Maximizing wealth: A strategic approach to minimize capital gains taxes on business sales

The sale of a business often represents a significant financial milestone for proprietors. However, the accompanying tax obligations can be substantial. But an innovative strategy exists that leverages tax-loss harvesting to allow business owners to defer a portion of the capital gains tax incurred from selling their business, if not the entirety. The primary objective is to delay the capital gains tax for an extended period, though specific scenarios may even enable complete tax avoidance.

Many business owners have spent a lifetime tending to their business with the hopes they could one day sell it and use the proceeds to fund their lifestyle in retirement. However, business sales are typically taxed as a capital gain, with rates reaching up to 23.8%i at the federal level and potentially higher in states imposing additional state income tax.

Building on the concept of “tax-loss harvesting, ” the innovation comes from an idea introduced in a 2018 Financial Analysts Journal article titled “Taxes, Shorting, and Active Management,” in which Sialm and Sosner introduce the power of using “short sales.” ii Their research found that one could both improve pretax returns and generate substantial capital losses. One could subsequently use these losses to offset many types of capital gains, whether from selling a business, real estate or other investments.

What Is Tax-Loss Harvesting?

Tax-loss harvesting means selling investments where one has a loss and replacing them with reasonably similar investments. With this approach, a previously unrealized capital loss is now realized.

Using Short Sales with Tax-Loss Harvesting

This innovation builds on the idea of tax-loss harvesting by creating more opportunities for it, which are typically available when there’s a loss in an investment.

Over extended periods, the U.S. markets generally experience growth. That means a portfolio consisting solely of long positions (investments expected to appreciate) is likely to offer limited chances for tax-loss harvesting due to the scarcity of underperforming investment assets. The breakthrough lies in incorporating “short” positions, which inversely correlate with market rises. As the market value increases, the value of these short positions falls.

Combining these shorts with an equal measure of long positions balances the overall market exposure. This strategy introduces the advantage of generating capital losses without relying on market trends.

How Impactful Can This Be?

A 2023 paper published in The Journal of Beta Investment Strategies, titled “Beyond Direct Indexing: Dynamic Direct Long-Short Investing,” stated that “if implemented with a sufficiently high level of leverage and tracking error, these strategies can realize a cumulative net capital loss of 100% of the invested capital within a few years and, at the same time, substantially outperform the benchmark index before tax, net of implementation costs.”

An Example of How It Works

Take a business owner who expects to sell his business in the next year or two. Currently, he has a $3 million balanced portfolio, which he agrees to use with this strategy.

The investor uses this core portfolio as collateral to purchase an additional 125% in long positions, or $3.75 million in individual stocks, and an equivalent amount in short positions. Note that the market value of new long and short positions balances out so that no additional market exposure is created.

Investors should review these positions and change them frequently, where losses are quickly realized, and investment gains are held long-term. The result is consistent monthly short-term capital losses, which can then be used to offset future short-term or long-term capital gains. In year one, the expectation is to create about 50%iv of the portfolio value — in this case, 50% of $3 million, or $1.5 million, in capital losses to offset gains in the same year — or to bank for future use as losses that can be carried over one’s lifetime. In this scenario, the owner can apply these losses to offset the tax burden of selling his business in the future and offset at least a portion, if not all, of his gain, depending on the timing and sale price of his business or “tax-loss harvesting.”

Final Thoughts

It’s important to note that when tax-loss harvesting, the replacement investments have a lower basis and, if sold, will recognize the gain deferred from the sale when first harvesting the loss.

That said, a good strategy may be to hold these positions in one’s portfolio for as long as possible and consider it a core holding, held long-term. It is also important to note that one may be able to avoid the capital gains tax entirely by either receiving a step-up on a basis at death or donating the investments in-kind to a charity, foundation or donor-advised fund.

Interested in tax loss harvesting with short sales or pursuing another investing strategy? A CFP® professional can help you decide on the best course of action for your specific situation. Find your CFP® professional today.

Read the full article at CFP Let’s make a plan.

Charles Sachs, CFA, CFP®, is a Chief Investment Officer at Kaufman Rossin Wealth, LLC, a Registered Investment Adviser.