all the money upfront, if you can spread that recognition of the capital gain over a number of years, 5, 10 years, 7 years, whatever you may be willing to accept, and if you feel like the buyer can assuage all of your concerns about security of getting those payments, taking those installment sales over a number of years could be very advantageous for some business sellers.

Jon: Now, let’s talk about deductions here. What type of business expenses related to the sale can be deducted for tax purposes?

Jason: There’s a number of related expenses, so your valuation that you need to get is part of preparing for a sale. There’s other legal fees, brokerage commissions, transaction costs that can typically be deducted.

Jon: All right, we’re continuing to tick down the list here, gentlemen. Depreciation recapture. In the context of a business sale, what is it and how does it work?

Bruce: Wow, this is a big one that affects a lot of people, both on when they sell the real estate involved in their business, or if you have big capital expenditures for equipment and other improvements, whether it’s trucks on the road, or manufacturing equipment, or construction equipment, or that. A lot of businesses accelerate the depreciation when they buy that equipment, or those investments, and so they can take the deduction up front, but when you sell that on the back end, the IRS makes you recapture that depreciation, and frequently that’s taxed at 25%. That’s a surprise for a lot of business owners, they don’t realize that they could get caught by this recapture depreciation, so we want our clients to be aware of this and that needs to go into the tax calculation when you’re contemplating selling your business.

Jon: We’ve talked a lot about taxes in general and this is– what you’ve talked about so far applies on the federal side. What about state-level taxes, what should sellers consider when planning for a sale?

Jason: The state that you’re in is going to matter quite a bit when you’re selling a business because state taxes vary quite widely. Here in Arizona, we have a pretty simple system, but for example, right next door in California, you have not just the state income tax but they’re going to have a capital gains tax that’s specific to California. There can be specific withholding requirements when you are selling real estate as part of a business transaction, so you got to make sure that you’re familiarizing yourself with the state tax rules as you’re planning to make this sale.

Jon: Jason, you’re saying there are high taxes in California? I’m shocked!

Jason: God forbid.

Jon: What about tax incentives and considerations when selling a business to an employee stock ownership plan, one of those ESOPs?

Bruce: Certain businesses, this is a great opportunity, so a lot of people don’t realize that an employee stock ownership plan is really a retirement plan for the employees and if the business has been successful for long enough, they can set up the plan and the plan can begin to purchase the stock from the owner and the incentive for the owner is that they can minimize and sometimes completely avoid capital gains tax by selling their business to the retirement plan for the employees, and employees can then become owners of the business and incentivizes them.

For some businesses, that is a great opportunity, they need to consider that. Usually, you’ve got to have revenues of about $10 million to make it worthwhile, but an ESOP sometimes is a very good option for some businesses.

Jon: Got it. We’ve talked in previous episodes about section 1031 exchanges. Talk about its applicability to the sale of real estate assets within a business sale.

Jason: A lot of businesses will often own real estate associated with their operations, whether that’s a headquarters or even just a place to park your truck.

Jon: Sure.

Jason: Section 1031, of course, allows you to sell a piece of real estate and buy another like-kind property and allows you to defer the capital gains tax. Sometimes that can be ramped up in the sale of a business, sometimes you’ll see where a business owner will roll out that real estate and do a section 1031 exchange outside of the business sale. Sometimes the owner will even retain the property for a while, lease it back to the new owner of the business, and then sell in the future.

Out of all those options, you want to remember that you have that section 1031 exchange available to the real estate assets of a business to be able to defer capital gains and recognize those in the future or continue to hold real estate until you die and a step up in basis is available for your heirs.

Jon: Got it. We’ve been going rapid-fire down a number of different aspects here guys, and this question may seem obvious but I think it’s worth mentioning. Talk about the role of due diligence in identifying potential tax liabilities or issues before a sale.

Bruce: That is so important, Jon, because sellers don’t really realize that they’re going to be scrutinized in the way they are, and the amount and the depth of the questions that a buyer is going to need to ask to do their due diligence it’s a lot of work to get that ready for a buyer. A seller needs to begin early on preparing their financial records, their tax records, their processes, their systems of procedures, everything that they have that a potential buyer is going to want to know about, they need to have all that documentation ready so when the buyers wanting to do their due diligence to value the business you’ve got that in place.

That is a lot of work potentially, so sellers need to prepare for it, and then buyers to ask all the right due diligence questions and not miss anything like that. This is a key point and there’s a lot of negotiation that pivots during the transaction based on due diligence.

