Ep 285: The Tax Alpha Protocol # 3...Your Exit tax bill is written before your LOI

Well, hey everybody, this is certified Financial planner David Chudick.

And you know I love talking to the business owners and I love talking about exit planning.

Today my friend Cliff Morgan and I are talking about using irrevocable trusts to help you mitigate some tax consequences when selling your business.

So this should be an interesting one, especially if you're someone who's thinking about selling your business selling sometime in the next few years welcome to the weekly Wealth Podcast.

I am certified Financial Planner David Chudick.

This podcast and my wealth management practice are both designed to help the mass affluent to live better lives by how they handle their money.

We talk about financial strategies, prosperous mindsets, and simply how to build true wealth.

So come on and let's enjoy this journey together.

When an entrepreneur dedicates decades of labor, focus and capital to building an enterprise, the culminating transaction represents the realization of life's work.

Navigating an exit of this magnitude requires thorough understanding of how corporate governance, fiduciary structures and capital allocation interact.

In our strategic consulting work, we observe business owners approaching corporate transitions to from multiple operational angles.

Our executive thesis today is that business owners preparing for major liquidity events should evaluate multi generational fiduciary architectures in close collaboration with their licensed legal and accounting advisors.

To understand how experienced founders prepare for liquidity, we must examine the relationship between operating entities and long term wealth stewardship.

Operating enterprises, whether organized as limited liability companies or conventional corporations, are structured primarily for commercial operations, market expansion, and active liability management.

However, when an enterprise approaches a liquidity event, the strategic priority shifts from daily commercial operations to long term capital preservation, risk diversification, and family governance.

Attempting to manage substantial post exit liquidity inside the original operating structure often introduces administrative frictions and unwanted operational complexity.

Now, to address these challenges, established structural governance frequently utilizes irrevocable non grantor trust to establish institutional permanence.

In an irrevocable non grantor trust, the founder transfers legal ownership of selected equity interests into an independent trustee who holds and administers those assets strictly for the benefit of of designated beneficiaries.

Because the trust functions as an independent legal taxpayer, it maintains its own employer identification number, keeps dedicated accounting records, and files an Annual Form 1041 Fiduciary Tax Return.

This legal separation ensures that fiduciary assets remain completely distinct from founders personal estate and daily commercial liabilities.

When evaluating this architecture, business owners must distinguish between basic probate avoidance and comprehensive wealth preservation structures.

Conventional estate structures often rely on basic revocable living trusts which serve primarily to transfer personal property outside of probate court upon the grantor's death.

While irrevocable trusts provide personal privacy and procedural convenience, they do not create an independent taxpayer nor do they provide balance sheet shielding during enterprise liquidity events.

In contrast, an irrevocable non grantor trust establishes an autonomous fiduciary structure that can hold private equity, oversee diversified portfolios, and execute multi generational governance policies over decades.

To ensure that an irrevocable trust operates effectively, the architecture must maintain strict governance discipline and avoid retained control triggers under federal tax law.

If a founder retains administrative dominion, maintains power of revocation, or borrows trust assets without adequate interest in collateral, tax authorities classify the structure as a grantor trust.

In that scenario, all tax attributes and investment outcomes continue to flow directly onto the founder's personal tax return or 1040.

By delegating administrative and investment authority to an independent corporate trustee or institutional fiduciary, the trust establishes clear legal boundaries that protect the integrity of long term wealth.

Architecture Modern fiduciary architectures also incorporate flexible oversight mechanisms such as independent trust protectors and directed trust provisions.

A trust protector is an independent third party empowered to review fiduciary performance, replace trustees if necessary, and ensure that trust administration remains aligned with the founder's stated intent.

Now furthermore, directed trust statutes allow families to separate administrative responsibilities from investment management, enabling specialized asset managers to oversee capital deployment while a corporate trustee handles reporting and statutory compliance.

This bifurcated governance model provides high net worth families with operational agility required to steward large pools of capital across market cycles.

To appreciate the economic significance of disciplined wealth structuring strategists model the mathematical compounding disparities between fragmented retail deployment and centralized capital stewardship.

For theoretical illustrative purposes, consider a hypothetical $20 million enterprise transaction.

When an entrepreneur approaches an exit without advanced structural coordination, transaction proceeds are frequently distributed across multiple taxable personal accounts, resulting in administrative friction and uncoordinated reinvestment.

In theoretical economic modeling, unaligned coordination can significantly impair long term compounding capacity over extended horizons.

In contrast, when corporate equity is placed into well designed fiduciary structure well in advance of the sale, the realized proceeds remain centralized within an institutional capital pool similar to university endowments and family offices.

This centralized approach enables a fiduciary to implement disciplined long term asset allocation models across commercial real estate, private debt, and diversified marketable securities over a 20 year horizon.

The theoretical advantages of disciplined reinvestment and asset protection and institutional scale can significantly expand the economic resources preserved for future generations.

