Should business owners sell their business via installment payments or lump sum?
Is this even the right question?
At Galena Fund we are approached often by CPAs, Business Brokers, Merger and Acquisition teams, and Financial Advisors. Each group wants to know the best way to structure a business sale, so that their Sellers can take advantage of the new tax options that opportunity zone funds can provide. Typically, we advise these groups by showing them a comparison between how things are currently done and how they can improve on this process by investing in an Opportunity Zone Fund. When these professionals share this new opportunity with their clients we hear about how glad they are to learn about this new option.
Typical Concerns
Clients will always be concerned with whether they can get enough money out of the sale of their businesses to retire. The specific terms of the sale are often just as important and sometimes the hardest to negotiate. We know that many advisors recommend that their business sellers take a series of payments to obtain the highest price possible and to avoid a huge tax bill. But, is this the best approach.
Below is a series of examples showing how the sale of a business can play out.
First a quick notice, these scenarios address only the part of the sale that results in a capital gain for sellers. For the purpose of these scenarios we have assumed a 20% federal tax that must be paid on the capital gains earned. Additionally, these scenarios only consider federal capital gains taxes.
Scenario 1: Sale of Dental Business
Your client worked as a dentist for twenty years and is now looking to retire. The buyer looking to take over the dental practice has limitations with the financing of the buyout. If the sale goes through your client will incur a $5,000,000 capital gain. Option one involves your client taking $4,500,000 now. Option two involves taking $3,750,000 now, but retaining a 40 percent ownership for 3 years, until they are paid in full. As operations continue, your client will receive around $105,000 per year in consulting fees, while he is an owner. Your client will receive a final payment of $1,618,786 ($1,250,000 and $366,786 of accrued interest at 9%), which helps them to net more money in the end.
Fundamental questions now are:
- Do they hold out for more?
- How did this affect their tax situation?
Our Suggestion:
Always look at the numbers. All your client’s consulting income and interest income will be taxed at regular income tax rates. Thus, the capital gains are where the real profit difference is determined.
The Numbers:
| Offer 1 | Offer 2 | |||
|---|---|---|---|---|
| Taxable Capital Gain | $4,500,000 | $3,750,000 | ||
| Capital Gains Tax 20% | $900,000 | $750,000 | ||
| Net Investment Income Tax 3.8% | $171,000 | $142,500 | ||
| Net Proceeds | $3,429,000 | $2,857,500 | ||
| Total Tax Bill | $1,071,000 | $892,500 | ||
| Year 2 Payment | ||||
| Net Proceeds (Net of 23.8% tax) | ||||
| Year 3 Payment | $1,250,000 | |||
| Net Proceeds (Net of 23.8% tax) | $952,500 | |||
| Total Offer Price Net of Tax | $3,429,000 | $3,810,000 | ||
| Difference | $381,000 |
Your client will incur risk if they carry the note on the buyer’s practice; after all, it could fail! Your client could lose their money but let’s assume it all goes well. Is this where the options should stop? Your client made more money by carrying a note and being a consultant for a few years. Wait! Should your client have weighed the tax implications differently? Its likely that your client has a CPA that recommended they investigate an Opportunity Zone Fund, before they finalize any response to the offer..
Offer 1 investing with an Opportunity Zone Fund
By investing in an Opportunity Zone Fund instead of in a typical stock/bond strategy, your client would generate more than 3X the return with the Opportunity Zone Fund over the average stock market portfolio return.
Offer 2 investing with an Opportunity Zone Fund
By investing in an Opportunity Zone Fund instead of in a typical stock/bond strategy, your client would generate more than 3X the return with the Opportunity Zone Fund over the average stock market portfolio return.
The most confusing part for many clients is why they waited three years to receive the rest of their payoff. Historically many have thought the client would net more money in the end. So lets check the numbers! Your client could potentially make more if they invested their money in a stock and bond portfolio. Was the risk of waiting to be paid a little more worth the additional net income of $5,362 in growth made on the invested money?
Deep Analysis
We know what you are thinking, why are we comparing a Stock / Bond portfolio with a respectable 10% / 5% return to a real estate return of 12%. Obviously the bigger number will win.
However, let us analyze this a different way. Compare what the average mutual fund or stock EFT does on average. Since inception SPY ETF have averaged 9.43% (the last 10 years have been better) and SPAB Bond ETFs have averaged 4.07% (the last 10 years have been worse). Real Estate investment rate of returns for iShare US Real Estate ETF s are 484% (only 400% for the last 10 years). Remember the low in real estate pricing was about 10 years ago.
When comparing to an Opportunity Zone Fund investment the tax savings is the bigger issue:
Your client starts with more to invest and pays nothing on the growth. This tax strategy investment style allows for the huge separation of total dollar return to the individual investor.
Scenario 2:
A couple spent 15 years working to build a business that would be able to support their family. Little did they know that in the twelfth year of the business they would develop a spin off product that would ultimately receive an offer from a large competitor. The unexpected offer fulfills their dreams.
They now are forced to weigh the two options in front of them.
The larger group requires the purchase of the business be spread out over three years. Part of the negotiation is to build in a staggered buyout over the three years. The couple will retain no ownership in the company after the contracts are executed. With either option they will have greater than $32MM in capital gains.
Offer 1 is for $20MM in year 1, $7MM in year 2 and $5MM in year 3.
Offer 2 is for $15MM in year 1, $10MM in year 2 and $10MM in year 3.
On the surface they net $3MM more through the second offer.
The same basic questions remain:
- Do they take less early to get more money over time?
- How does this affect their tax situation?
If you are like us, you probably want to skip ahead in your logic; nice work if you know that there are probably deeper questions to ask.
What are they going to do with the money?
How do they plan to grow it?
How much money do they need to fulfill their dreams?
