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A Tax-Smart Way To Turn Your Business Into Retirement Income

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Denny and Marie run a successful business manufacturing and retailing aluminum sliders. After the hassles of the pandemic – supply disruptions, PPP loans and employee turnover – they’re ready to retire. As they start to look at the prospect of endless weekends, they’re envious of their friends who are retiring as employees. These friends have built up sizeable 401(k) accounts and will be able to spread out their retirement income – and their taxes – over many years. Denny and Marie don’t have this luxury. Their business is their retirement, so they will first have to sell their business – and satisfy the taxman – before they can enjoy their retirement savings. It’s not like they can sell their business in bits and pieces over their retirement, so understandably they worry about paying all the tax on their retirement capital upfront.   

Business owners typically face an extra step in retirement planning. They first need an exit plan – a way to convert their highly illiquid business equity into a stream of retirement income while still keeping in mind the tax implications. While a traditional installment sale of the business can help spread out income taxes over a period of years, these transactions incur two challenges. First, the buyer may insist on paying for the business in a lump sum, negating the opportunity for the seller to benefit from installment sale treatment. Second, if the buyer does want to pay in installments, the selling business owner suddenly becomes a creditor. The installment payments are usually made out of the business revenue, so if the business fails under the new owner, there is the risk of default. The seller’s biggest retirement asset will now be a note from the buyer, collateralized by the very business the seller wants to leave. 

An Alternative Approach

In the right situation, it may be possible to sell your business for a lump sum yet spread out the gain for tax purposes. Take the situation described above with Denny and Marie (we’ll call them “D&M”). They’re in their 60s, getting ready to sell, and are confident that there are large, well-financed companies interested in buying their aluminum slider business. These companies will likely want to pay the purchase price up front, which is great – except for taxes. Since D&M will use the sale proceeds for their retirement income planning, it’s costly for them to have to pay all of the income tax on the sale in just the first year of their retirement.

By using what’s called a “deferred sales trust” or “installment sale trust” (I’ll call it a “DST”), D&M may be able to sell their business up front yet spread out most of their taxes. The transaction design can vary among advisors who create these arrangements, but here’s the basic blueprint: D&M create an irrevocable trust and appoint an independent trustee to oversee the assets. They then sell their business to the trust for its fair market value, taking back an installment note that pays out the proceeds monthly, with interest, over 20 years. This allows for D&M to use IRC Sec. 453 to spread out their taxes over the installment period.

How does the trust come up with the money to pay D&M each month? The trust sells the business to an outside buyer for a comparable fair market value, receiving the sales proceeds in a lump sum. Because the trust bought the business from D&M, creating a tax basis equal to the fair market value, it will incur little if any income tax on the sale of the business to the third party. Once the sale of the business to that third party closes, the trust has the proceeds and can use an appointed investment manager to direct the management of the trust portfolio’s assets. To D&M, this transaction has the potential to be the best of both worlds. The sale has been secured and paid for, with cash in the bank (though it is in the trustee’s custody, not D&M’s possession), and both payments and taxes are being spread out over D&M’s retirement. They now have a retirement income paid monthly for 20 years.

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Will It Fly? 

On its face, this concept addresses an important planning challenge. Deferred Sales Trust™ Trustee Garrett Griffin puts it this way: “You want to safeguard your financial future—but it’s difficult to be certain you’re making the right choices to protect and leverage your assets. Rather than experiencing the debilitating drain from a fully taxable sale when a business owner is prepared to exit, the DST concept permits the seller to generate a potentially higher rate of return by leveraging the pre-tax proceeds from the sale, which can be significantly greater.”

Still, anytime a taxpayer hears about a “best of both worlds” tax opportunity, they should be skeptical. With the DST concept, there is clearly a risk that the IRS will not look kindly upon the transaction. In sum, if it lacks economic foundation, and is being undertaken purely for tax leverage, assume the IRS will come hunting. And if they do object, they have a number of legal weapons they can employ, such as calling it a sham transaction, step transaction, constructive receipt, or other court-tested tax argument.

What should D&M do to avoid the wrath of the IRS? A guiding principle is to be thorough and be fair. Consider who the parties to this transaction would be, and how they can contribute to making this exit plan work for the couple. 

–        Start with Denny and Marie. This is a sale, not a chance to monetize their business interests while they continue to run operations. When D&M sell their business to the trust, they must exit stage left, and become retirees. Their involvement with the business ceases.  

