How do taxes play into the sale of a business, and how can owners minimize those taxes while still maintaining some personal liquidity to fund their swan song? This article will explore three different methods to defer or avoid capital gains tax on stock sales while also being able to extract some liquidity.
Stock vs. Asset Sale
Businesses can be sold by either a stock sale or an asset sale. While this may be an oversimplification, shareholders, partners, or members can dispose of their stock or membership interests in whole or in portions. Sellers typically prefer stock sales, and buyers typically prefer asset purchases.
Buyers prefer asset sales due to the generally higher depreciation and/or amortization amounts, the avoidance of any unknown liabilities from a stock purchase, and the ability to pick and choose the assets. Sellers would like to avoid asset sales because taxes are generally higher due to things like depreciation recapture, potential double taxation, and the inability to employ some specific tax deferral or avoidance strategies, which will be discussed later.
This foundation is important because the tax treatment could alter the terms of a deal. Many sellers are most interested in the net after tax proceeds. A situation could arise where a seller is willing to accept a lower price if they know that a capital gain on a stock sale could be avoided. Conversely, a buyer may be willing to pay more for an asset sale so they can depreciate or amortize purchased assets.
Method One: Qualified Opportunity Zone
A qualified opportunity zone is an economically distressed community certified by the Secretary of the U.S. Treasury where new investments, under certain conditions, may be eligible for preferential tax treatment.1 Eligible gains include “capital gains and qualified [§]1231 gains, but only gains that would be recognized for federal income tax purposes before January 1, 2027, and that are not from a transaction with a related person.”2
While qualified §1231 gains are outside the scope of this article since they are specific to asset sales, it is worth noting that contractors with §1231 gains from the sale of assets (such as heavy equipment) could potentially reinvest those qualified §1231 gains.
Benefits
IRC §1400Z-2 allows the deferral of “eligible gains” when gains are reinvested in a qualified opportunity fund – i.e., an investment vehicle that files either a partnership or corporate federal income tax return and is organized for the purpose of investing in a qualified opportunity zone property – within 180 days.3 In addition to deferring capital gains tax, reinvestments in a qualified opportunity fund receive a 10% step up in basis if held for five years.4 Additionally, capital gains from the sale of an investment in a qualified opportunity fund are excluded if held for longer than 10 years and sold before January 1, 2048.5
An interesting qualified opportunity fund benefit compared to other deferral strategies (such as §1031 and §1045) is that sellers can keep their basis while only reinvesting the gain while still receiving tax deferral. Tax deferral is not automatic, and an election is made by following the instructions on Form 8949 and filing it with the tax return on which the gain would be due had it not been deferred.6
For example, Diane is a shareholder of X Inc. Diane sells all of her shares on January 15, 2020 and reinvests her eligible gain into a qualified opportunity fund within 180 days on March 1, 2020. Her basis in X Inc. was $1 million, and she sold her shares for $2 million. She was able to keep her initial $1 million investment and reinvest the $1 million gain.
On December 31, 2026, she is required to recognize the gain from the 2020 sale of her shares. Since she held the qualified opportunity fund investment for five years, she was able to increase her basis in the qualified opportunity fund from zero to $100,000 (10% of the eligible gain). Therefore, she would only recognize a $900,000 gain in 2026.
Diane is pleased with her investment in the qualified opportunity fund, so she holds the investment until July 1, 2030 at which point she decides to sell it for its fair market value of $3 million. Since she held this investment for 10 years and disposed of it before January 1, 2048, she would not recognize any gain from it.
Sales using the installment method can also enjoy tax deferral. In fact, a taxpayer currently receiving installments from a sale that took place before 2018 can defer eligible gains within the 180-day reinvestment period.7 Each installment payment received can have its own 180-day period or the start of the reinvestment period can be on the last day of the tax year in which the taxpayer would have recognized the gain under the installment method.8
For example, let’s say Diane sold her shares via an installment sale on July 1, 2017, and she is receiving quarterly installment payments for five years. Even though the initial sale happened before the creation of the code section, she can still reinvest eligible gains from 2020 into a qualified opportunity fund. She can use a single date as the start of the 180-day reinvestment period, the last day of the tax year, or she can use a separate 180-day reinvestment period from the date she received each installment payment.