When the time comes for a business to go to market, a potential source of strife may be the impending tax bill. Despite an influx of cash upon sale, a business should consider entering into a tax-efficient structure upon sale. A “deferred sales trust” (“DST”) is a tax deferral structure, meaning owners can structure a sale to stretch tax payments over a period of years.
A DST is a structure that sellers can implement to take the “bite” out of a tax bill. Generally, when owners sell their business, a large, one-time tax bill accompanies the sale. An owner is subject to tax because the business sold an asset with a low tax basis, but the asset’s fair market value was much higher. The difference between the fair market value and the tax basis is where tax is applied. For owners who have labored to grow their business, getting stuck with a hefty tax bill may cause them to feel like they are getting the short end of a deal.
Typically, when owners sell their business, the value of the business is greater than its tax basis. A classic example is the stock of a family-owned corporation. If a business owner sells the stock (and this stock likely has a very low tax basis), that same owner will owe capital gains tax on the difference between the purchase price and the tax basis. Despite the owner being taxed at capital gain rates on the asset appreciation, the tax bill could still be a tough pill to swallow. Instead, the selling owner may have saved money if the transaction had been structured differently.
By engaging a DST, an owner sells the business to the irrevocable trust in exchange for a promissory note. Now, the irrevocable trust owns the business, and the owner holds a promissory note payable by the irrevocable trust. Then, the irrevocable trust will sell the business to an end-buyer for cash. With the end-buyer holding the business, the irrevocable trust now has the cash, and the irrevocable trust can pay down the promissory note to the now-former owner. While the irrevocable trust makes payments on the promissory note, the proceeds from the sale are invested, and those investments can generate income to help pay down taxes on the original sale.
A DST structure is a complex arrangement. Before an owner implements a DST, an owner should engage a sophisticated advisor familiar with the tax code, mergers and acquisitions, and estate planning. Without proper implementation, a DST could come under the scrutiny of the IRS. This means that the IRS could challenge the tax deferral of the sale of the business and instead find that the taxes cannot be stretched over a period of years. A skilled advisor, well-versed in structuring these transactions, can help advise owners if preparing for sale with a DST is appropriate for their business.
While a DST is not a panacea for every owner, under the right facts, this structure may provide value to legacy business owners on exit. Because a DST defers taxes while creating an opportunity to invest proceeds, a DST may be the right tool for you to preserve the value on sale.
For more information or to seek counsel from our Mergers & Acquisitions group, please reach out to request a consultation or call us at 216-696-1422.
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*This article was originally authored for publication in Crain’s Cleveland Business. To view this article on the Crain’s website, follow this link.
