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“If I sell my business, how much tax will I pay?” is one of the most common questions we hear when someone is deciding whether they should sell their business. Selling your business with a proper plan in place before the transaction occurs is the easiest way to minimize your tax burden from a business sale. Depending on your situation, there are several steps you can take to ensure a tax-efficient process. Understanding these tax implications when selling a small business now can help you eliminate costly post-sale surprises later.
If you sell a business, how is it taxed? The answer depends on the structure of the sale. Most business sales are structured as either an asset sale or a stock sale. In an asset sale, the seller is selling some or all of the company’s assets (and possibly liabilities as well), then transferring those individual assets and liabilities to a new entity controlled by the buyer. A stock sale, on the other hand, is selling the shares of the existing legal entity to a new owner. This transfers ownership of all company assets and liabilities to the buyer. For tax purposes, sellers typically prefer stock sales, while buyers usually prefer asset sales.
If your business is organized as either a C-Corporation or an S-Corporation, you may want to consider a corporate stock sale as the method for selling your business. Other business structures, such as a sole proprietorship, partnership, and limited liability company, are not eligible for a stock sale transaction, as none of these entity structures have issued stock.
Generally, sellers prefer stock sales because 100% of the sales proceeds are taxed at capital gains tax rates and not subject to ordinary income tax. Additionally, in the case of C-Corporations, taxes at the corporate level are bypassed with a stock sale, avoiding double taxation that may be caused by an asset sale. To calculate the value of a taxable gain in a stock sale, you simply take the purchase price of the stock and subtract your cost basis of the stock. This gain is then taxed at the appropriate capital gains tax rate.
In an asset sale, the purchase price agreed on by the buyer and seller must be allocated among the assets that are being transferred. According to IRS regulations, the buyer and seller must use the same allocation. It is important to keep this in mind while negotiating the terms of the purchase and sale agreement, as you can advocate to attribute a larger portion of the company’s value to assets that qualify for advantageous capital gains tax treatment.
Some assets, such as inventory, accounts receivable, and amounts paid for non-compete and consulting agreements will always result in taxation at your ordinary income rate, while other assets, such as capital assets and amortizing intangible assets, can be subject to the more favorable capital gains tax treatment.
Regardless of whether you choose an asset sale or stock sale for your business transaction, in order to receive preferential tax treatment, you need to qualify for the long-term (rather than short-term) classification of capital gains. This requires the company to have held the asset for more than a year at the time of sale. The current long-term capital gains tax rates are 0%, 15%, or 20%, depending on the amount of sale proceeds and the filing status of the taxpayer. The capital gains tax is progressive, similar to income tax. Short-term capital gains are currently taxed at the same rate as ordinary income, which is graduated between 10% and 37%, depending on income and the filing status of the taxpayer.
Let’s say your company owns an asset valued at $1 million for less than 12 months when you decide to sell. This sale would qualify for short-term capital gains treatment, which is the same rate as ordinary income. Therefore, these sale proceeds would be taxed at a rate of 37% for those already in the top IRS income bracket. However, qualifying for long-term capital gains would reduce the tax rate to at least 20%, a savings of almost 50%. Planning the timing of the business sale accordingly can create very meaningful tax savings.
Various types of restructuring initiatives can potentially reduce the tax associated with selling a business. Examples of strategies to explore in this category include:
It’s important to understand how each of these options influences the tax consequences of selling a business before moving forward. For example, if you own a corporation and plan to sell the business to another corporation, you can structure the sale as a tax-free merger. This requires reorganization under Section 368 of the Internal Revenue Code. Generally, you must demonstrate that the transaction reduces costs and/or streamlines operational efficiency.
Another potential solution to the inquiry of how to offset capital gains from the sale of a business is to reinvest the proceeds of a sale into a Qualified Opportunity Zone. By rolling a capital gain into an Opportunity Zone, you will be able to defer the capital gain tax for up to seven years and exempt up to 15% of the original gain plus 100% of the post-reinvestment gain.
In addition to these tax implications of selling a business at the federal level, you should also investigate your state’s tax on the sale of a business. You may want to consult with a business tax professional and a legal professional with detailed knowledge of the ever-changing and complicated state, federal, and local tax codes. Someone with experience in your industry and location can provide the most precise, personalized answer to the question of “If I sell a business, how is it taxed?”