The Tax Foundation 2024 State Business Tax Climate Index
The Tax Foundation 2024 State Business Tax Climate Index lists California as 48th among all states, ahead of New Jersey and New York. However, the Business Finance Council (BFC) notes that California ranks number one in innovation and technology. 99.8% of California businesses are small businesses, employing 48.8% of the California population. The BFC points to the following five reasons for California's business-friendly environment:
- A large population of 40,223,504, making California the most populous state.
- Diverse customer or client base.
- Access to a vast professional network provides greater access to lawyers, accountants and other professionals.
- A robust economy, California's GDP is proliferating, and it is poised to pass Germany and become the fourth-largest economy globally after only the United States, China and Japan.
- Robust infrastructure supporting the highest level of imports compared to other states.
I cannot speak to the statistics, but our experience is that the California economy is very robust, with a high level of business mergers and acquisitions without regard to interest rate changes or high tax rates. We are increasingly busy with business sales and acquisitions and related tax planning.
Tax Planning Strategies for Business Owners Installment Sale Strategies
We help successful families and business owners minimize income and estate tax, better protect assets and transition client legacies and family values to the next generation. Our goal is to make a transformational change that improves the lives of our client's families. We recently obtained a $2.75 million reduction in estate tax with a supplemental estate tax for a farm family, enabling them to pay the remaining tax over 10 years. This enabled that family to continue farming into the next generation and beyond.
Business owners often work a lifetime or sometimes for multiple generations to develop a family business representing the family's most valuable asset. The income is frequently compressed into a year when the company is sold, triggering the highest federal tax brackets. The highest federal tax bracket for capital gains is 20%, and for ordinary income is 37%. The highest tax rate for California is now 14.4%. The combined rate for ordinary income is 51.4%, and for capital gains is 34.4%. One-third or more of the business value is lost in taxes.
One way to receive some relief is to use an installment sale to spread income to future years and obtain a lower tax bracket in later years. Note that Internal Revenue Code Section 453A puts a $5 million per person limit on installment sales. Some assets, such as publicly treated stocks or securities, do not qualify for installment sale treatment.
There are at least a dozen ways to reduce, defer or eliminate tax on capital gains or the sale of appreciated assets. Many prospective clients call to say they have sold their business or building and would like to minimize the related tax. However, the best, most attractive planning is done before the sale is closed or negotiated. Ideally, a client should begin planning in 2024 for a sale to close in 2026. This timing allows the most attractive planning.
The Two-Year Installment Sales Strategy
One such alternative is the Two-Year Installment Sale. Here's how it works: You can sell the asset to your children or a separate trust (sometimes called the "deferred sale trust") on a long-term installment sale. That way, your children or other beneficiaries can receive the total value and enjoyment of the property before the gain is recognized and subject to taxation. After a two-year waiting period, even the tax on the $1 million dollar can be minimized, and the property can be sold to a third-party buyer for cash. The children's trust receives the sale proceeds in cash, whereas the parent is deferring the tax for as much as 20 years.
Example Scenario:
For example, let's say you own Blackacre, a parcel of land you originally purchased for $200,000. Today, it has a fair market value of $10 million. You want it to benefit your children, so you sell Blackacre to your kid's deferred sale trust for $10 million to be paid over 20 years. The IRS requires a two-year gap between a related party installment sale and a second sale of the same asset. So, two years and one day later, we sold Blackacre to a third party for $11 million, paid in cash at closing. The deferred sale trust recognizes a gain on the sale tax over 20 years. Yet the family receives the entire $11 million of value while paying tax only on the $1 million gain. Yes, the trust will continue to pay off the note over the next 20 years. You recognize any gains and pay the taxes over the 20 years. However, this provides a significant time difference during which you invest the funds and receive the income and appreciation. Plus, you can also reduce your taxable income and pay taxes from a lower tax bracket in future years with additional planning.
Benefits of the Two-Year Installment Sale Strategy
This strategy is beneficial because the gain is taxed at a reduced rate as a long-term capital gain instead of a short-term one, which would be taxed as ordinary income. Your beneficiaries will still receive all the cash proceeds in the year of the second sale. Also, this strategy provides an opportunity for a far greater overall return. If you invest the funds you have otherwise paid in taxes in the year of the original sale, you earn 6% or more each year on that amount.
