Preface: Should you sell your business in 2020 to a non-grantor irrevocable trust? Such a sale will be taxed in 2020 at the current top federal capital gains rate of 20%.
Minimizing Tax on the Sale of Your Business or Commercial Real Estate in 2021 – Preliminary Sale to a Non-grantor Trust
Credit: Donald S. Feldman, CExP™, CPA, CVA, MBA
For the last two years, whenever anyone asked me about saving taxes on the sale of a business, I had a stock piece of advice: “Sell before the end of 2020”. We are living in a historically low tax environment in which we are also experiencing record government budget deficits. Even before the pandemic and the multiple trillion-dollar bailouts, the handwriting was on the wall. Higher taxes were on the way.
Now here we are near the end of 2020 and you haven’t yet sold your business. Perhaps the pandemic and the resulting freeze-up of the M & A markets prevented you from selling. Perhaps you finally have a deal to sell your commercial real estate but it won’t close until 2021. The immediate political outlook is uncertain. Biden campaigned on a platform of a 39.6% capital gains tax rate for gains greater than $1 million, compared to the current top rate of 20%. This would be an extraordinarily high tax hit on the once in a lifetime sale of your most valuable asset. But in order to have a working majority in the Senate (with VP Harris casting the deciding vote in a 50-50 Senate), the Democrats will need to win both Senate run-offs in Georgia. The January 5, 2021 Georgia Senate elections are attracting a tsunami of political money. It has already been dubbed the Super Bowl of political fundraising. In what would otherwise be a relatively low turnout special election, with so much at stake and both parties geared up, anything can happen. Even without a working majority, the Democrats might be able to pry loose a Republican or two to vote in favor of higher taxes.
Any new tax law in 2021 will almost certainly be retroactive to January 1, 2021. Considering that the sale of your business or commercial real estate is likely to be the biggest financial transaction of your life and on which your future financial security depends, the question you need to ask yourself is, “Do I feel lucky about 2021 tax rates”?
As it happens there is actually something you can do to lock in gains on the sale of your business or commercial real estate at 2020 tax rates – sell your business in 2020 to a non-grantor irrevocable trust. Such a sale will be taxed in 2020 at the current top federal capital gains rate of 20%. The business in the hands of the trust will have the higher basis of the sale price so that any sale in 2021 from the trust to a third-party will result in a nominal gain (or loss). A non-grantor irrevocable trust is essentially a trust that you, the business owner, do not control. “Nongrantor” is a term of art in the tax code. The “grantor” is the person (sometimes referred to as the trust “settlor”) who establishes the trust and contributes assets to it. Certain sections of the Tax Code (IRC 671-679) define the elements of control that makes a trust a “grantor” or “non-grantor” trust.
For example, if the grantor has the right to the income from the trust, or can designate who receives the income, or is entitled to a so-called “reversionary interest” (i.e. trust assets revert to the grantor on the happening of certain events) then the trust is deemed to be a “grantor” trust. If the trust has “grantor” status, then for tax purposes the trust is treated as identical to the grantor; the sale of the business to the grantor trust won’t be recognized because it is essentially a sale to yourself. Only if the trust has “non-grantor” status will the sale be recognized so you can lock in the maximum 20% tax rate.
So how do you get paid? The sale to a non-grantor trust in 2020 will be for a promissory note. When the trust sells the business in 2021, the trust will have the cash to pay off the note.
Sale of the business via a note means that you are eligible for federal tax purposes to use the installment method of reporting the sale – i.e. recognize gains based on the actual receipt of payments on the note. However, using the installment method will defeat the purpose of the tax planning, because taxes are likely to be higher in 2021 when you receive the cash proceeds. However, you can elect out of the installment method and choose to recognize all of the gain in 2020. You need to make this election no later than the extended due date for filing your 2020 tax return – October 15, 2021.
The downside risk here is if you execute a sale to a non-grantor trust in 2020 but fail to sell it to a third party in 2021, you might be stuck paying tax without getting cash. However, you can probably unwind the transaction in 2021. If you don’t sell in 2021, you can refrain from electing out of installment sale treatment and if the trust doesn’t have the cash to make payment on the note and defaults, you can get the business back.
Forming an appropriate non-grantor trust and documenting the transaction is complex. Be sure you are dealing with an attorney who is expert in trusts. Don’t try this one by yourself.
This article is general in nature, and it does NOT contain legal nor tax advice. Please contact your accountant or trusted advisor to see what applies in your specific situation.
“Don Feldman’s success as an Exit Planner rests on three essential elements. (1) Don “gets” the needs of business owners. (2) He has created and constantly adds to a tool box chock full of proven planning strategies and ideas. (3) His ability to deconstruct, demystify and explain complicated tax and valuation issues in a way that owners–and even attorneys like me!–can understand.”— John Brown, Founder, Business Enterprise Institute, Denver, CO