–        The trust is the center of attention in the DST concept. First, the attorney drafting the trust and sale arrangement must not only be competent, but skilled, in this area. D&M shouldn’t use their general counsel to structure this transaction any more than a heart surgery patient uses their family physician. Next, the trustee must be truly independent – preferably an institutional trustee. The IRS has an impressive string of court victories where they have successfully challenged trust arrangements involving trustees who were related to or otherwise under the grantor’s control.

–        The third-party buyer must buy the business from the trust, not the grantor. With D&M, they may know viable candidates who are potential buyers, but they cannot have the sale in hand when they set up the trust. D&M sell the business to the trust; the trust sells the business to the third-party buyer. Anything less could be attacked as a sham transaction. 

Is It Worth It? 

John Leonetti, author of Exiting Your Business, Protecting Your Wealth,” offers that “deferring the tax on sale may sound appealing but, if I were selling my business and looking to enjoy the immediate gratification of not paying taxes upon the sale, I would seriously evaluate two critical components: first, the future of tax rates given the level of national debt, and second, the rate of return that I expect to receive on the amount of tax ‘savings’ I receive through the deferral.” In other words, will tax rates go up – erasing the benefit of deferral – or will there be sufficient return on investment to make it worth the effort?

Something additional that must be factored into the equation is expenses. Like any sophisticated sales transaction, there are a lot of moving parts. And that means there is the potential for significant costs associated with hiring professional advisors. Further, there are many opportunities to make mistakes, therefore compounding expenses. Still, if successful, the DST approach has several advantages:

–        Retirement planning. This arrangement creates an exit plan that transitions a taxpayer from a business owner into a retiree. With D&M, they are getting out while they can so they can enjoy the good life, and all without having to worry about how the ultimate buyer of their old business is doing.

–        Asset diversification. Different from a traditional installment sale, the retiree, through the sale to the trust, has assets that are in a diversified portfolio of investments. Rather than holding a note from a third-party buyer who may succeed or fail, the trust has an investment portfolio backing up its ability to make payments to the seller. D&M created a trust with an investment direction that suits their style. While they can’t control the assets in the trust, they have had a say in who does. 

–        Assets are converted into a stream of income. When a business owner retires, control of the business is lost. The DST turns business equity into a stream of monthly payments generated by a diversified portfolio of investments – every retiree’s dream. Best of all, the use of the trust eliminates the risk of default. D&M now enjoy a predictable retirement income and may even have some flexibility to revise payment terms with the trust if necessary.

–        Tax efficiency. While this transaction can’t be created solely to save taxes, it does have the potential to address a common business owner challenge – spreading out payments without paying taxes upfront. D&M are now on tax parity with their friends who were employees. They’re taxed on their income as it’s paid to them. Even better, much of that income is potentially taxed as long-term capital gain.

As compared to the typical employee, a business owner has both more options and more challenges in retirement planning. The DST concept is one more option to examine when planning your exit and contemplating your retirement. In considering this option, factor in timing. Because of the complexity and expense of the DST transaction, as well as the need to sell your business directly to a trust you’ve created, it’s important to get an early start on your planning. Your planned exit from your business can lead to a successful retirement.

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A Deeper Look At DeSantis’ Anti-ESG Legislation: What Is ESG?

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Florida’s anti-ESG legislation, championed by Governor Ron DeSantis, is positioned to be the model for anti-ESG legislation in the United States. 20 Republican Governors have already signed on to adopt similar policies. The legislation itself is massive and sweeping, touching on multiple areas of law and policy. This is the first in a series of articles that will deep dive into Florida’s proposed legislation and look into its potential impacts in the larger ESG debate. However, before looking at the language of the legislation, we must start at the beginning. What is ESG?

ESG stands for environmental, social, and governance. It has gone by other names over the years including impact investing, social impact investing, and sustainable investing. At its core, it is an investment strategy. A way to use your money to impact change. We often see this in political movements. Conservatives boycotting Disney because of “woke” policies, or going to a business to support their Christian values. Liberals boycotting businesses over Black Lives Matter stances, or supporting environmentally friendly companies. Companies know that, and they include it in their marketing strategy.

In theory, ESG just took that to the next step and applied it to your retirement funds, giving you the option to choose how your money is invested. Fund managers already present their clients with multiple options, allowing the investor to choose their level of risk. ESG adds another option, where the investor can choose a lower return, but feel like their money is doing something good. Investing in a green company may not make you as much money, but you’ll feel like you’re doing your part to help the environment. If that is your choice, you should be allowed to make it. However, ESG took on a life of its own.

