It is, of course, most appropriate that financial advisors seek to prepare their clients in advance of a major liquidity event such as the sale of a business, a public offering, or a similar event. An experienced, knowledgeable, and creative advisor can figuratively perform magic if he or she has sufficient time to prepare for a liquidity event. To optimize results, the advisor will want to participate in structuring – even steering – the client’s participation in the event and will want to be well prepared for all of the possible event-related outcomes from a tax, estate planning, investment, cash-flow, and risk-management perspective.
Pre-event tax and estate planning techniques available to the advisor and the client, for example, include:
(1) Transfers to trusts, family limited liability companies, and other vehicles;
(2) Leveraging gifts through grantor-retained annuity trusts, intentionally defective grantor trusts, and similar vehicles;
(3) Charitable transfers;
(4) Section 83(b) and other tax elections;
(5) State tax and domicile planning; and
(6) Some of the more mundane tax strategies such as deferring income and accelerating expenses.
Yet, regardless of whether an individual has gone through a rigorous planning process prior to a substantial liquidity event, he or she should pursue an equally rigorous, comprehensive post-liquidity-event planning process. Needless to state, this process will vary depending on the nature of the event, the individual’s personal circumstances, and the macro and micro outlooks available at the time of the event. Nevertheless, there are several fundamental steps that must be considered following a liquidity event – even in the absence of pre-event planning.
1. Tax Planning
Most immediately, an individual who undergoes a major liquidity event will need to ensure that full consideration is given to the tax consequences of the event itself and whether, through strategic timing, tax elections, or further structuring, those consequences can be further optimized. For example, in the case of a public offering or similar event, simple questions such as when and in which year to sell any newly public securities can make a dramatic difference with respect to the potential deferral of the associated income, realization of any available capital losses, timing of state tax payments, and applicability of special taxes such as the alternative minimum tax.
In the context of a business or asset sale, an analysis should be performed to confirm all of the relevant tax attributes, including basis, holding period, capital account (if applicable), and tax character (i.e., capital asset or otherwise). The individual also will require advice on the taxation of any deferred sale payments such as contingent earn-outs and escrows. Questions surrounding the use of the installment method of accounting for any gains not only are critically important but also are compounded in complexity when considering the various ways that cost basis can be recovered or the fact that some states impose different rules regarding the application of the installment method.
More recently, yet another analysis became necessary – specifically surrounding the applicability of the net investment income tax under the Affordable Care Act. Many individuals incorrectly assume or even are advised that this tax applies to any sale of securities or assets that they own. In fact, this tax does not always apply, and exceptions for business-related sales where the individual has been actively involved in the business may very well be available – potentially saving him or her substantial amounts of tax.
In any event, it is prudent to ensure that an adequate reserve is established to pay the current and future tax liabilities generated by the liquidity event. This reserve should be segregated and invested in short-term, conservative, and liquid positions so as to ensure that funds are readily available when needed.
Finally, a new set of ongoing considerations may also arise if an individual’s financial circumstances change in a substantial way after a liquidity event. If, for example, the individual’s income shifts from primarily earned income to primarily investment-related income, a new tax strategy, including a plan for paying estimated taxes, must be adopted for federal, state, and local tax purposes. Capital loss utilization, the ACA net investment income tax, the alternative minimum tax, and the mere absence of most tax withholding regimes can represent an entirely different set of considerations under such circumstances.
2. Estate Planning
Estate planning does not end after a liquidity event. In fact, proper estate planning is a continuous, lifelong process.
Although much of the higher-impact estate planning should ideally occur prior to a liquidity event, substantial planning can still occur afterward. Annual gifts, transfers to trusts and family LLCs, and a variety of charitable planning techniques remain available even after the event and can considerably mitigate future estate taxes.