Using a Charitable Remainder Trust to Sell a Business
By Matthew Wiese
March 4, 2023
For Washington business owners looking to sell, the possibility of paying an additional 7% capital gains tax is concerning. For owners that sold in 2022, their payments are due on April 18, 2023, while the Washington state Supreme Court considers the constitutionality of the new tax.
The 7% Washington tax is in addition to the federal capital gains tax of 20% and net investment income tax of 3.8%. The total tax a Washington business owner could owe could easily be 30.8%.
One strategy to reduce the payment of tax is to use a charitable remainder trust. CRTs are irrevocable trusts that let a taxpayer donate assets to charity and draw annual income for life or for a specific time period.
Using a CRT to sell a business means that before a sale, the owner transfers all or a portion of the equity interest (C corporation stock or LLC interests) or assets to an irrevocable trust with the right to receive a specified payout for lifetime or term of years. Because the CRT is the selling party and because the CRT is a charity for income tax purposes, there is no capital gains tax on the sale. In addition, the owner gets a charitable deduction based on the value of the company less the retained interest. After the sale, the proceeds remain in the CRT and are paid out annually to the owner for the specified term. At the end of the term, the remaining amount is paid to the charity or charities designated in the CRT. The charity can be the owner’s private foundation or donor advised fund.
To illustrate this, consider the following comparison of a company worth $10 million. The original owner has zero tax basis in the company’s stock and dies 20 years after the sale. Assume there is no available exemption from estate tax.
The straight sale results in the owner netting $6,920,000 after payment of federal and Washington tax ($10 million less 30.8%). If the net sale proceeds grow at 8% a year while taking out 5% to spend, after 20 years the owner will have received $9,156,687 and have $12,139,254 left that will be subject to federal and Washington estate tax (combined rate of 52%). When you apply the estate tax hit at death, the owner’s total benefit is $14,983,429 ($9,156,587 received during life plus $5,826,842 net amount left to family at death).
By using a CRT, the owner starts out with all $10 million of sale proceeds because the CRT pays no federal or Washington tax. The owner also gets an immediate tax deduction of $3,704,210 to use in the year the business was sold and carryover for another five years. The CRT then invests the $10 million that grows at 8%, while paying out to the owner 5% each year for 20 years. At the end of 20 years, the owner will have received $13,232,062 and the CRT will now own assets of $17,542,275, which will not be subject to estate tax because it all goes to the owner’s charity.
The straight sale results in the owner receiving an overall benefit of $14,983,429 while the CRT results in the owner receiving a direct benefit of $14,743,379 (distributions of $13,232,062 plus dollar value of charitable deduction of $1,511,317 for owner in 37% tax bracket) and an indirect benefit to owner’s charity of $17,542,275. Another way to look at it is the amount of taxes paid. In the straight sale, the owner pays total income and estate taxes of $8.9 million. With a CRT, the owner pays zero taxes at time of sale and at death and also receives a charitable tax deduction, although the payments to owner during the term are taxed as distributions of the trust’s income and gains. At end of the term, the owner’s charity has assets of more than $17 million that can be used for any charitable purposes the owner favors.
For those who prefer charitable giving to paying taxes, using a CRT to sell a business may become more relevant, especially if the 7% Washington capital gains tax is ruled constitutional.
