Wealthy clients who sell their small business have more to think about than how they’re going to spend their future workdays. Advisors say sellers need to consider that business sales trigger ordinary income or capital gains taxes on the profit from the deal.
The taxes differ—long-term versus short-term capital gains come into play, for instance—depending on the business structure and how long you owned the business. The gains can also push a wealthy seller into a higher income tax bracket.
“Investing in a direct index vehicle and deploying a disciplined loss-harvesting strategy soon after the sale of the business can be very helpful from a capital gains tax standpoint,” said Erik Preus, head of investment solutions at Envestnet PMC in Minneapolis. “Those losses can be used to offset the capital gains tax they’ll have to pay on the sale of the business.”
In the wake of the pandemic, businesses are back to changing hands in big numbers. Sales of businesses are increasing this year steadily quarter by quarter, according to the BizBuySell Index Report, which tracks U.S. business transactions and sentiment through surveys of business owners, buyers and brokers.
The median sale price on business deals in the second quarter was $300,000, down slightly from previous quarters—but still enough to constitute a liquidity event, according to the report.
Donald N. Hoffman, a Baltimore-based partner at Eisner Advisory Group and president of The Prosperity Consulting Group, said issues arise with liquidity.
“Part of the plan when investing new funds is not to invest it all on day one,” he said. “Money needs to be invested over a six-month period, for example, to deal with market fluctuations. With the Federal Reserve position and short-term Treasurys hovering at 5%, barring any major economic surprises, it’s a good idea to invest some of that money in short-term Treasurys for money that you need to use in the next six to 18 months.”
Hoffman also advises clients put funds into intermediate-term investments such as Treasury bonds, corporate bonds [and] other high quality fixed income, which can attain price appreciation when rates start to fall; he thinks that fall will happen long-term “and you want to lock in the rates while they are still available.”
Certainly for long-term investment appreciation, clients should look at assets allocation in the equity markets to achieve appreciation and dividends, he said.
“Put it to work right away or wait for the right opportunity? Successful investors typically don’t build fortunes by sitting on cash,” said Steve Parrish, adjunct professor and co-director of the Center for Retirement Income at the American College of Financial Services in King of Prussia, Pa. “A major mistake is that the client ignores tax consequences of the transaction until after the sale has closed. For example, can they sell on an installment note rather than for a lump sum?
“Does the client want to put their money back into the market?” Parrish said. “Particularly if the sale involved real estate, using a 1031 transaction, they have 45 days to reinvest in like kind property. This will avoid recognizing capital gain on the sale. If the client is worried about the significant capital gains generated by the sale, another way to lessen the tax bite is to invest in a Qualified Opportunity Zone.
“If the transaction has closed, have they considered ways to lessen the tax sting by maximizing the use of qualified retirement plan strategies?” Parrish said. “This may seem like a small move financially, but collectively they can position the client for future tax savings.”
Another advisor preached patience.
“Rushing to make investment decisions from a fear of missing out on opportunities may lead to unintended consequences,” said Jeff Mattonelli, a financial advisor at Van Leeuwen & Company in Princeton, N.J. “It can cause clients to make irrational investment decisions and potentially take on more risk than they really need to. It’s important to plan for these types of events in advance, so when the sale occurs, clients can be prepared to act in accordance with their ... goals.”
Parrish also said it sometimes pays to keep deals simple.
“Sometimes it’s better to accept that their successful sale-generated taxable gain,” Parrish added. “Trying to avoid taxes through questionable schemes or chasing tax strategies lacking economic substance can be a fool’s quest.”