Risk is minimized for your clients since they would be under contract with a large group to buy their business no matter if it makes that group money or not. Our suggestion is turn to the numbers.
The Numbers:
| Offer 1 | Offer 2 | |||
|---|---|---|---|---|
| Taxable Capital Gain | $20,000,000 | $15,000,000 | ||
| Capital Gains Tax 20% | $4,000,000 | $3,000,000 | ||
| Net Investment Income Tax 3.8% | $760,000 | $540,000 | ||
| Net Proceeds | $15,240,000 | $11,460,000 | ||
| Total Tax Bill | $4,760,000 | $3,540,000 | ||
| Year 2 Payment | $7,000,000 | $10,000,000 | ||
| Net Proceeds (Net of 23.8% tax) | $5,334,000 | $7,640,000 | ||
| Year 3 Payment | $5,000,000 | $10,000,000 | ||
| Net Proceeds (Net of 23.8% tax) | $3,810,000 | $7,640,000 | ||
| Total Offer Price Net of Tax | $24,384,000 | $26,740,000 |
Their CPA suggests they look into investing in an Opportunity Zone Fund, so we will continue with the same analysis, we know you have jumped to the conclusion that the Opportunity Zone Fund investment is the best. However, we will run the analysis anyways. As a special notice, we would never recommend that an investor place a majority of their capital in one asset class or one investment only. As a way to provide balance to a portfolio all investors should consider opportunity zone real estate as an option for a portion of their investment. To illustrate the power here, we will continue to show all their capital gains invested in either a stock / bond portfolio or an Opportunity Zone Fund investment.
Offer 1 with an Opportunity Zone Fund
| Offer 1 | Offer 1 OZ Plan | ||||
|---|---|---|---|---|---|
| Taxable Capital Gain | $20,000,000 | $20,000,000 | |||
| Capital Gains Tax 20% | $4,000,000 | ||||
| Net Investment Income Tax 3.8% | $760,000 | ||||
| Net Proceeds | $15,240,000 | $20,000,000 | |||
| Total Tax Bill | $4,760,000 | ||||
| Year 2 Payment | $7,000,000 | **** | $7,000,000 | ||
| Net Proceeds (Net of 23.8% tax) | $5,334,000 | ||||
| Year 3 Payment | $5,000,000 | **** | $5,000,000 | ||
| Net Proceeds (Net of 23.8% tax) | $3,810,000 | ||||
| Year 7 | |||||
| Taxable Capital Gain | ** | $27,800,000 | |||
| Capital Gains Tax 20% | $5,560,000 | ||||
| Net Investment Income Tax | $1,000,800 | ||||
| Total Tax Bill | $6,560,800 | ||||
| Investment Return on 10 Year hold | * | $29,451,076 | *** | $64,579,238 | |
| Year 10 Tax Bill 23.8% Cap Gains | $7,009,357 | $0 | |||
| Net 10 Year Return | $22,441,719 | $64,579,238 | |||
| * 60/40 Balance Investment Portfolio – Stock 10% Growth / Bond 5% Growth | |||||
| ** Year 7 Taxed at 85% of original gain, 90% basis on Year 2 and Year 3 Payments | |||||
| *** Invested 12% Growth (our workforce housing projects generated returns) | |||||
| taxes due in year 7, remainder of the investment continues to grow for 3 more years tax free | |||||
| **** Only gets a 10% tax reduction in basis |
Yes, investment in an Opportunity Zone Fund wins again. There is no way to make up for the tax deferred head start and the tax-free growth OZ investing provides. Problem is, that was not the basic question we were asked in this case. We were asked to help your clients determine which payout plan they should take, so let’s run the analysis on offer 2, then we can decide from there which plan is best.
Offer 2 with an Opportunity Zone Fund
| Offer 2 | Offer 2 OZ Plan | ||||
|---|---|---|---|---|---|
| Taxable Capital Gain | $15,000,000 | $15,000,000 | |||
| Capital Gains Tax 20% | $3,000,000 | ||||
| Net Investment Income Tax 3.8% | $540,000 | ||||
| Net Proceeds | $11,460,000 | $15,000,000 | |||
| Total Tax Bill | $3,540,000 | ||||
| Year 2 Payment | $10,000,000 | **** | $10,000,000 | ||
| Net Proceeds (Net of 23.8% tax) | $7,620,000 | ||||
| Year 3 Payment | $10,000,000 | **** | $10,000,000 | ||
| Net Proceeds (Net of 23.8% tax) | $7,620,000 | ||||
| Year 7 | |||||
| Taxable Capital Gain | ** | $30,750,000 | |||
| Capital Gains Tax 20% | $6,150,000 | ||||
| Net Investment Income Tax | $1,107,000 | ||||
| Total Tax Bill | $7,257,000 | ||||
| Investment Return on 10 Year hold | * | $32,212,116 | *** | $64,518,339 | |
| Year 10 Tax Bill 23.8% Cap Gains | $7,666,484 | $0 | |||
| Net 10 Year Return | $24,545,632 | $64,518,339 | |||
| * 60/40 Balance Investment Portfolio – Stock 10% Growth / Bond 5% Growth | |||||
| ** Year 7 Taxed at 85% of original gain, 90% basis on Year 2 and Year 3 Payments | |||||
| *** Invested 12% Growth (Galena Opportunity Fund workforce housing projects generated returns) taxes due in year 7, remainder of the investment continues | |||||
| to grow for 3 more years tax free | |||||
| **** Only gets a 10% tax reduction in basis |
So now that the math is done, we push the information back to the advisors. If you were advising them, what would you tell them to do? With an investment in an Opportunity Zone Fund your clients make basically the same amount, but in the Stock / Bond investment they can take less money up front and take the higher payout over three years. Now the decision is up to them, we know what we would do. Do you?