As in life, when selling a business, timing can be everything

As the saying goes, “There’s no time like the present.” And with tax changes looming on the horizon, owners who are thinking about selling their businesses and retiring in the near future may want to consider doing so now.

The extension of the “Bush tax cuts” that reduced the long-term capital gains tax rate from 20% to 15% is due to sunset on December 31, 2012. Then the federal capital gains tax rate is expected to return to 20% on January 1, 2013. What’s more, capital gains will be subject to an additional 3.8% Medicare tax imposed by healthcare reform legislation enacted in 2010. Is now the time to consider an exit strategy?

A historical perspective

In 1978, the top federal rate for long-term capital gains was lowered to 28% from 35%. During the next 25 years, the rate fluctuated between 20% and 28%. Then, in 2003, the Tax Relief Reconciliation Act cut the rate to 15%. This rate was due to expire in 2010, but was extended for an additional two years to December 31, 2012.

Today, the U.S. finds itself in fiscal need of debt reduction. And as the government searches high and low for additional revenue, it seems unlikely that we’ll see another extension of the 15%. But there’s more; something that didn’t exist until 2010 – the Health Care and Education Reconciliation Act. On January 1, 2013, as per the act, an additional 3.8% Medicare tax is scheduled to be tacked onto net investment income, including capital gains and investment income taxes. This increase will apply to single taxpayers with income over $200,000 ($250,000 for married taxpayers). That means for a business owner, for every $1,000,000 in gain on the sale of a business, he or she may pay up to an additional $88,000 in
tax in 2013 (and beyond).

The opportunity today, the impact on tomorrow

Business owners have many decisions to make, none of which is more important than the decision to sell the business – and that includes when to sell. Many entrepreneurs have built businesses with the dream of creating assets that when sold would carry them comfortably through their retirement years. For business owners looking to sell and retire in the near future, taking advantage of today’s lower capital gains tax rate may be worth considering in order to maximize net profits.

To make the opportunity in 2012 clear and to illustrate the impact of the tax increase slated for 2013, we’ll use the illustration of a business sale generating $10 million in capital gains and assume there are no changes to the scheduled tax increases.

What the graph below shows is this: the seller will pay 59% more in capital gains taxes in 2013 (and beyond) than in 2012. Which means to achieve the same after-tax profit, the business would need to be sold for $11.15 million – an 11.5% increase in sell price – in 2013.

We realize that it takes time to sell a business – between six to 12 months – and many decision factors are involved. But for those with an exit strategy and marketing plan in hand, it may be time to put that plan into action – and sell that business now.

A charitable remainder trust can help others – and owners – when selling a business.

When most people think about selling a business, the most obvious way is to sell the stock to a buyer, then invest the proceeds to produce income for the seller. But there are capital gains to consider – which will increase on January 1, 2013, from 15% to 20% with an additional 3.8% Medicare tax imposed by healthcare reform legislation enacted in 2010. But if the stock is transferred through a charitable remainder trust (CRT), a charity can receive a benefit and the seller can receive multiple tax benefits that increase net income received from the sales proceeds.

How it works

Let’s say an entrepreneur, Jane, has a sizable C corporation that she sells the traditional way for $10 million. Her capital gains tax of 20% costs $2 million. The Medicare tax of 3.8% takes an additional $380,000. That leaves Jane with net proceeds of $7,620,000. If she invests that for an 8% annual return, Jane would receive $609,600 annually, which after taxes would net about $403,860.

But if Jane transfers $10 million in stock through a CRT, it’s a different story. There are no capital gains or Medicare taxes and the trust has the full $10 million to invest. If the money receives the same annual rate of 8%, it will produce $800,000 – 31.2% more than the $609,600 generated by the traditional sale. The trust pays Jane – and other family members if desired – a specified annual income for life. Upon the death of all income recipients, trust assets are distributed to the charity according to Jane’s specifications.

What’s more, if Jane takes the $800,000 out of the CRT each year instead of receiving $609,600 as in the last scenario, annual income after taxes would be about $533,333 – $129,473 more than the first net income of $403,860. In addition, the gift of the stock to the CRT may result in an income tax deduction to Jane, which in turn would further increase Jane’s after-tax income.

