I would rather expire at my desk than to sell my business and pay Uncle Sam one dime in taxes. How many owners that have paid their fair share of taxes for twenty years of building their business feel this way? The tax bite is the single biggest factor in an owners reluctance to sell his/her company.

I have previously written articles discussing various aspects of transaction structures to minimize taxes. As a result, I am often contacted by a panicked seller that is a week from closing his business sale as he looks in disbelief at his accountants spreadsheet detailing the tax burden of his impending sale.

Recently, the seller of a Sub Chapter S Corporation with an $8 million transaction value contacted me. The tax basis was below $200,000 and $4 million of the transaction value was the assumption of debt. When the dust settled, he was looking at a capital gains tax liability of a staggering $965,000 while only receiving the remainder of proceeds after the assumption of debt. The assumption of debt is considered as part of the capital gain for tax purposes.

The owner sent his accountants spreadsheet to me and since I am not a tax accountant, I sent it to my tax wizard at BDO Seidman. He found a few small tweaks, but said that there was not much that could be done from an accounting standpoint for this owner. When I reported this back to the seller I could feel his disappointment and frustration.

So I began my quest for a better solution. After several dozen phone calls to my professional network, I was directed to a little known vehicle called a Private Annuity Trust. This vehicle has passed the scrutiny of the IRS and the Tax Court. It is not a way to avoid the payment of taxes, rather a method of deferring them with substantial economic benefit to the owners beneficiaries.

Below is a simplified description of the process. As the owner contemplates the sale of his business (or any highly appreciated asset for that matter) he sells it to a trust PRIOR to its ultimate sale. This trust purchases the asset at FMV and exchanges an annuity payment stream complete with IRS life expectancy tables and interest rates. The trust then sells the company to the buyer to fund the annuity.

The transaction is accompanied by a gift to the trust in the amount of 7% of the face value of the annuity. This is so it qualifies as a trust by creating an entity with economic value. Remember, the private annuity is viewed as having zero economic value because the asset minus the obligation theoretically equals zero.

The trust is in the name of the owners beneficiaries and all aspects of the trust are controlled by the trustees/beneficiaries and not by the owner. The trust for the benefit of the heirs owns the assets and owns the annuity payment obligation. The trust can be structured to defer the annuity payments for a period of time to coincide with the owners need to receive these payments, lets say, for example, ten years During those ten years the trusts investments or a commercial annuity grow without incurring a tax bite for the business sale.

When the annuity payments start, the owner is taxed at his then current tax rate for the portion of the annuity payment attributable to the capital gains, his basis (no tax), and depreciation recapture from the sale, and the income produced from the annuity. The annuity pays the owner and spouse this annuity payment until last to die or until the annuity investments run out. If the owner and spouse die, any remaining assets are transferred to the beneficiaries outside of estate tax liability.

If your investments perform at the rate used in the annuity calculation and the last to die lives to their exact life expectancy, theoretically the trust value will be whatever the gift portion (7% of the selling price) has grown to. However, if the investments do very well and you outlive the life expectancy tables, you could receive payments well in excess of the original annuity face value. Those excess payments would be taxed at your then current income tax rate.

If the investments do well and the value grows above the required annuity reserve amount, the excess can be distributed to the beneficiaries as income.

In the simplest of views, this acts like an IRA. You are not currently taxed on the amount you put in, it grows tax deferred and you pay taxes upon distribution, hopefully at a far more favorable tax rate. In the case of the frustrated seller from above, what if he deferred all payments by ten years on the full sale price and the $965,000 in capital gain taxes owed? He had a life expectancy of 20 years beyond the start of the distributions. The $965,000 that he did not pay in taxes grows at 7% to $1,939,323 by the time distributions start.

Every annuity payment contains a portion of the capital gain or 1/20th of the total capital gain annually. Therefore, the bulk of the resulting investment value of the capital gains tax deferral provides huge returns for years to come.

If it seems too good to be true, remember it is tax deferral and not tax avoidance. The owner has sold his business first to the trust in return for an annuity payment stream. The owner cannot control the trust. To the extent that the owner wants immediate access to some of the sales proceeds, he would pay all taxes in proportion to the amount he is receiving. In cases like the one above, this tax deferral tool can have a dramatic impact on the financial status of the owner and his heirs by allowing the tax deferred funds to compound for many years before their ultimate distribution and the payment of any tax.

Dave Kauppi

David Kauppi is an M&A Advisor with Mid Market Capital, Inc. MMC is a private investment banking firm specializing in providing corporate finance and intermediary services to entrepreneurs and middle market corporate clients in a variety of industries. The firm counsels clients in the areas of mergers, acquisitions, divestitures, resolution of shareholder issues, private placements of debt and equity, valuations, corporate growth and turnarounds.

Dave began his Mergers & Acquisitions practice after a twenty-five year career with a Multi-Industry background that included banking, high tech, and services. While in the leasing industry he gained a reputation for ?finding a better way? through creative deal structure. During one fiscal year, Dave?s region successfully negotiated over $200 million in financing transactions. He was instrumental in negotiating three multi-million dollar strategic partnerships in the service industry and launched and managed a very successful division.

In his M&A practice, Dave has completed transactions that range from succession planning exits, to finding strategic buyers for healthy, rapidly growing companies seeking a partner to provide scale, to division divestitures, to troubled companies. Dave has also been a speaker on shareholder issues and has published several articles on Mid Market M&A. His career focus has been in sales and sales management and he has received numerous awards for sales excellence. He brings his strong negotiating and facilitating skills to his practice, successfully managing transactions to a win-win result.

Dave graduated from The Wharton School of Business, University of Pennsylvania with a BS in Economics with a concentration in Finance. He received an MBA with a concentration in marketing from DePaul University. Dave is a Certified Business Intermediary (CBI), a licensed business broker, and a member of IBBA (International Business Brokers Association) and the MBBI (Midwest Business Brokers and Intermediaries). Contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com

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