If I told you that the United Nations developed a plan to manipulate financial investments to force businesses to enact environmental and social policies that align with their goals, announced by Al Gore, you would probably start pushing me into the conspiracy theory category. Yet, it happened. It didn’t happen in secret. There are no leaked documents or conspirators. It happened in public, through public meetings, with clearly stated goals and outcomes, and they held a press conference to announce it. We just didn’t know what they were talking about.

That push drove ESG, primarily in the European Union. This rapid growth was problematic for those tasked with making financial decisions. The first real issue for ESG was the lack of clarity. Sure, “e” stands for environmental, “s” stands for social, and “g” stands for governance. “C” is for cookie, and while that is good enough for the Cookie Monster, that is not good enough in the world of financial investments. Terms need clear definitions, measurements, and projected outcomes.

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When most people discuss ESG, they gravitate towards the environmental piece. It appears to be fairly self-explanatory; a company that is environmentally friendly. However, environmentally friendly is a vague term. It could be a reduction in waste, adding solar panels, low emission vehicles, or any number of factors, all of which are self-reported by the company. As no reporting standards are currently in existence, companies can make their claims based on their own internal calculations, and fund managers can make their choice to invest based on what they choose to prioritize. This has led to what is known as greenwashing, or when a company exaggerates its environmental policies in order to appear more environmentally friendly than they really are.

Do not overlook the social and governance components, as that is where the real conflict arises. In the United Kingdom, social includes investment in affordable housing. In the European Union, it looks at factors like the use of slave labor in the supply chain. In the United States, it includes diversity and inclusion. Those factors, and how they are weighed, vary wildly from jurisdiction to jurisdiction and fund manager to fund manager. ESG is not just about the environment.

There are international efforts to create reporting standards, but they will not be released until later this year and no front-runner has been selected. That alone is problematic, to say the least.

To this point, I’ve presented ESG as if it is your choice, but ESG has taken a turn from elective to mandatory. A select group of fund managers followed the UN’s lead and started including ESG factors in all their funds, under the premise that ESG is good for the long-term growth of a company. This approach has wide ranging impacts. It effects long-term growth calculations for publicly held companies. It impacts credit ratings for government bonds. Banks are calculating the risk of business loans and accounts based on ESG. What was an abstract concept a few years ago, is now directly driving sectors of the business and financial markets.

In response, business leaders and Republican elected officials began pushing pack. The Trump administration introduced a Department of Labor rule limiting ESG that was eventually overturned under the Biden administration. States then started taking action. Texas struck first by adjusting how they invested state pensions. Florida followed soon thereafter by doing the same, then took it a step further introducing their anti-ESG legislation.

The legislation addresses five key areas: investment of state money, investment of pension funds, issuing bonds, banks, and government contracts. Those areas are about states controlling what they can control. Over the next few articles, each of those areas will be looked at in depth. What is happening in Florida could be the future of the anti-ESG movement in the United States.

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Don’t Make A Mess Out Of The Texas Citizens Participation Act

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The Texas legislature is considering a proposed amendment to the Texas Citizens Participation Act (TCPA), which is the Texas Anti-SLAPP law and roughly the equivalent to the Uniform Public Participation Act (UPEPA) which is in the process of being adopted nationwide. Because the proposed amendment has the potential to create more problems than it solves, and in fact may create a mess of things, some analysis is in order.

The TCPA is found at Texas Civil Practice and Remedies Code § 27.001, et seq. The TCPA basically provides that if one party files an action some sort of action which infringes upon certain constitutional rights of another party, that second party (movant) may file a motion to dismiss the action of the first party (respondent) in certain circumstances.

I will not go into the entire operation of the TCPA, but will instead here focus upon only the part that is relevant to the proposed amendment.

If the movant’s motion to dismiss is unsuccessful, then the movant may appeal under § 27.008 of the TCPA and the corresponding § 51.014(a)(12) that provides for an interlocutory appeal of a trial court’s denial of a motion to dismiss. Very importantly, § 51.014(b) provides that while this appeal is ongoing, all other proceedings at the trial court are stayed pending the appeal.

The stay pending the resolution of the appeal is necessary to avoid potential wasted effort by the trial court and the litigants. Otherwise, if the litigation were to proceed before the trial court while the appeal was ongoing, but the appeal later reversed the denial of the TCPA motion, everything that the trial court and the litigants would have done in the interim would be totally wasted activity.

Of course, the respondent who defeated the motion to dismiss wants to get on with their case, but the truth is that the stay pending appeal is probably not going to be very long anyhow, because § 27.008(b) provides that “[a]n appellate court shall expedite an appeal or other writ, whether interlocutory or not, from a trial court order on a motion to dismiss a legal action under Section 27.003 or from a trial court’s failure to rule on that motion in the time prescribed by Section 27.005.” So, if there is a delay in the litigation, it should be only a short one and thus there is no need for a relief from the stay.

