Capital gains tax is a fact of life. Depending on the structure of the deal and the amount of proceeds you receive from the sale of your business, the capital gains tax you pay could be substantial. The question is: how can you reduce the tax burden so you can have more of the proceeds available to sustain the lifestyle you want to enjoy? Cal Garvin of Garvin Associates brings over 35 years of experience in the financial services industry to discuss the options that are available to business owners today, including one option specifically intended for retiring baby boomers who are exiting the business world with no intention of returning.
It's almost like creating your own retirement plan, over and above what already have been up until this point.
- Cal Garvin
Jeff: And what I’d like to start with is to talk about how you’ve come to this point in your career, helping business owners with that difficult decision. And it’s difficult for financial reasons and sometimes for psychological reasons, and a number of other things. And we’re going to talk about the three main questions or scenarios or outcomes, I guess you could say, that business owners often face and they have to deal with in their head, before they could go ahead and make that decision to sell or not. But, Cal, what I’d like you to do is start about by talking first about your story, because it’s an interesting one. Fellow Wealth Manager, still really a registered Investment Advisor, from what I understand. Go ahead and take it from there. What got you to wealth manager, or from wealth manager to where you are today, helping business owners?
Cal: I had a very good business. In fact, I was in the top 2% of the industry. And my business and real estate, both of them combined were where the 405 and Warner Avenue come together in Fountain Valley. And I accumulated a lot of engineers, CPAs, attorneys; they were my clients primarily because I taught at several local colleges in the neighborhood. I got to the point where I had about ten employees. Now, anybody who has a business understands the frustrations of having a few employees. The clients I dearly loved, in fact, I still have a good relationship with a lot of them, but it got to the point one day, where I came home and said to my wife, “Honey, I’m done. I want to sell.” She says, “You can’t sell. Do you have any idea the taxes we would pay?” which in California is a lot.
Anybody who has a business understands the frustrations of having a few employees.
Jeff: Yup, that’s right.
Cal: And I was telling a good friend of mine up in Fresno about this, who was also in the business, and he says, “Cal, have you ever heard of something called the ‘deferred sales trust’?” “No.” So he e-mailed me some information on it. I looked at it, and “Oh, wow. This is too good to be true.” And there’s an old adage in the business, “If it’s too good to be true, it usually is.” But I had the proverbial ace in the hole, Jeff. My wife, her background, simply put, she was over 20 years US Treasury Department attorney, GS-15, if you know what that is. It’s the end grade for the general. She was working over in Long Beach, that office, and so, I handed it to her and said, “Honey, check this out.” And so she came back two days later and says it’s legitimate.
Jeff: The real deal.
Cal: So, go ahead and sell it. You can sell them now. Now, do you think for a moment my wife is going to let me do something she didn’t want me to do?
Jeff: Well, not if you’re smart, Cal. And with her designation too, obviously, she’s got a certain body of knowledge that she can use to your advantage. And when I say “your advantage,” I’m talking about yours and your wife’s. So what we’ve learned about this, Cal, is the fact that you come from a standpoint of someone having experience, selling their business, and you did so only after you had really a true level of comfort to be able to move forward and pull the trigger, so to speak, on this. And this is where I like to talk about those three thoughts that people face, or the three possible scenarios that a business owner has to look at, or face, or question themselves about as they’re considering selling their business. And you talk a little bit about these…tell me what those three possible scenarios are, those outcomes, as we might like to call them.
Cal: Well, there are three primary, I used to teach this kind of stuff at school, and I can remember my own father, at one point, he had over 250 apartment units, 11 supermarkets and a major producing, you know, all those kind of businesses. And this is a normal thing for people by the time they hit their mid-60s, they’re done. But if they sell, they’re going to pay a ton of taxes. That’s option one. You don’t sell. Of course, what you have is a lifetime job, which is something they really don’t want but they don’t know how to deal with them.