These mathematical models are hypothetical projections that do not account for individual tax brackets, ongoing management fees, or market volatility.

Remember, past performance never guarantees future financial results.

In executing any pre liquidity equity transfer, Transition Council consistently emphasizes that timing represents the primary legal consideration.

Legal advisors evaluate the assignment of income doctrine, noting that transferring equity interest after executing a definitive purchase agreement or binding letter of intent will typically cause tax authorities to attribute the sale proceeds direct to the founder.

When founders examine fiduciary structuring during early operational stages or preliminary exploratory discussions, the trust can stand as a genuine owner of record, allowing the trustee to participate directly in the closing of as the legal seller.

While fiduciary trust architectures provide an exceptional framework for generational continuity, they represent only one component of a complete transition strategy.

Successful enterprise liquidity requires seamless integration between private wealth governance and corporate mergers and acquisition Mechanics that brings us to my co host David Chudick.

He's a certified Financial Planner and an Investment Advisor representative with Parallel Financial David evaluates exit liquidity through statutory corporate instruments, including the specific provisions of the Internal Revenue Code and the critical negotiation points of corporate purchase agreements.

David will examine the statutory side of the transaction execution, focusing on how qualifying technology and manufacturing founders utilize section 1202 qualified small business stock.

He will analyze both the substantial benefits and the strict qualification boundaries of that exemption.

And he will explain how buyers and sellers navigate structural tension through section 338, 10 elections and contractual gross up covenants.

This episode is brought to you by a partnership with the National Insurance Agency.

Hi, I'm Ashley with the nia.

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If something went wrong to my like a fire, a lawsuit or a serious accident, would your insurance actually cover it?

Most policies get set up once and never revisited even as your home value, income or business grow.

That's why we offer a complimentary risk management review.

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To schedule yours, just email me at ashleyointhenia.com that's a s h l e I g-h@jointhenia.com now back to David.

David, would you present the Practical Execution.

Framework Cliff just walked you through private contract trusts.

My job is the other side of the table.

When a founder actually sells, what does the law clearly give you?

Where does it get messy and what do you have to fight for in a purchase agreement?

And I'll say one thing up front about trust based deferral structures.

They're built on contracts not A specific code section that blesses them.

The IRS has gone after arrangements that look similar in the past.

It doesn't make every version bad.

It does mean that you want independent tax counsel and a written opinion before you go near one.

So keep that in mind.

Make sure you're getting clear accounting guidelines guidance and legal guidance.

All right, so let's talk about section 1202.

Is this the best deal in the tax code?

It may be, if you qualify.

If you can qualify, you can exclude up to 100% of your federal capital gain when you sell it.

Not defer it, not exclude it, just exclude it.

The cap is the greater of 10 times your basis in the stock or a flat dollar amount.

That flat amount used to be 10 million.

Under the 2025 tax law, the stock issued after July 4, 2025, it's a $15 million, an index for inflation going forward.

That's the good news.

Now here's the catch.

Most founders I talk to don't qualify.

And there are four reasons why.

Four hurdles.

Hurdle number one is it has to be a C corporation.

Most closely held businesses are LLCs, partnerships, or S Corps.

And it makes sense.

Early on, you want your losses and deductions flowing to your return, and you don't want double taxation.

But only a C Corp can issue QSBs.

And you can flip to a C Corp the month before you sell and glare out the exclusion.

When you convert, the stock is valued at fair market value that day.

All the value you built before the conversion is still taxable.

And your holding clock starts on the conversion date, not the day you open the doors.

So here's hurdle number two.

And that's the holding period.

This one our producers flagged, and it matters.

For the full 100% exclusion, you have to hold the stock more than five years.

The 2025 law added a partial step down, but only for stock issued after July 4, 2025.

Hold three years, you get 50%.

Four years, 75%.

Five.

Five years, 100%.

For older stock, it's still five years or nothing.

So here's the real world problem.

Say a founder converts to a C Corp.

Builds fast and gets a strong offer in year three.

Under the new rules, half that gain is still exposed.

Under the old rules, all of it is.

Buyers don't time their offers around your holding period.

So here's hurdle number three, and this is the size test.

The company's gross assets can't exceed $50 million or $75 million for stock issued under the new law at any point before and immediately after the stock is issued, take a big round of outside capital that pushes you over the line.

The stock issued after that doesn't qualify.

So we need to make sure that we're watching over this size test.

Now, hurdle number four is the type of business.

And a lot of service businesses are flat out excluded.

Healthcare, law, accounting, consulting, financial services, hotels and restaurants, among others.

If you're a physician practice or professional firm, 1202 likely isn't your tool.

So 1202 is the gold standard for tech or manufacturing C Corp. That checks every box.

For everyone else, we might need some other tools.

So now let's talk about what actually happens when a buyer shows up.

Once you grant a price, the structure of the deal decides how much you keep.

And the buyer's interest and yours points in opposite directions.

Now, the buyer wants an asset purchase.

Now why is this?

