By Peter Shanahan, CFP, CRPC, MPAS
Naturally, when it comes time to sell a business — whether it be a widget factory or a horse farm — we want to sell for as much as possible. But simply getting the largest dollar sum for the sale may not be the best way to maximize your value. Here’s an example:
Fred built his farm over several decades. He added barns, outbuildings, a covered ring and loads of equipment. When it was time to sell, he naturally wanted the largest dollar sum the market would bear. When he negotiated the final $2.9 million price with his buyer, which included a $500,000 note, he was happy, and so was the buyer. Unfortunately, they both missed a few opportunities to maximize value by saving taxes.
Fred found out from his accountant that the barns, sheds and equipment he had been depreciating were subject to “recapture.” This meant that the tax rate on the “recaptured” depreciation would be much higher than the usual 20 percent capital gain tax rate. As a result, he ended up paying an extra 17 percent tax on the last half million. Cost: $85,000.
Fred was able to avoid paying taxes on the gain on the sale of his personal residence, which was on the property, and that was good for him. But what Fred wasn’t thinking about was his buyer. Fred’s buyer intended to use the rest of the farm as Fred had: as a business. That meant that he was going to use cash flow from the business to finance the note. The terms of the note were 10 years at 5 percent, payable monthly, with a payment amount of roughly $5,300 per month. But the buyer needed to earn over $7,500 before tax each month to make the $5,300 payment. Then, when Fred got the money, much of it was taxable to him as gain (much of which was taxed as “recapture” of depreciation), and some was taxed as interest on the note. In the end, Fred only ended up with about $4,500. So, Fred’s buyer needed to earn $7,500 just to get $4,500 into Fred’s hands. That’s $3,000 per month lost to taxes! That’s because the way Fred structured the sale, his buyer was able to deduct the interest portion of roughly $136,000 over the life of the loan, but not the $500,000 of principal. What a tremendous lost opportunity!
What could Fred have done to shelter some of the gain from taxes and to have some of the note payments taxed at a reduced rate?
This is a job for Fred’s team. He would need to involve his CPA, attorney and financial advisor. First, Fred could have looked into a strategy to help him defer tax on the sale of the business assets (the working farm; not the residence, which would need to be deeded separately. Fred’s attorney would do this after consulting with Fred’s CPA). A section 1031 tax free exchange is one way. The problem is that it’s messy. He would have needed to identify property to be exchanged prior to selling his farm, and he would have needed to close on the property within 180 days of the date his farm sale closed. But what if there was no suitable property at that time; what if the price of the property he identified to buy didn’t match the price of the farm he was selling; and what if the deal fell through at the last minute? And what if Fred didn’t want to own and manage another business property — he wanted out? What Fred might have done in this case is a commercial 1031 exchange for shares of a Delaware Statutory Trust established for this purpose. His financial advisor would facilitate this after consulting with Fred’s CPA. He could choose to do this for all or any portion of the sale price of business real estate (but again, not the residence). The rest would come to him as cash.
The portion of the sale price financed by the note would not be eligible for this exchange. But Fred could get a bit creative here, too. As for the problem of the note payments being paid with after-tax dollars from the buyer, and then taxable to Fred, he might have negotiated a consulting agreement with the buyer. He might have lowered the sale price and reduced the note — say by $100,000. The seller’s note payment would thereby be reduced by $1,060 per month, but that $1,060 would become Fred’s consulting fee. The buyer could then deduct that expense, and so use pre-tax dollars for this portion of the purchase price.
The consulting fee Fred would receive would, of course, be taxable to him as ordinary income rather than capital gain; but then, Fred might be able to deduct expenses like his car and professional equipment, as well as travel and, possibly, the cost of his home office. Fred might also invest a significant portion of the consulting fee in a pre-tax retirement plan. He would still have FICA taxes to pay, but he might still find that his net proceeds increased by a meaningful amount. Not to mention that when Fred was negotiating with his buyer, the two of them might have agreed to split the tax savings, reducing the net cost to the buyer while increasing the net benefit to Fred.
Fred also has a significant investment in depreciated equipment — let’s say $200,000. Rather than sell it as part of the farm sale, forcing him to pay ordinary tax rates on the recapture, and forcing his buyer to finance the purchase with after-tax dollars, Fred might consider leasing the equipment to his buyer. This would allow his buyer to have a clean paper trail to deduct the lease expense, and it would allow Fred to get an income stream based on the total value of the equipment, rather than on the net after-tax value.
These strategies are by no means a definitive list. The point here is that the sale of your horse farm business may offer a variety of opportunities that aren’t immediately visible and that you could easily miss — particularly if all you’re looking to do is maximize that one number, the sale price. On the other hand, if you’re willing to take some time, to involve your team early in the process and to think outside the box, you might find that there are any number of ways to improve the outcome, both to you and to your buyer. Sometimes the problem is, indeed, the way we look at the problem.
Peter Shanahan is a graduate of the College of William and Mary, a Certified Financial Planner and Chartered Retirement Planning Counselor. Peter has also earned the distinguished designation Master Planner Advanced Studies (MPAS). He is one of the founding partners of a wealth management practice with Hilliard Lyons in Hendersonville, North Carolina. He has been in practice for over 30 years, and has contributed to the training of hundreds of financial advisors. Peter owns a horse farm near Tryon, North Carolina, ) and has earned colors with two local hunts, having served as treasurer for one of them. He also currently serves as president of a local equestrian trail association. He has lectured extensively on a variety of financial topics, but his primary area of interest is the intersection between his two passions: financial planning and equestrian pursuits.