Well, number two, if it’s primarily real estate, this doesn’t work too well in business, but this is the 1031 Exchange. And I even did it once. I was up the 24 units and I decided this is too much work. I just don’t want to pay the taxes. But people have spent years and decades building apartment empires, so to speak, like Dad. He had 250 units. And he got at a point that, “You know what, I got five employees just taking care of these places and family is more important.” You’re going to find a lot of this coming on with the baby boom generation coming on towards that point in life. So number two, you can 1031 Exchange, but you still have a job for life. And the third option was just simply to sell and pay the taxes.
Now, before the DST existed, this is what Dad did. He just got to a point where family is more important. Thanks, Dad. And so, he sold and paid the taxes. So those were the three things up until the deferred sales trust came along. That’s what the people had, either don’t sell or 1031 if possible, or sell and pay the taxes which really cuts into the bottom line income. In other words, you look at the value of your business and you deduct the taxes, there’s not that much money left to go on in the income front, is there?
In selling a business, owners either don't sell or 1031 Exchange or sell and pay the taxes.
Jeff: No, there’s not. Now, we’re going to get to option four, which is the one option that most people don’t have any clue about, or maybe don’t know about, and I think that there’s been very, very little that has been written about this. And certainly, there’s probably a number of people that are going to benefit from this conversation, just having been educated on that fourth alternative which is, I think, probably going to be very, very attractive. But let’s – building up to that – when faced with the likelihood of one of those three primary possible outcomes, how do most business owners usually respond in the beginning?
Cal: Well, their initial kneejerk reaction is, “Well, I’m not going to sell.” And so, they have just accepted the fact that they have a lifetime job. But eventually, they begin to realize, “You know what, the days are numbered and there are some things that are more important. That’s usually down the road a few years until they get to a point, “You know what, it’s not worth it. I’ll pay the taxes.” And that usually takes time. So the initial is, “No, I’m not going to sell. I’m not going to pay the taxes.”
Jeff: Talking about obviously long-term capital gains taxes, which is really when we’re talking about taxes, this is the one that really hits people hard, business owners, where do rates stand right now and is there a large variation from state to state depending on where you do your business?
Cal: First off, you’ve got the Federal. And at the level I work with that in, it’s usually the 20% mark, okay? And then you have the state. Now, not all states have taxes. California, its ordinary income. They don’t have long-term capital gains. So they’re sitting at a rug. They jump around between 9% and 13%. Then, but Nevada, they don’t have any, neither does Texas. Every state is different. So if you want, we’ll use California as an example. So 20+, the 13, and then there’s the Affordable Care Tax now, Affordable Care Act Tax, I can say that, in other words, Obamacare, that’s 3.8%. All of a sudden, we’re in the high 30s. Over a third of the gains are going to be taken out in taxes. That’s a chunk of change.
Jeff: It’s a huge chunk of change indeed. What are some of the other tax considerations, Cal, that business owners may not take into consideration when they’re thinking about selling their companies?
Cal: Oh my. That’s a multitude-
Jeff: The list goes on, right?
Cal: It’s one that I confront a lot. And we have to deal with this even outside the deferred sales trust because the IRS, who has reviewed this program and then will have a problem with it, looks at it, “You know, we’re going to put some exceptions in there.” And the one that hits people a lot is accelerated cost depreciation. They’ve let the people and have their money up way back when, now they want it even outside the deferred sales trust. Other than that, there’s not a lot.
Jeff: Cal Garvin is our guest today on Deal Talk. He is the Owner and President of Garvin Associates Incorporated. And Cal works a lot with business owners who are considering selling their business and he is someone who provides an alternative to the typical situations or scenarios that most business owners may face, at least the primary scenarios. You just heard us talk about them. Number one, of course, not selling is an option that you have. Okay, just choose not to sell, not have to deal with paying the taxes, 1031 Exchange.
You still have to work in both the first and second scenarios. You’re talking about lifetime work for you. And number three option; primary consideration, sell your business and just deal with having to pay the taxes and be done with it. But you’re talking about a third of your income. Let’s go to that fourth option though, however, Cal, none of those three above. Option four, this is different and this is something that might be worth a look to some business owners. Tell us what this is, this discovery that you found out about yourself when it came time to sell your own business all those years ago.
