Your business is your baby. You’ve sacrificed for years, nurtured, endured sleepless nights and now it’s time to sell your business. This means income…and income means…well, taxes.
The tax side of selling a business has many moving parts, and if you get nothing from this article…remember this! ALWAYS consult a tax or financial advisor.
Here are four tax-related issues to keep in mind…
- Are sales proceeds taxes as ordinary income or capital gains?
- Is the sale assets or stock?
- All cash deal or payment installments?
- Can sale be treated as tax-free merger?
Remember these issues are relevant for federal income taxes…different states have different rules and may collect more or less taxes than the IRS on the same deal.
How Are Business Sales Taxed?
The IRS, with few exceptions, treat the business as individual assets, not one big sale.
Those assets will be put into two buckets
- Long-term capital gains (real or depreciable property)
- Short-term capital gains at ordinary income rates (A/R and inventory)
Pro Tip #1: Plan +2 years ahead of selling your business to reduce ordinary income tax
If you sell an asset that you’ve held for more than 12 months, the proceeds will be treated as long-term capital gains. The maximum tax rate for most taxpayers is 15%, with the maximum rate at 20%. Proceeds treated as ordinary income are taxed at the taxpayer’s individual rate. Currently the top individual federal income tax rate is 37% more than twice as high as the long-term capital gains tax rate.
Obviously, sellers will want most of their assets treated as long term capital gains. However, most times, during negotiations, the buyer may want a different allocation, that in turn, can reduce the new owner’s tax bill.
Pro Tip #2: Negotiate on sales price, to receive a more favorable asset allocation
It’s a potential conflict, as the buyer often wants as much of the price as possible allocated to costs that can be deducted or assets that depreciate.
For instance, the IRS says that selling inventory produces ordinary income. But selling capital assets held for more than a year creates a long-term capital gain.
In addition to asset allocation, the deal’s structure can affect the tax bill. If the seller agrees to take the price in installments, for instance, they can defer paying taxes until the payments are received.
Pro Tip #3: Buyer competent? Doing your due diligence can spread out your tax bill
Buyers may end up paying more when they don’t have to pay everything upfront. And the seller may also be able to charge interest, in addition to saving on taxes. Installment sales do add more risk, though, because the new owner must run the business well enough to produce profits to make payments.
Corporate Stock Sales
Sales of sole proprietorships, partnerships, and LLC’s are commonly treated as sales of separate assets. However, when a corporation is sold the deal can be presented as a stock sale rather than a sale of assets. This is important because if the corporation sells its assets, sale proceeds will be taxed twice.
- When the corporation pays taxes and…
- Again, when its shareholders file individual returns
In contrast, a stock sale gets taxed once, saving on taxes for the seller.
Tax-Free Corporate Mergers
If one corporation is buying another corporation, the deal can be done by exchanging strictly stock. Under the right circumstances, this can mean no taxes at all, as long as no cash is involved.
The Bottom Line
No matter the size of your business, consult a financial and tax advisor as taxes can eat into the cash you were hoping to get out of your business. All this is governed by a complex set of IRS rules, which may not always be straight-forward.