Interested? Work with experts

There are many important things to consider – like the permanent nature of the trust – and many variables to analyze. But if a CRT seems like a course you may be interested in, please consult with your financial advisor and trusted tax professionals. They can help you come to a decision that is right for you and your business. The returns mentioned are hypothetical, do not include costs and fees, and do not represent the performance of any security.  Investing involves risks, including the potential loss of capital.

Help your employees and yourself with an employer-sponsored retirement plan

An employer-sponsored retirement plan is a great benefit for employees and a tax-advantaged method to save for your own retirement. But before you start counting tax deductions, you’ll need to decide which one is right for your business – and there are several. To help, we’ll use hypothetical businesses to introduce three that may be less expensive and easier to administer.

Simplified Employee Pension (SEP) plan

Ann has a website development company that she runs with the help of her son, who’s serves as the company’s principle web designer, and two other administrative employees on which Ann relies to keep her business running smoothly. Because of their loyalty over the years, Ann wanted to offer an additional benefit that would also provide a tax offset for the cost. So Ann decided to implement a SEP plan.

Through the SEP, Ann contributes money for her employees and herself directly into traditional individual retirement accounts
(SEP IRAs) – that are vested 100% from the start. One thing Ann really liked about implementing her company’s SEP is it did not have the
startup and operating costs of a conventional retirement plan.

Ann must make contributions on behalf of any employee (at least 21 years of age) who’s worked for the business in any three of the preceding five years. She also has discretionary control over annual contributions to her employees’ funds – up to 25% (or a maximum of $50,000 in 2012) of their individual compensation. Ann’s SEP contributions are tax deductible, and all earnings are tax deferred. Ann’s fiduciary duties are also minimized with an SEP because participants choose their own investments after establishing their SEP IRA accounts.

Owner-only/one-person 401(K)

Bill has a home improvement business he operates as an S corporation. When he needs additional help, he uses day labor to avoid hiring permanent employees. Bill wanted to start a savings plan through his business that would let him prepare for retirement and one that would let him include his wife. He also wanted a plan that would offer high contribution limits so his savings would grow faster. After talking with his financial advisor, Bill decided an owner-only/one-person 401(k) was the right plan choice.

With this plan, a participant can contribute up to 25% of his total compensation, or a maximum of $50,000. But since Bill is over 50, he can make an additional “catch-up” contribution of up to $5,500, for a maximum of $55,500. Contributions are tax deductible for the business.

Though this plan was designed for a business with no employees, there is an opportunity for spouses to participate. And since Bill’s wife works as the company’s bookkeeper, she can participate in the plan, too.

Simple IRA plan

Charles and his business partner, Sam, have a chain of dry cleaning stores that employs between 40 and 50 workers. The two owners wanted to encourage their employees to save for retirement and to provide another benefit in addition to medical insurance. Since they have fewer than 100 employees, they chose a Simple IRA plan. Their decision was also due in part to the lower administrative costs compared to those of a 401(k) plan.

Through the plan, employees can defer up to $11,500 (indexed for 2012), with no set maximum percentage of compensation. The plan also allows Charles and Sam to make mandatory contributions as either matching dollar-for-dollar on the first 3% elective deferral or a uniform 2% contribution to all employees, regardless of whether they made elective deferrals. They chose the latter. And contributions are tax deductible for the business.

Seek professional guidance

Of course, there is the ubiquitous 401(k) profit sharing plan and the Roth 401(k) plan, but these usually incur higher administrative costs. The best thing to do if you’re interested in a retirement plan is talk to a professional, like your financial advisor. He or she can help assess the facts and figures to choose a plan that will help you and your employees save for retirement and on taxes.

License your product, grow your business

You have a business. And through hard work and perseverance it’s successful. But like other business owners, you may start to wonder what you can do to make your business grow further. There are many strategies for doing this and some depend on the type of business you own and your available resources. But here’s one that will work whether you have a branded product or a branded service: Licensing.

Licensing can be an effective, low-cost growth medium that can also minimize your risk. Compared to the price tag associated with starting a company to produce and sell a branded service or product, the cost of licensing is relatively low. Licensees usually pay a one-time or annual fee, and/or an amount of sales, usually between 3% and 7%.

But don’t confuse licensing with franchising. Franchising is a far more complicated venture with longer start-up times plus fees and taxes that licensing does not incur. In fact, Starbucks uses licensing for non-corporate owned stores.

To start, talk to your business’ attorney or an attorney that specializes in business licensing. And start researching companies that provide products or services similar to yours where your product may be a good fit.