Cal: Right. It’s called the deferred sales trust. Now, understand we call it the “DST” as a nickname. The deferred sales trust, it is copyrighted and it is trademarked. I tell people, “Don’t try to do this yourself.” A law firm over in Kansas came up with this concept and it’s based on the 1933 Installment Sales Act. You will not see it as a tax code. It is a process that the IRS does recognize. And it’s one that they created. Now, the best way to explain how it works, if this is the question you’re asking for, is to compare not using it versus using it. And normally, if you don’t use it, you have the seller and you have the buyer.
Usually a business broker or somebody will negotiate and help the two negotiate a deal. And then, you get an LOI or letter of intent, and at this point, whatever deal is cut, is what they negotiated and the taxes are paid or whatever. That is normal, not using the DST. Now, if we’re going to use a DST instead of just a straight line between the seller and the buyer, we’re going to create a triangle, okay? And what we’re going to do in the middle of this triangle, we’re going to create this trust.
Now, there are all different kinds of trusts. This is called the deferred sales trust as one in particular, and it’s run by the estate planning team out of Palm Springs and the Midwest area. And it works like this, the seller and the business broker goes ahead and cuts the deal with the buyer. And once they have a done deal at this point, I tell people we stop and we get a case manager involved, which is usually a tax attorney. And he takes a look at it. And once he understands it and he thinks it’ll work for the seller, and the seller wants to do this, then they go ahead and open up escrow, which is in California. And the case manager, at the same time, now the way it works is this, the seller actually sells the business to the trustee of the trust at the same transaction in escrow, it’s all done at the same time.
Now, the trustee sells the business to the buyer. Now, the buyer goes ahead and pays the trustee whether it was negotiated. The trustee, who is at the top of the triangle, pays the seller a dollar plus a note for the balance. And so, the assets go inside the trust in the middle of the triangle. Now, the assets in essence are the collateral for the note. Now, the money is at this point invested, it’s very open. They use TD Ameritrade. They could look online and see what’s going on with their money. Right now, they have, some say, just not every day, can and want to do trades. But investments are made that the trustee feels comfortable with. See, there’s more than one set of eyes looking after this, not just the seller, not just me, but also the trustee. Now, let’s assume the note is set up for 8%. At this point of the assets that are inside the trust, the trustee starts paying the seller 8%. The system is designed for people who want to sell, retire and go home, they’re done. It’s not designed for people who want to roll it over and do another business or another piece of real estate. Does that help them understand, Jeff?
The system is designed for people who want to sell, retire and go home, they’re done. It’s not designed for people who want to roll it over and do another business or another piece of real estate.
Jeff: I think it does. Now, the difference is that I’m understanding here, and correct me if I’m wrong, Cal, all of the revenue from the sale of the proceeds does not come all at once, is that correct?
Cal: Tthat’s not uncommon. And when I sold my business, I asked for 60% balance over two years. And 27 people wanted to buy my business, and I narrowed it down to one. And they were more than happy to do that.
Jeff: Now, you mentioned that the trustee is in Inland Southern California and the Indian Wells Palm Springs area, correct?
Cal: Well, that’s where the estate planning team is headquartered. Trustee that manages my trust is a CPA up in Bakersfield, we’re all across the United States; we’re everywhere.
Jeff: Very good. So this isn’t something that is simply unique to California, but this is something that anyone who is interested in using this route could take advantage of regardless of where their business is located in the country?
Cal: All 50 states and Puerto Rico.
Jeff: So tell us how long does this process typically take? Is there still the regular process recommended essentially going through a business appraisal, or in having your company appraised and going through the valuation process and is everything pretty much the same up to when you get to the point where you get the buyer involved with the trustee?
Cal: Well, let’s put it this way, to the buyer, it doesn’t mean a thing. It doesn’t change what he does whatsoever. And as far as the seller is concerned, it might add another hour’s worth of time. That’s about it.
Jeff: Let’s talk about then, questions that you may get from those people who come to you and you turn them on to this idea. How am I going to know the amount of the payments that I’ll receive from the trustee? Let’s start with that one.