The next best time for a client to reach out is in 2024 for a sale that will close later in 2024 or 2025. This timing permits a discussion of structures to use before the sale to mitigate the tax bite and additional steps to take after the sale to reduce the tax cost further.
Timing and Structure of Tax Planning
The most attractive planning is done before the existence of a binding obligation to purchase and sell. Note that there are both charitable and noncharitable structures that can be used before the binding obligation. For a charitable structure, a portion of the assets sold may be transferred to the charitable trust or entity. A portion of the sale may not be taxable depending on the type of charitable structure. For example, a Charitable Remainder Trust or a Split Interest Charitable Income Trust would not be subject to tax. A Charitable Contribution Deduction is generated to offset income tax on the remaining sale proceeds, which go directly to the client. A grantor Charitable Lead Trust (CLT) would not provide a nontaxable portion of the sale. Still, a CLT often provides a dollar-for-dollar income tax deduction for amounts contributed to the CLT. The key to any such structure is the economic benefits flowing to the family.
Case Study: Hoensheid v. Commissioner
Note that the timing for this type of planning is critical. In Hoensheid v. Commissioner TC Memo 2023-34, the tax court found that implementing a plan two days before a binding agreement between the Buyer and Seller was too late. This was an illegal assignment of income. The tax benefits from some otherwise traditional and well-respected planning were lost. The lesson is not to wait too long and ensure significant deal points for sale are still being negotiated after the planning and related title transfers and entity formation are completed.
Subchapter S Stock Sale Planning
Tax planning for a Subchapter S stock sale can be challenging. This is because of the substantial restrictions on who can be a qualified Subchapter S shareholder, which is generally limited to individuals and very restrictive trusts (the Qualified Subchapter S Trust (QSST) or Elective Small Business Trust (ESBT). Neither the QSST nor the ESBT is conducive to minimizing tax on selling S Corporation stock.
Under the right circumstances, goodwill for a business conducted by a corporation can be owned individually by the business founder or developer. If so, this personal goodwill can be transferred to a charitable structure to generate substantial tax savings and economic benefits for the seller and their family. This is done without the restriction of who can own S corporation stock.
First, property rights for income tax purposes are determined under state law. Most states recognize some form of personal goodwill. Much of the case law establishing personal goodwill arose in divorce proceedings, where a soon-to-be ex-spouse sought compensation for or to share in this often-precious asset.
The recent sale of a business for $6 million resulted in tax savings of over $1.4 million. This was done by contributing personal goodwill to a lifetime income charitable pooled trust before the sale. In addition, the seller could invest and receive income for the life of the amount contributed to a split-interest charitable income fund.
This provided a very substantial benefit for the family as follows:
This lifetime income charitable pooled trust can substantially increase a family's wealth over simply paying the tax. If we paid the tax, the family would net $2.25 million after paying federal and state (estimated) tax of 25%, or $750,000. If invested at 7%, that would provide an income of $157,000 per year. That offers a value of $1,668,557. Adding to the $2.25 million resulted in a total increase in wealth at $3,918,557. If we avoid taxing that same $3 million, we save tax of $750,000 and invest the entire $3 million to receive a safe, predictable income of $210,000 every year. If invested for 20 years, That equals a value of $8,609,053. The preset value of that is $2,224,743. When added to the $3 million net proceeds from the sale, that provides a preset value of $5,224,743. This is an increase in wealth of over 33%.
In addition, the client received an income tax deduction of $2,202,641 to avoid tax on other income. The total tax savings was $1,564,977, representing the tax savings from the deduction and the charitable portion of the sale not subject to tax. This substantially benefits the family, particularly when added to the abovementioned investment income.
These are just a few lesser-known techniques to minimize tax on the sale of capital assets. As indicated above, our experience is that the California business climate is healthy and robust.
John M. Goralka is the founder of The Goralka Firm. He assists business owners, real estate owners and successful families to achieve their enlightened dreams by better protecting their assets, minimizing income and estate tax and resolving messes to preserve, protect and enhance their legacy. Goralka is one of few California attorneys certified as a Specialist by the State Bar of California Board of Legal Specialization in Taxation and Estate Planning.
