How to tax plan for business succession
We attended the Forbes Ag Summit in Indianapolis in September, and while Steve Forbes continues to advocate for a flat tax and tax simplification, tax codes continue to be complicated. These are the rules business owners must navigate as they position their business for transition.
Reduction in Corporate Tax Rates
Federal corporate tax rates were reduced to 21%, and for a growing business that plans to reinvest profits, converting to a C Corporation may make sense. Some ideas include:
Finding capital to buy out a minority shareholder or invest in a new product line or add more employees
Reducing the overall tax rate: a way to redirect capital from tax expense to other strategic needs. This may be beneficial from a positioning standpoint as well. For example, if a business is currently formed as an S Corporation and is considering an ESOP, or, financial buyers such as private equity firms or family offices are likely to show interest in the business, entity type matters. This is not a decision that should be made without careful analysis of all relevant factors, including qualitative factors. The lower corporate tax rate has reopened this discussion, and is one which business owners should pay close attention.
Part of our planning process for any business succession planning engagement includes evaluating the tax impact of the sale of a business. Business owners have a variety of options on how to use proceeds from the sale of their business, and the TCJA created a new option: any capital gain generated from the sale of the business could be reinvested in a Qualified Opportunity Zone (QOZ).
By investing the gain in a QOZ, business owners defer paying taxes on that gain until 2026, when taxes on the gain will become due. In addition, any QOZ investment held for 10 years can avoid any tax as any appreciation in that investment is not taxable.
Tax impact matters. Consider that the tax brackets for individual taxpayers range from 12% to 37% – a difference of 25%. The difference between the highest ordinary rates of 37% and the lowest capital gains rates of 15% is 22%.
Passthrough entities are taxed at the individual level, as taxable income is passed through to the individual shareholders or partners. For a C Corporation, the rate is 21% and for individuals, the highest rate is at 37%, a difference of 16%.
Consider the sale of a business with a taxable gain of $5 million. Does a difference of a tax rate of 25% or 22% make a significant difference? Absolutely.
Business succession planning is a good business strategy, regardless of your proximity to a planned exit.