Goralka estate tax lawyer san francisco skylineThe Business Climate in California is Golden!

by John M. Goralka

The Tax Foundation Says:

The Tax Foundation 2024 State Business Tax Climate Index lists California as 48th amongst all states, ahead of only New Jersey and New York. However, the Business Finance Council (BFC) notes that California rates number one (1) in terms of innovation and technology. 99.8% of California businesses are small businesses employing 48.8% of the California population. The BFC points to the following five (5) reasons for California businesses friendly environment: (1) large population of 40,223,504 making California the most populous state; (2) diverse customer or client base; (3) access to wide professional network provides greater access to lawyers, accountants and other professionals; (4) a very strong economy, the California GDP is growing so quickly that it is poised to pass Germany and become the forth (4th) largest economy globally after only the United States, China, and Japan; (5) strong infrastructure supporting the highest level of imports compared to other states. 

I cannot speak to the statistics, but our experience is that the California economy is very robust with a high level of business mergers and acquisitions without regard to the interest rate changes or high tax rates. We are increasingly busy with business sales and acquisitions and the related tax planning.

We help successful families and business owners minimize income and estate tax, better protect assets and transition client legacies and family values to the next generation. Our goal is to make a transformational change improving the lives of our client families. We recently obtained a $2.75 million reduction in estate tax with a supplemental estate tax for a farm family and enabled them to pay the remaining tax over a ten (10) year period. This enabled that family to continue its farming operations into the next generation and beyond. 

Business owners often work a lifetime or sometimes for multiple generations to develop a family business representing the family’s single most valuable asset. When the business is sold, the income is often compressed into a single year triggering the highest federal tax brackets. The highest federal tax bracket for capital gains is 20% and for ordinary income is 37%. The highest tax rate for California is now 14.4%. The combined rate for ordinary income is 51.4% and for capital gains is 34.4%. One third or more of the business value is simply lost in taxes. 

Relief is Possible

One way to receive some relief is to use an installment sale to spread income to future years and possibly obtain a lower tax bracket in later years. Note that Internal Revenue Code Section 453A puts a $5 million per person limit on installment sales. Some assets do not qualify for installment sale treatment such as publicly treated stocks or securities.

There are at least a dozen ways to reduce, defer or eliminate tax on capital gains or the sale of appreciated assets. Many prospective clients call to say that they have sold their business or building and would like to minimize the related tax. However, the best, most attractive planning is done before the sale is closed or even negotiated. Ideally, a client should begin planning in 2024 for a sale to close in 2026. This timing allows most attractive planning.

One such alternative is the Two-Year Installment Sale. Here’s how it works: You can sell the asset to your children or to a separate trust (sometimes referred to as the “deferred sale trust”) on a long-term installment sale. That way, your children or other beneficiaries can receive the full value and enjoyment of the property before the gain is recognized and subject to taxation. After a two-year waiting period, even the tax on the $1 million dollar can be minimized, and the property can be sold to a third-party buyer for cash. The children’s trust receives the entire sale proceeds in cash whereas the parent is deferring the tax for as much as twenty (20) years.

For example, let’s say you own Blackacre, a parcel of land that you originally purchased for $200,000. Today it has a fair market value of $10 million. You want it to benefit your children, so you sell Blackacre to your kids deferred sale trust for $10 million to be paid over twenty (20) years. The IRS requires that there is a two-year gap between a related party installment sale and a second sale of the same asset. So, two years and one day later, we sell Blackacre to a third party for $11 million paid in cash at closing. The deferred sale trust recognizes a gain on the sale taxed over twenty (20) years. Yet the family receives the entire $11 million of value while paying tax only on the $1 million gain. Yes, the trust will continue to pay off the note over the next twenty (20) years. You recognize any gains and pay the taxes over the twenty-year (20) period. But this provides a significant timing difference during which you invest the funds and receive the income and appreciation. Plus, you may also be able to reduce your taxable income and pay taxes from a lower tax bracket in future years with additional planning. 