Jon: Oh, I’m sure. How should business owners address employee benefits like retirement plans and stock options during the sale process?

Jason: You need careful planning in this area to ensure a smooth transition of your employees to the new business owner. There’s all kinds of considerations depending on your business to take into consideration, so if you have some key employees or key executives, you’ve probably heard the term golden handcuffs before, that’s using certain types of benefits or retirement plans that vest over time to incentivize those employees to stay with the business let alone the other types of benefits for all the other employees and making sure that you’re going to be able to transfer those over to the new owner and have continuity for the employees to ensure a smooth transition.

Jon: The golden handcuffs sometimes prevent you from jumping out in the golden parachute right, Jason?

Jason: That’s right.

Jon: What factors should a business seller take into account when deciding on form of payment for the business? Cash, stock, combination?

Bruce: That combination of how you receive payment can affect dramatically the price that a buyer is willing to pay you for your business. If you’re demanding all cash up front, that price may be lower. If you’re willing to carry some of it back or perhaps there’s financing or there’s some combination of that, that all goes into the negotiation of how the price is going to be valued, the business is going to be valued and that cash flow coming out of there, so sellers need to be very aware of what their financial needs are going to be when, and that can affect the negotiation and the value of the business to an incoming buyer.

Jason: One of the popular methods that we’ve seen recently with some of our business owners is called a roll-up, and specifically in the software and technology industry, you’ll see this where a company is acquired and the owner will take some ownership in the roll-up, and they’ll continue to participate in the umbrella company that has bought them out and have future liquidity events available, so all of these need to be taken into account and not just in the consideration of your current sale but also in future opportunities.

Jon: In the context of selling a business, gentlemen, what are some essential aspects of exit planning that our sellers listening today should consider?

Bruce: Certainly, the first thing that any business owner needs to contemplate is how do they calculate if they can even afford to retire, and they have to have a retirement income plan, a financial plan created to let them know if I’m going to stop working and now I’m going to rely on this pile of money that I’m receiving or the income stream or installment sale, whatever it is, is it going to be enough for us to maintain our standard of living? I think in our next podcast, we’re going to talk about that, but that’s foundational for every business owner, they need to do the math to see if they can even afford to retire when they sell the business.

Jason: Then outside of the math, which, of course, is very important, you have to look at how you’re going to spend your time, what is your life going to be about when– a business owner so often will have their self-identity wrapped up into their profession and their business, how are you going to find meaning in retirement or whatever you’re going to do next? Having a plan for what comes next is key to successfully transitioning a business.

Jon: I can say we’re recording this a day after a holiday weekend and I was getting antsy by the end of three days off that I wasn’t working because to your point, Jason, I’m so involved in my business and what I do, it’s such a part of my identity. I was getting itchy. I can only watch so much football over three days. I’m excited to get back to work today. As Bruce alluded to, we’re going to cover in our next episode knowing whether or not you’re okay to sell a business and what goes into that calculation for retirement after you sell your business.

Jason will get this metaphor probably before Bruce does but the whole Scrooge McDuck diving off the diving board into the pile of gold coins if you are that versus running your business day-to-day, there’s a big difference there. Before we go, if our listeners want to come talk to you at Hosler Wealth Management about exit strategy for a business or anything related to their financial future, how do they best find you?

Bruce: The best way to get a hold of us, Jon, is on our website https://hoslerwm.com, Hoslerwm.com or either one of the offices in Prescott 928-778-7666, you can speak to Jason, or in Scottsdale 480-994-7342, Alex is down there. We’re ready and willing to speak to anyone about their business and their retirement plans and we can help you get on track, so give us a call.

Jon: Thank you both, we’ll talk again soon.

Bruce: Thanks, Jon.

Jason: Thanks, Jon

Jon: Securities and advisory services offered through Commonwealth Financial Network, member of FINRA/SIPC, a registered investment advisor. Forward-looking commentary should not be misconstrued as investment or financial advice. The advisor associated with this podcast is not monitored for comments and any comments should be given directly to the office at the contact information specified.

Any tax advice contained in this communication, including any attachments, is not intended or written to be used and cannot be used for the purpose of, 1) avoiding federal or state tax penalties or, 2) promoting marketing or recommending to another party any transaction or matter addressed herein. The accuracy, completeness, and timeliness of the information contained in this podcast cannot be guaranteed. Accordingly, Hosler Wealth Management LLC does not warranty, guarantee, or make any representations, or assume any liability with regard to financial results based on the use of the information in this podcast.

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