The best way to prepare for the sale of your business is to sell your stock to a grantor trust (often called a Dynasty Trust) In addition to other benefits, this will protect the appreciation of your stock from estate taxes as well as other potential creditors
If you want to provide incentive to key employees by promising them a portion of the proceeds from a sale of the business, a “profits interest” may be the most tax efficient way to do it A “profits interest” is simply an interest in the future profits of a partnership without any current equity or liquidation rights A profits interest can be granted without any income tax affect and it can allow an employee to receive long-term capital gains from the proceeds of a sale A profits interest can be designed with any kind of limits, restrictions, adjustments, vesting schedules or other specific features.
If you give an employee a bonus plan, this will result in ordinary income and employment taxes to the employee If you give an employee stock, this is ordinary income to the employee when it is received If you give an employee stock options, this will create ordinary income to the employee when the options are granted, or when they vest Incentive stock options result in AMT income instead of ordinary income, but the end result is almost equally negative Also, most of these options can’t be undone if the employee is terminated.
Consider this example of a profits interest Assume that you give your key employee a profits interest defined as 10% of the proceeds from the sale of the business, but only to the extent the proceeds exceed the current business value of $10,000,000, and only if the employee is not terminated for cause before the sale If the business sells for $15,000,000, the employee will receive $500,000 as a long term capital gain and pay $75,000 in taxes (using the current 15% federal rate) If the employee had received the same $500,000 as ordinary income, the employee would have paid $175,000 in taxes (assuming a 35% federal rate).
On the other hand, a sale to a grantor trust for an employee can accomplish the same result as a profits interest, with even greater control and flexibility And a sale to a grantor trust works just as well with a corporation as it does with a partnership or LLC If you are starting to get the impression that I attempt to solve all of life’s problems with a grantor trust, you may be on to something I haven’t found too many problems that can’t be solved with fresh air, duct tape, or a grantor trust!