Cal: Well, it’s a multitude of factors; the most popular being it’s what we negotiate, what you, the seller, negotiates with the trustee. Now, that’s based on - this is where I get involved – I do what they call an “investment policy statement questionnaire” and I get a feel for their risk tolerance, what they’re comfortable with, and what they’re not comfortable with, because what’s inside the account is anything that’s legal inside the United States. And I’ll use my own account as an example. 40% 0f my money is in real estate. And 30% of my money is in stocks all across the board. And the other 30%, two-thirds of that is in bonds, and 10% of it is in cash.
I do what they call an “investment policy statement questionnaire” and I get a feel for their risk tolerance, what they’re comfortable with, and what they’re not comfortable with.
Jeff: Now, you mentioned the word risk, and we get up in the morning out of bed and we run the risk of breaking our ankle on our way to the bathroom or something like that. And so, there is risk there in everything that we do. But if I find somebody, Cal, that is interested in buying my business outright and I want to be done with it, and I find somebody who can do this and do it quickly, and they want to go ahead into it, they know everything about my business there is to know. Both sides have done their due diligence, and everybody’s happy. I can sell my business and essentially be out from underneath it. Now, I’m going to have to pay the taxes, that’s true, okay, and that’s a fact of life. But with this particular option, are there any risks that I run the risk of taking — you see I use the word “risk” twice there. I don’t know if you saw what I did there — but are there any risks that are unique to this particular option that may make it not suitable for just everyone, for example?
Cal: Well, primarily, it’s designed for people who want to retire, okay? And with people like that we tend to get a little on the conservative side. If it’s somebody that’s not ready to retire, the odds are this isn’t for them. It’s almost like creating your own retirement plan, over and above what already have been up until this point. And so, is it for everybody, no, usually, I can figure that out upfront with just two or three questions: What are the plans? What are you trying to do and why? What do you want to do in five years? This kind of stuff, and if it’s things like “I want to start another business,” I wouldn’t recommend this.
Jeff: Okay. Now, does this eliminate having to pay taxes, or does it just simply mitigate them or cut them down, reduce them? How does it work? Because that really is in fact one of the big advantages to this option, isn’t it? Not having to pay quite the taxes that you might otherwise expect to pay.
Cal: Well, let’s be very, as I say, upfront about this.
Cal: We owe the taxes. I still owe the taxes on the business I sold, I’m just not paying it yet. And the question I get asked, “When am I going to pay the taxes?”
Jeff: Very good, and that clears it up. This is a deferred sales trust.
Cal: And my answer to that, when people ask me when I’m going to pay my taxes, “You know what, I’m going to let the kids deal with it.”
Jeff: You’re going to let the kids deal with it. Okay, well, what happens, Cal, if I die, if I die in the process of this whole thing here?
Cal: And you’re sitting here with a deferred sales trust?
Jeff: There you go.
Cal: It passes on to whoever your beneficiaries are, your children, your cousins, your spouse, whatever, it passes on to them and they get the same options you had. Now, the one copy that I’ll throw in there; it is part of your estate. And so, if it’s a good chunk of change, which when you start hitting the $4 million or $5 million mark, that’s a chunk of change we have to deal with estate taxes also. But we can deal inside of that with the estate planning team. We have ways of dealing with that.
Jeff: Cal Garvin is with Garvin Associates, he’s my guest today on Deal Talk, brought to you by Morgan & Westfield. And, Cal, once again I appreciate you joining us today. We’re talking about deferred sales trust today. And this is another option and answer perhaps for those business owners who want to get out from underneath their business, or they want to hang them up. Maybe they don’t have any errors or they don’t have anybody in the family who wants to take over. They just want to get out and go ahead and be out from underneath all of these. But they don’t want to be hit with those taxes all at once. And that’s why we call it the “deferred sales trust.” What about flexibility, variability and the payment streams, such as increasing the payments over time? How does this all work? Is this one of those, is it kind of one-size-fits-all, or can I go ahead and make the determination as to how I get those payments?
