For me, the end goal of tax planning not just how much tax savings can be gained. It is how those tax savings can be used to benefit the client in the most meaningful ways possible. A project I had recently illustrates this real value of proactive tax planning for taxpayers.
A man contacted me wanting to sell his family farm and retire. During all his years of farming he had thought the built-up equity in his farm would provide the bulk of what he would need to fund retirement. Unfortunately, that was not the case. To simplify it quite a bit, at a sale price of $2,250,000, and after the sale costs and debt he owed were paid, he would have no amount left at all on which to retire. Worse, he would have to pull more than $600,000 “out of pocket” to pay the rest of the $1.2 million in taxes he would owe. He was deeply worried.
He had multiple options to reduce or defer that large immediate tax payment to save his retirement plans, but he had to think through each one. He called me in because the options all had serious tax implications.
What are the many options for passing on or selling appreciated property (or any asset for that matter)?
Inheritance – This was not an option my client considered, but there are well-known benefits to passing assets on through inheritance. The current $5.45 million gift and estate tax exemption ($10.9 million, if married) from estate tax is one, and for the heirs, the stepped-up cost basis to the assets’ market value at owner’s death is a second.
One big issue is the open-ended timing before inheritance occurs. Everyone hopes, of course, it is a long wait, but that requires the older generation to remain owners of an illiquid asset. If the next generation does not plan to get involved in the farm or business, the owners also face real management issues as they age. This was the case with my client.
Take on minority partners – Owners sell a minority stake to the next generation or new business partners, and sell further stakes year-by-year until the next generation/new partners become majority owners, and assume responsibility for running the business. If the new owners are the children or relatives of the old owners, this could provide a gradual transition in place of waiting for an inheritance.
Tax implications remain and, of course, vary for each transaction. In this case, each tranche sold will likely include taxable gain and taxes would have to be paid. And, in addition, a business risk remains that the assets could depreciate through poor performance. The seller is forced to rely on the partners to protect the value of the asset over time.
Sell the farm or business via installment sale. In this situation, the asset is fully transferred to the new owners up front rather than over time, with the seller agreeing to accept payment on an installment schedule. The seller retains no ownership, but still carries risk. The business, for example, could fail and the buyer default on the loan. Or the business is still viable, but the buyer can’t make payments. In either event, the seller is forced to foreclose, take the enterprise back and is now back in business against his or her will!
Tax implications: Each installment payment is a taxable event, with the same cost basis/appreciated value questions that apply to the minority partner scenario. Capital gains taxes are paid over the term of the installment sale payment period along with ordinary income taxes on the interest received during the term of the contract.
Sell the farm or business outright. This is the cleanest transition for all involved, with any inheritance relating only to the future value of the funds received.
Tax implications: This option carries the most burdensome tax implications for the sellers because the full hit of capital gains and other taxes come due upon sale. This option leaves the least money in the pockets of the sellers overall to fund future activities (whether for retirement or reinvestment.)
Sell the asset by coupling a monetization loan with an installment sale. This option revises the structure of the outright sale. It combines an installment sale with a simultaneous monetization loan to the seller, allowing the seller to defer the taxes for decades. By implementing this planning approach, my client could effectively defer far into the future the $1.2 million in taxes and receive at close of escrow more than $420,000 tax-free to help fund his retirement.
Tax implications: Taxes due are deferred for an extended period, allowing the seller full access to the loan proceeds to invest as desired to fund retirement or other activities. Taxes are paid when the installment and monetization loans are closed simultaneously years down the road.
As you can see, the specific needs of the business, or in this case a farm owner, must drive the decisions about how to shift the asset to other owners and give the seller the financial means to fund the next stage of his or her life.
My client opted for the installment sale with the concurrent monetization loan. He and his financial advisor set up the appropriate retirement plan to best use the money he received, and he easily set up a structure to guarantee that the funds will be available to pay the deferred taxes on that distant day when they finally come due.
Explore all the options – Doing it now is the best time to begin
This transaction was completed within just a few months for our client. But, frankly, the very best time to think about which path to take is years ahead of the event. It’s never too early to set up your tax planning to maximize the benefits you receive, and minimize (and defer!) the taxes you must pay regardless of your personal goals.
About the Author...
Bruce Jones got his start in financial services in 1970 and has taught the subjects of tax management and financial strategy planning since 1974. He is President and CEO of TaxWealth®, a tax analysis and solutions research firm which provides comprehensive income, capital gains and estate tax remedies for owners of real estate, privately-owned businesses and other capital assets. He also supports CPAs, attorneys, financial advisors and real estate and business brokerage professionals, helping to solve their clients' tax problems.
TaxWealth works with clients and professional partners nationally from its home office in Newport Beach, California. Visit their web site at www.taxwealth.com or call Mr. Jones toll-free at (800) 300-4723 to discuss your tax concerns.