This strategy is beneficial because the gain is taxed at a reduced rate as a long-term capital gain instead of a short-term capital gain, which would be taxed as ordinary income. And your beneficiaries still receive all the cash proceeds in the year of the second sale. Also, this strategy provides an opportunity for a far greater overall return. If you invest the funds you might have otherwise paid in taxes in the year of the original sale, you might earn 6% or more each year on that amount. For more information on the Two-Year Sale strategy, click here for the Best Lawyers article (link to How You Can Reduce Capital Gains Taxes with a Two-Year Sale Strategy).

The next best time for a client to reach out in 2024 for a sale that will close later in 2024 or 2025. This permits a discussion of structures to use prior to the sale to mitigate the tax bite and perhaps additional steps to take after the sale to further mitigate the tax cost. 

The most attractive planning is done prior to the existence of a binding obligation to purchase and sale. Note that there are both charitable and non-charitable structures that can be used prior to the binding obligation. For a charitable structure, a portion of the assets sold may be transferred to the charitable trust or charitable entity. A portion of the sale may not be taxable at all depending upon the type of charitable structure. For example, a Charitable Remainder Trust or a Split Interest Charitable Income Trust would not be subject to tax. A Charitable Contribution Deduction is generated to offset income tax on the remaining sale proceeds going directly to the client. A grantor Charitable Lead Trust (CLT) would not provide for a portion of the sale to be nontaxable, but a CLT often provides a dollar-for-dollar income tax deduction for amounts contributed to the CLT. The key with any such structure is the economic benefits flowing to the family. 

Note that the timing for this type of planning is critical. In Hoensheid v. Commissioner TC Memo 2023-34, the tax court found that implementing a plan two (2) days prior to a binding agreement between Buyer and Seller was too late. This was an illegal assignment of income. The tax benefits from some otherwise traditional and well-respected planning was lost. The lesson to be learned is not to wait too long and be sure significant deal points for the sale are still being negotiated after the planning and any related title transfers and entity formation are completed. For more information, click here (link to the Best Lawyers article on Tax Planning Cautionary Tale).

Subchapter S

Tax planning for a Subchapter S stock sale can be challenging. This is because of the substantial restrictions on who can be a qualified Subchapter S shareholder which is generally limited to individuals and very restrictive trusts (the Qualified Subchapter S Trust (QSST) or Elective Small Business Trust (ESBT)). Neither the QSST nor the ESBT are conducive to minimizing tax on the sale of S Corporation stock. 

Under the right circumstances, goodwill for a business conducted by a Corporation can be owned individually by the business founder or developer. If so, then this personal goodwill can be transferred to a charitable structure to generate substantial tax savings and also substantial economic benefits to the seller and his or her family. This is done without the restriction or who can own S corporation stock.

First, property rights for income tax purposes are determined under state law. Most states recognize some form of personal goodwill. Much of the case law establishing personal goodwill arose in divorce proceedings where a soon to be ex-spouse sought compensation for or to share in this often very valuable asset. 

A recent sale of business for $6 million resulted in tax savings in excess of $1.4 million. This was done by contributing personal goodwill to a lifetime income charitable pooled trust prior to the sale. In addition, the seller was able to invest and receive income for life of the amount contributed to a split interest charitable income fund.

This provided a very substantial benefit for the family as follows:

This lifetime income charitable pooled trust can provide a substantial increase in a family’s wealth over simply paying the tax. If we simply paid the tax, then the family would net $2.25 million after paying federal and state (estimated) tax of 25%, or $750,000. If invested at 7%, then that would provide income of $157,000 per year. That provides a value of $1,668,557. When added to the $2.25 million, that provides a total increase in wealth at $3,918,557. If we avoid tax on that same $3 million, we save tax of $750,000 and invest the entire $3 million to receive a safe, predictable income of $210,000 every year. If invested for twenty (20) years, That equals a value of $8,609,053. The preset value of that is $2,224,743. When added to the $3 million net proceeds from the sale, that provides a preset value of $5,224,743. This is an increase in wealth of over 33%. 

In addition, the client received an income tax deduction to avoid tax on other income in the amount of $2,202,641. The total tax savings was $1,564,977, representing the tax savings from the deduction and the charitable portion of the sale not subject to tax. This provides a substantial benefit to the family particularly when added to the investment income described above.

These are just a few of the lesser-known techniques to minimize tax on the sale of capital assets. As indicated above, our experience is that the California business climate is not only healthy but very robust.

Post A Comment