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The bottom line is that there is nothing wrong with this stay during appeal as it currently exists in the statutes. It doesn’t need fixing. Nevertheless, in SB896/HB2781 the Texas legislature is considering tinkering with § 51.014 to limit the application of the stay pending appeal to three circumstances:

First, where the motion to dismiss failed because it was untimely under § 27.003(b);

Second, where the motion to dismiss not only failed, but was also deemed to be either frivolous or assert solely for the purposes of delay, per § 27.009(b); or

Third, where the motion to dismiss was denied because an exemption to the authorization of the motion existed (such as commercial speech, wrongful death claims, insurance disputes, evictions, etc. ― Texas has a bunch of such exemptions) under § 27.010(a).

The reason for this tinkering is implicit: If the TCPA motion to dismiss does not seem like a close call, there is no reason to delay the litigation while the movant (who lost the motion to dismiss) prosecutes what is likely a fruitless appeal.

Except that there is.

The hard truth is that trial courts frequently get things wrong. So frequently, in fact, that states such as Texas have full-time appellate courts with numerous districts to review purported errors by the trial courts. Particularly where the state courts are asked to consider matters with constitutional implications ― issues which, unlike the federal courts, they rarely deal with ― the state courts have a tendency to err. Plus, once a trial court has made one misjudgment, the effect is usually to snowball and result in other bad rulings that follow, such as sanctioning a party who was right in the first place.

Thus, long ago it was determined that it did not make any sense for litigation at the trial court level to go on at the same time that there was an appeal pending, for the reason that if the appeal ends in a reversal then whatever the courts and the parties were doing up to that point in the trial court becomes a giant pile of wasted judicial resources and efforts. This is the very reason why § 51.014(b) stays activity at the trial court level for interlocutory appeals. Such is even more important in the Anti-SLAPP context, such as with the TCPA, where one of the primary purposes of such statutes in the first place is to conserve the judicial resources of the courts and the parties — and particularly the party against whom abusive litigation has been brought.

However, the single counterargument against allowing the litigation to go forward during the appeal as in the proposed Texas amendment is this: The appeal is not going to last very long anyway, because of the mandate of § 27.008(b) that the appellate court must resolve a TCPA appeal expeditiously. Because the appeal period will be short, there is really no compelling reason to risk wasting judicial resources and the parties’ resources in the meantime. The proposed amendment to the TCPA is a solution in search of a problem.

It also must be considered that what the Texas amendment really attempts to do is to negate what amounts to a frivolous appeal by a party that has lost its TCPA motion. However, there is already a remedy for that, which is that the Texas Court of Appeals may itself award monetary sanctions for a frivolous appeal. Thus, if a party files a bogus appeal of the denial of their TCPA motion, the Court of Appeals may award appropriate monetary sanctions, not just against the party who brought the appeal but also against the counsel who filed that appeal. This is a significant deterrent to the bringing of such appeals.

But let us consider what might be done in these circumstances if somebody really just wanted to do something for the sake of doing something. It would not be the proposed Texas amendment. Instead, the appropriate solution would be to allow the Court of Appeals the discretion to lift the stay under § 51.014(b) upon the request of a party or upon its own initiative in the described circumstances.

What happens with all appellate courts, including the Texas Court of Appeals, is that the particular panel makes a decision on the outcome of the appeal pretty quickly. The delay in the Court of Appeals issuing its ruling is that it takes time to write the opinion to support the ruling. If the Court of Appeals knows that it is going to rule to deny the appeal, then the Court of Appeals at that time could lift the stay at the trial court level in anticipation of their future formal decision denying the appeal.

The problem of the stay pending appeal is not a trial court issue, and should not be resolved by changing what goes on with the trial court, but instead is an appellate issue that should properly be resolved (if at all) by allowing the Court of Appeals the option of terminating the stay. One thing is certain: The proposed amendment to the TCPA that automatically terminates the stay is not the way to deal with this issue ― if, indeed, an issue actually exists at all.

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What Are The 2nd Quarter Teflon Sectors?

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The FOMC decision last week fulfilled most expectations, but it was the details that hit stocks Wednesday afternoon. The conflicting comments between Fed Chair Powell and Fed Secretary Yellen on bank guarantees spooked the market as the futures dropped 70 points in the last hour.