Cal: Well, you start out with your note. Say, hypothetically you want to get 8% on it for the rest of your life, or as long as you want to have it, but what happens sometimes, and I’m looking at the situation on 20% of my trust. I own a chunk of real estate down in Vista, California, and it’s right next door to a Costco. We know where the baby boomers like to go spend their money. This piece of real estate is doing quite well and it looks like it’s going to double or triple. Well, that will definitely increase the payments. But I’ve got to wait until the end of the note and I roll the note over and I’ll just increase the size of the note, that’s all; to cover. Does that answer your question?
Jeff: It does. Now, what happens if capital gains tax rates are changed after I set up the deferred sales trust?
Cal: Well, it doesn’t affect the money inside the trust at all, unless you decide you want to take the money out. This trust is liquid. Any time you want it, a phone call will take care of it or we’ll send you a form to sign saying that you are aware that when you receive this money, it will be less to taxes, because the taxes have to be paid. And if you take the money outside the trust, the taxes will be paid. Now, the income you’d get on it by the principle of sitting inside the trust, you pay ordinary income taxes on. But let’s put it this way, I’ll now use an example of a million dollars. Say, you had a million dollars taxable inside the trust; which would you rather have, 8% of a million dollars or $700,000? 8% of $700,000 is not as much as 8% of a million, is it, Jeff?
This trust is liquid. Any time you want it, a phone call will take care of it or we’ll send you a form to sign saying that you are aware that when you receive this money, it will be less to taxes, because the taxes have to be paid.
Jeff: No, indeed. No, and even I can figure out that math and didn’t even need a calculator to do it for a change. When the trust sells the property, can I keep some of the cash from the sale, Cal?
Cal: Sure, say, you want 10%. Well, that 10% from the sale of the property or the business, you’re going to pay taxes on. The 90% goes into the trust, and the taxes are deferred.
Jeff: Let me see if we can do this. We’ve got maybe about five or six minutes left here in the program, Cal. Let’s say I have maybe a hardware store. It’s an independent hardware store business and I’ve been in the business for 60 years. I can’t really manage it anymore against Lowe’s and Home Depot, and it’s a family-owned business, and I’ve done all I can to go ahead and be done with it. Let’s say, I’ve had sales of, I don’t know, it’s probably generous for a hardware store, an independent hardware store, but it’s a round figure, it’s even, it’s a million dollars and I’m done with it. How essentially does the process work if you can just step-by-step it for us?
Cal: Okay. We have somebody who wants to buy it. And at this point, the way it works, we’ll assume that we have a deal and that the broker representing the sellers help cut the deal for him. We turn it over to the case manager. He looks at it. He’ll ask a few questions, usually down with the conference call, the business brokers involved, he’s never out of the loop. And if it’s a go, go ahead and finish it up. Now, open up escrow. And at this point, the trustee takes over and he helps complete the transaction. Again, using me as an example from the time I cut the deal and escrow is open, three weeks later, it was done that fast. It really didn’t make that much of a difference. And to the buyers, they could care less I was using a deferred sales trust. Jeff, thousands of these have been done over the last 15 years, it’s just not advertised. This is really pretty much word of mouth.
All they have to do is sign a non-disclosure agreement, an NDA, and they will be given all the information as to how the process works. And once they see it, and in every case, they always say, “Oh, okay. Go ahead and do it then.”
Jeff: Cal, I’m sorry. I don’t mean to break in, but why do you think that is? Because it’s a great idea, obviously thousands of these have been done. Legally, it’s on the up and up, but why is it that it’s not talked about, do you think?
Cal: Well, a formal major corporation has never taken it on; the concept is owned by a select few people, and they don’t take advantage of it by doing this either. A question I get quite frequently is “How much does this cost?”
Jeff: Let’s talk about that; how much does it cost to get everybody involved?