Because they get a step up in basis of what they're buying to today's value.

That means new depreciation on equipment.

And more importantly, they can advertise goodwill and customer lists over 15 years under section 179.

Those deductions.

Those deductions shelter the buyer's future profits.

That is actual real money to them.

Now, you're the seller.

You want to stock sell clean capital gain on the whole price, no depreciation recapture.

The buyer takes the company as is history and all.

So these are some of the items that will be negotiated during your due diligence.

Now, Section 338, the compromise that can cost you.

So to split the difference, buyers often ask for section 33810 election.

Now, this generally applies when a company is an S corporation or a subsidiary of another corporation.

So if you're an S Corp owner, pay attention.

Here's how it works.

Legally, it's a stock sale.

Your contracts, licenses, vendor relationships and permits, they all stay with the company.

Nothing has to be reassigned.

But for tax purposes, the IRS treats it as if the company sold all of his assets and then liquidated.

Great for the buyer.

For you, the seller, it can be expensive because now the price gets allocated across the company.

Assets, receivables and inventory can create ordinary income.

Equipment you've depreciated triggers recapture under section 1245, taxed as ordinary income.

And if you have a sale of a business, you're going to be in a high tax bracket that year.

So we want to avoid as much ordinary income as possible.

Real property improvements can trigger recapture under section 1250.

And some states treat a deemed asset sale differently than the irs.

Does which can add tax at the state level.

Which is why we need legal and accounting advice throughout the process.

So you walk in expecting capital gains on the whole things and you walk out with a chunk of it taxed as ordinary income.

That difference can be very large.

If a buyer wants338.10election, don't agree to it without a gross up in the purchase agreement.

A gross up is a simple concept.

The buyer pays you extra at closing to cover the additional tax the election costs you.

And here's how your accountants would build it.

First, figure out what you net after tax in the straight stock sale.

Second, figure out what you'd actually net under the 338.

10 With recapture with ordinary income and with state taxes all backed in.

Then the buyer pays the difference.

Now one more piece that people miss.

The gross up payment is itself more purchase price, so it is taxable too.

The proper gross up covers the tax on the gross up.

Otherwise you are still short.

So a simple illustration.

And remember we're talking round numbers, purely hypothetical.

Say the election costs you an extra $500,000 in tax.

If the buyer writes you a $500,000 check, you'll owe tax on that check and still come up short.

The math must solve for the full amount.

So my view is straightforward.

If the buyer wants the tax benefit of a step up, the buyer pays for it.

You shouldn't be subsidizing their future deduction out of your exit.

So here's how I think about it.

If you're a C corp in a qualifying industry and can hold for 5 years, th 1202 can wipe out your federal gain, plan for it early, not at the letter of intent.

If you're an S corp and a buyer wants a 338 10, negotiate the gross up.

Don't give away the step up for free.

And if you're looking for contract based deferral structures like the one Cliff described, go in with your eyes open, get independent counsel and understand how the IRS has treated similar arrangements before you come in.

So protecting the sale is a big win.

But for most owners and executives, the bigger ongoing number is income.

Once your business or your leadership team crosses that line, states start asking who owes them tax and on what states have gotten aggressive.

Here nexus audits remote executives where compensation gets taxed.

So in exit four, Cliff and I will dig into multi state tax exposure and how to stay compliant.

When your income touches more than one state.

And Cliff, you probably know that after Covid, income can touch a lot of states.

There are people working remotely.

And this, my friend, can get very complicated.

So thanks for listening to episode three.

Check out the episode notes for the resources we mentioned.

And before you make any decisions on an exit, sit down with us.

Give us a call.

You can email me davidarallelfinancial.com and Cliff, tell us your email address.

If anybody is interested in chatting with you about these concepts, I'll tell you.

The best way to connect with me is go to NWA briefing.com and you'll be able to schedule directly with me from there.

All right, nwabriefing.com to reach Cliff David at Parallel Financial, if you'd like to chat with me and we can walk you through some of these concepts.

All right everybody, until next episode, we wish everybody a blessed week.

Thanks Cliff.

Thank you.

The information presented on this podcast is for general educational purposes only and does not constitute financial investment, legal or tax advice.

Parallel Financial is registered with the U.S. securities and Exchange Commission as a registered investment advisor.

Registration does not imply a certain level of skill or training, nor does it constitute an endorsement by the sec.

All investing involves risk, including the potential loss of principal.

Please consult a qualified financial professional before making any financial decisions.

And here is your bonus content for this week's episode.

So Cliff and I, we talked about some pretty complicated concepts.

We talked about them at a 30,000 foot level and remember who, not how, right?

So when you have complicated scenarios in your life and in your business, you need a bunch of who's and you don't need to figure out how to do it yourself.

So make sure that you're working with your attorney, make sure you're working with your accountant, make sure you're working with a business advisor.

And your financial advisor is typically the quarterback of the entire scenario.

All right everybody, until next episode, I wish everybody a blessed week.

Thanks.