It was not surprising that the concerns over the banking system continued last week after last weekend’s emergency buyout of Credit Suisse. The pressure on Deutsche Bank (DB) increased Friday as the US shares were down 5.5% in reaction to their credit default swaps (CDS) hitting a four-year high on Thursday.

For the month DB is down almost 25% as the German Chancellor Olaf Scholz came out with supportive comments on Friday. Most banking analysts do not appear to be worried as Stuart Graham and Leona Li, analysts at global financial research firm Autonomous, said that “Deutsche is in robust shape.” Also, DB has turned in 10 straight quarters of profits.

What was surprising for most was the stock market’s ability to rally on Friday as most of the major averages did close the week higher. Once again the Nasdaq 100 led the way up 2% to push its year-to-date gain to 16.7%. The S&P 500 ($SPX) and Dow Jones Industrial Average ($INDU) had smaller gains of 1.4% and 1.2% respectively. The disparity on a YTD basis has widened further as $INDU is down 2.7%.

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The iShares Russell 2000 had a volatile week but closed up 0.7% while the Dow Jones Utility Average was the weakest, down 1.4%. It is now down 5.9% YTD as it is the weakest performer. For the week the NYSE advance/decline ratio was positive as 1808 issues were advancing with 1385 declining.

As of Friday’s close, the Invesco QQQ Trust (QQQ) was up 1.97% in March as it closed just above the 20-month EMA at $305.24. The next monthly resistance is the August high at $334.42. The multiple-month highs from early in 2022, line a, are in the $370 area. The March low at $285.19 is now an important support level to watch.

The Nasdaq 100 Advance/Decline line is a bit higher this month but still below its WMA as it has been since August 2022. A move above the WMA does not look likely this month. The weekly A/D line (not shown) is fractionally above its WMA as is the daily A/D line.

The monthly relative performance (RS) has moved above its WMA for the first time since late 2022. This is a sign that the QQQ is leading the SPY higher as we move into April. In late January the weekly RS signaled that QQQ was leading the market higher.

The outperformance of growth stocks was not the consensus view at the start of the year or in February. Now the question is whether the growth stocks will continue to move higher despite the strong recessionary fears.

So far in March, the iShares 1000 Growth ETF (IWF) is up 3.5% while the iShares 1000 Value ETF (IWD) is ETF is down 4.3%. The ratio of IWF/IWD formed a V-shaped bottom at the start of the year and moved back above its 20-week EMA in late January.

The downtrend (line a) was broken two weeks and the resistance at line b has also now been overcome. The August peak at 1.631 is the next barrier for the ratio. The ratio is well above its 20-week EMA so it is a bit extended on the upside. The MACD-His did form a slightly positive divergence at the late 2022 lows, line c, and is still rising strongly with no divergences yet.

The monthly analysis of the iShares 1000 Growth ETF (IWF) shows that it closed on Friday just below the 20-month EMA at $237.87. The February high was $242.87 while the monthly starc+ band is at $290.06. The long-term support from 2020, line a, was tested in October.

The monthly RS has just moved above its WMA suggesting that IWF can continue to lead the SPY over the next quarter. The volume has declined over the past two months and the OBV is still slightly below its WMA. The weekly indicators (not shown) are positive.

Of the eleven sectors, there are just two where the monthly RS is rising and it is above its 20-month WMA. The Technology Sector Select (XLK) is up 7.1% so far in March and is currently trading above the February high. The high from August at $150.72, line a, is the next barrier.

The monthly RS has moved further above its WMA in March consistent with a market leader. The volume increased a bit in March and the OBV has moved above its WMA for the first time since April. The weekly indicators (not shown) are positive as the RS is well above its WMA.

The Communications Services Sector (XLC) is up 6.2% in March with the next resistance at $60.24. On a move above this level, the monthly starc+ band is at $67.60. The March low at $51.37 should be good support.

The monthly RS has just moved above its WMA indicating that XLC is leading the SPY. The RS dropped below its WMA in October 2022, one month after the high. The volume has been strong this week and the OBV has moved above its WMA and the resistance at line c, which is a good sign. The weekly studies (not shown) are positive with last week’s close.

Crude oil reversed on Friday to close back below $70. In last week’s review I shared my concerns over this sector as it could hold the major averages back. Sharply lower crude oil prices also could add pressure on some of the regional banks which is not what they need.

In conclusion, the analysis of the Growth/Value ratio and the monthly RS analysis suggests that growth stocks and EFFs should be favored on any pullback. The technical evidence indicates they should be Teflon-like in the next quarter and hold up better than the value stocks.

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