Cal: True. Okay, and the best I can explain that, it’s based on the complexity of the deal, and no payment is made until it actually closes escrow or it’s done. And I’m going to give you a range. It depends on the complexity. I’m going to say upfront, the cost is set up, is somewhere around 1.25% and 1.50%, that’s it. Now, there is an annual fee, and again, depending on the complexity, that’ll run anywhere from 1% to 1.5% a year, that’s it. That takes care of the tax filings and everything, because, yes, the trust has to follow a tax return. So that takes care of the trustee, the CPAs, the attorneys and all. If ever you’re audited because of this, or it doesn’t have them audited, you will have representation. It will not cost you a penny and every one of them had passed the audits with flying colors.
Jeff: Now, can I have my own tax advisor or attorney to take a look at this in order to make sure that I’m doing the right thing?
Cal: I highly recommend it, Jeff. What I will say is this: if most CPAs or attorneys who have never heard of this, and a lot of them haven’t, even my own tax attorney which was over in Huntington Beach…he never heard of it. The initial kneejerk reaction to an attorney or CPA who’s never heard of this is “no, don’t do it.” Well, it’s human nature to say no to something you don’t understand or never heard of. But all they have to do is sign a non-disclosure agreement, an NDA, and they will be given all the information as to how the process works. And once they see it, and in every case, they always say, “Oh, okay. Go ahead and do it then.”
Jeff: Very interesting. Now, let me ask you this. Is this something that can be cancelled? I just go ahead and decide, “No, I just want my money and let’s just go ahead and just get the deal done. Just sell it outright.”
Cal: Well, you can just sell it outright and not do the DST and pay the taxes. And like I said earlier, this is liquid, say, you’re three years into it, you decide, “You know what, I’d rather have my money.” Sign the form saying you’re aware that you will pay the taxes, and as soon as that’s received, the check will be mailed out within the week less the taxes. The trustee will send the taxes off to the Feds, the state and whatever.
Jeff: Wow, this is really, really an eye opener for many of us who aren’t necessarily familiar with this concept of deferred sales trust. And I say it’s a concept, but it’s actually a real, living, breathing thing. This is an option that has been, like you said, Cal, out there for many years, has been used by thousands of businesses. At least that’s what you’re telling us to be true, and we know that you have done this yourself. And your wife was for so many years; I think you said she worked for the Treasury Department, worked for them about 20 years. Is that right?
Cal: She was an attorney, yes.
Jeff: My goodness. And she said she checked it out in the early going, and this was all on the up and up. And this of course was when this was in its infancy many years ago. But since then, this whole idea, this option has been matured. It’s been tested and so many people have used this. And this has got to sound like a dream come true for many people who may be listening today, who are considering selling their business, but they just can’t pull the trigger because they don’t want to pay all those taxes. And yet at the same time, they don’t want to be involved in their business anymore. And so here we are, this allows them to make a break, deferred sales trust. Now, no doubt, there are going to be those who have questions out there, Cal. We can’t answer everybody’s questions in the scope of this program. Everybody’s situation is different. What is the next step?
Cal: Oh, sure, Jeff. Easy. I tell people that if you want more information, you could go to my own personal website, simply it’s calgarvin.com. That’s “C-A-L-G-A-R-V-I-N”.com. Calgarvin.com. And you’ll find all contact information there, including my phone number. If you want to talk, call me. If I’m not available, I’ll get right back to you. Sometimes, I’m busy, but I won’t leave you hanging, that’s a promise.
Thousands of these [DSTs] have been done over the last 15 years, it’s just not advertised.
Jeff: Well, Cal Garvin, we appreciate this time today. We have run out of time, but we’re sure to thank you for appearing on our program. And we hope that maybe someday, if we’ve got any other questions about this, we can bring you back on.
Cal: Just let me know when.
Jeff: Thank you again to Cal Garvin, President of Garvin Associates Incorporated for joining us today on Deal Talk. And that’s going to wrap up today’s edition presented by Morgan & Westfield, a nationwide leader in business sales and appraisals.
If you’d like more information about buying or selling a business, call Morgan & Westfield at (888) 693-7834 or visit Morganandwestfield.com. Until next time, my name is Jeff Allen. I’ll see you again.