When you sell a business, the transaction may represent a lifetime of work. However, without thoughtful planning and preparation, a significant portion of the proceeds can be lost to immediate capital gains taxes.
At McCullough Law, we help clients structure transactions in ways that may allow them to keep more of their money working for them. One example of this is our Escrow Strategy.
1. What Is the "Escrow Strategy"?
Internal Revenue Service guidance acknowledges that when sale proceeds are placed into a properly structured escrow that is, subject to substantial legal restrictions, the seller is not recognized as having received those funds for tax purposes until the restrictions lapse.
In simple terms, the escrow strategy allows a seller to:
- Receive a portion of sale proceeds at closing;
- Place the remaining proceeds into a legally restricted escrow account; and
- Defer capital gains tax on the escrowed portion until the escrow term ends.
Because the seller does not have unrestricted access to the escrowed funds, the IRS does not treat the seller as having effectively received that income.
2. How the Escrow Strategy Works
Step 1: Structure the Transaction
At closing, the purchase agreement allocates a portion of the sale price to be paid directly to the seller and a portion to be deposited into a third-party escrow account governed by a written escrow agreement.
The escrow must:
- Serve a bona fide business purpose (e.g., securing representations, warranties, or performance obligations);
- Impose meaningful restrictions on the seller's access to the funds;
- Be administered independently; and
- Be carefully aligned with the purchase agreement.
Step 2: Invest the Escrowed Funds
At McCullough, the full pre-tax escrowed principal remains invested during the escrow term (for example, five or six years). Unlike a scenario where taxes are paid immediately and only post-tax proceeds are invested, the escrow allows the entire pre-tax amount to generate returns during the deferral period.
Investment earnings are typically taxable as they are received, but the principal capital gain tax remains deferred until release of the escrow funds.
Step 3: Taxation Upon Release
When the escrow term ends and restrictions lapse, the seller recognizes the deferred capital gain and pays the applicable tax at that time.
A Simple Illustration
Assume a $20 million sale:
- $10 million is paid directly to the seller at closing (taxed immediately).
- $10 million is placed into a five-year escrow.
If the seller's capital gains rate is approximately 28.30% (federal, State of Utah, and net investment income tax combined), investing after-tax proceeds would leave about $7.17 million working. However, under a properly structured escrow, the full $10 million remains invested during the escrow term.
At an 8.00% net annual return, that difference can translate into more than $1 million of additional earnings over five years, simply because more principal remained invested before tax.
4. How McCullough Law Helps
The escrow strategy is not a template solution. It works only when properly designed and documented. Improper structure can trigger immediate taxation under the constructive receipt or economic benefit doctrines.
At McCullough Law, we provide attorney-structured escrow solutions that:
- Coordinate the purchase agreement and escrow agreement;
- Comply with IRS guidance and case law;
- Establish legitimate business purposes for the escrow;
- Structure meaningful restrictions to support tax deferral;
- Work alongside your CPA and financial advisor; and
- Oversee independent escrow administration.
If you are preparing to sell a business, the escrow strategy may allow you to balance immediate liquidity with long-term tax efficiency.
Contact McCullough Law for more information.
1 See Rev. Rul. 77-294, Rev. Rul. 79-91, Stiles v. Commissioner, 69 T.C. 558, 569 (1978), acq., 1978-2 C.B. 3, PLR 2005210074, and IRS Publication 537.