Using a Private
Annuity Trust to Sell a Business
One of my girlfriends is
selling her auto mechanic shops. Yeah, a woman who
owns more than one car repair shop. She has about
three, locally, and is getting rid of them all. On
the one hand, it’s kind of sad to see a woman-owned
business drop out of a male-dominated field –
especially one that’s so successful. On the other
hand, I’m happy for her because she’ll make a
bundle. I’ve given her a few planning tips to avoid
having to pay all of the capital gains tax on the
sale, and I’m sure other business owners could
benefit.
First, consider her situation.
My friend is young, in her mid-forties. Also, she is
divorced with two kids – one in her second year of
college, one who will graduate from high school next
year. She probably won’t retire and do nothing, but
I think the chances of her ever punching a clock
again are slim to none. So, long story short, she’ll
need a good, steady stream of income for a long
time.
The answer to this question
lies in how the sale is structured. One option a
person could have in this type of situation is to
carry back the financing of the sale. This means
that the buyer of my friend’s business would make
payments directly to her. I don’t think this is a
good idea, and fortunately, neither does she.
Basically, it means she gets out of the auto repair
business and into the debt servicing business. Like
I said, I don’t think she’s going to retire, but I
don’t think she wants to spend her days chasing
checks. Besides, the point of having and then
selling the business is to secure her future, not to
sit around wondering if she’s ever going to recover
the value of her business.
To minimize headaches and
maximize her income stream, she needs a large sum of
money that she can put to work for her. My friend
will get this large sum of money, as most people do,
through third party financing. Some bank will pay
her the purchase price, and the buyer will pay the
bank principal and interest over time. If she gets a
corporate buyer, they may be able to skip the
financing altogether.
Of course, just getting a bank
to hand you a lump of cash isn’t structuring.
Besides, she would immediately owe a ton of money in
taxes – money that would be gone forever. There’s
more to be done, mostly, I think, setting up a
private annuity trust and selling the business
through it. It’s a really good option for her, and
most successful business owners, for three reasons:
1) it allows her to defer all of the capital gains
tax until she begins taking payments from the trust,
and, even then, the tax burden is spread out over
the course of those payments; 2) she can get the
proceeds out of her estate, so that it passes to her
kids estate, gift, and generation skipping tax free
(they will pay income tax), and it passes to them in
trust, if she wants it that way; and 3) she gets a
stream of income to support her and her kids for the
rest of her life or over however many years she
chooses to receive it.
It works like this. She sets up
the trust and then places the business in it. The
trust sells the business, and then invests the
proceeds in whatever other investments are
appropriate. The trust then makes periodic payments
to my friend out of the principle and income of the
investments. There is no tax on the sale to the
trust because the trust has technically purchased
the business at fair market value (that’s why it’s
making payments). The transfer of the business to
the trust isn’t taxable, but part of the payments
she receives from the trust will be taxable as
capital gains, income, and recapture of
depreciation. Of course, part of the payment will be
non-taxable return of capital.
She can only get these benefits
if the trust has certain provisions in it. The
trustee of the trust must be independent of her,
meaning she can choose whoever serves, but that
person is not beholden to her. She cannot have any
control over the assets in the trust or how they are
invested (though she can give a little informal
advice from time to time), and the annuity itself
cannot be secured in any way.
I’m sure the sale of my
friend’s business has more capital gains lessons to
reveal. I’ll follow the sale and let you know if
there’s anything interesting you should know.
Paula Straub
Save Gains Tax
760-917-0858
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