Bill and Alice started their family business many years ago. The early years were very challenging. Both worked without salary and it was a great struggle to finally get the business on a solid financial base. But after three decades of building the business, it now runs very well with an excellent cash flow.

They are now nearing retirement and enjoying this phase of life. Bill and Alice have their home, two IRAs and savings. But a major part of their net worth is the value of the family business. When they retire, they would like to sell part or all of the business.

Like many business owners, they face two major decisions. First, will they sell to family members or to an outside party? Second, should they sell for cash and pay a very large capital gains tax or should they use a tax-free sale through a special charitable trust to reduce or eliminate their tax?

In the case of Bill and Alice, they have decided that it will be appropriate to sell to a third party, and have had offers from two larger companies. After considering the offers, Bill stated, "I am a loyal American and I support my government. However, I have fully supported the government through taxes these past years! If there is a way to sell and reduce tax, I am open to learning about that."

In summary, Bill and Alice have two major goals for the sale - they would like to have a very good retirement income and reduce their taxes.

Sale and Unitrust for the Plant

Their negotiations proceeded smoothly with a potential buyer of their business. The business is operated as a limited liability company (LLC) and is worth $1,600,000. After negotiating for two months with the larger business, they agreed to sell the operating LLC for $1,600,000 and to lease the plant on a monthly lease. Because they started the business with no cash investment, all $1,600,000 of the cash payment for the LLC is long-term capital gain. Facing a major tax payment, Bill and Alice decided to sit down with their CPA George and discuss their next step.

George: "Bill and Alice, you have sold the LLC for $1,600,000. Your federal and state capital gain tax rate is approximately 35%. That means that your tax bill on that sale would be approximately $512,000. This leaves you with $1,088,000 to invest."

Bill: "That's a big tax. It would be great if we could figure out a way to reduce the tax. We have been renting the plant to the new buyer. Last week they indicated an interest in purchasing the plant."

George: "I recall that you and Alice own the plant personally. The building basis has been reduced through straight-line depreciation. We call your cost basis an adjusted basis because it's been reduced by that depreciation. Your basis in the building is now about $100,000."

Alice: "We did have an appraisal done last year on the land and building. The appraiser indicated that the property would be worth about $1,200,000. If we have a basis of $100,000 and were to sell it for $1,200,000, is our capital gain about $1,100,000?"

George: "Yes, that's exactly what you would have for gain. And you would pay $352,000 in tax on that sale. Your total taxes this year could be $864,000 if you sell both the business and the plant."

Bill: "Ouch! That sure will hurt us. Is there a better solution?"

George: "You already have sold the business for $1,600,000 cash and will have a very large capital gain. You might consider setting up a charitable remainder trust for two lives with the plant. If we set up that trust, the two of you could receive 5% income for your two lives. Hopefully, we can earn more than 5% over time and the principal would grow. The initial $1,200,000 value of the trust would produce another $60,000 of income."

Alice: "But would it save taxes?"

George: "Yes, there would be two savings. First, if we transfer the plant to the trust and then sell to a new buyer, we save the capital gains tax on that sale by the trust. In addition, there is a charitable deduction for part of the value because after both of you pass away the assets will go to your favorite charity. The charitable deduction will be about $500,000 and that could save about $185,000 in taxes. With the tax-free sale and the $185,000 savings offsetting part of the $512,000 tax payable on the LLC sale, your net tax bill is reduced from $864,000 to $327,000."

Bill: "Wow! Rather than paying $864,000 we could cut our taxes down to $327,000 by using the charitable trust. That is a great deal. Let's go forward with that plan!"

Setting Up the Charitable Unitrust

Bill and Alice contacted their attorney. She drafted a charitable remainder trust and a deed. CPA George served as the initial trustee. Bill and Alice deeded the land and building into the two-life charitable remainder trust with George serving as the initial trustee. The trust then sold the property to the larger business for $1,200,000. Bill and Alice saved all of the capital gains tax and their income tax deduction produced additional savings of $185,000. Their net tax for the year was reduced from $864,000 down to $327,000.

Bill and Alice enjoyed their tax savings on their vacation to Hawaii. They were last seen smiling as they flew off into the sunset.

Sale Guidelines for a Charitable Remainder Trust

There are several important rules that George shared with Bill and Alice to make sure that all of the tax benefits are received. First, the sale cannot be prearranged. When the trust was signed and the plant deeded to George as trustee, he needed to have the ability to select both the purchaser and the price. It is not possible to create a binding contract for sale, fund the trust and still enjoy the capital gains tax savings. Fortunately, Bill and Alice understood this rule and allowed CPA George to sell the building after the trust was funded.

Second, it is helpful to have an independent trustee for sales that are completed over a fairly short period of time. Because it was obvious that the larger business was the logical buyer for the property, it was helpful for CPA George to serve as the initial trustee. If Bill and Alice later wanted to be in control, George could resign and they could take over as successor trustees.