There are tax implications for selling a business. However, the way the deal is structured could have a big impact. There are a lot of decisions to make that can have an impact on the taxes of the sale, though there are restrictions on these decisions by the IRS. The preferences of the buyer or seller may have an impact as well. If you’re planning on selling a small business, learn more about what to expect with your taxes so you can make the right decision for your situation. As always, this article should not be considered as tax advice for your particular situation, so please consult with your tax advisor before making any final decisions.
Tax-Related Issues to Consider
When a business is sold, there are a few tax-related issues the seller needs to keep in mind. They’ll want to consider whether the proceeds will be taxed as income or capital gains, whether the deal includes installment payments, whether stocks or assets are sold, and whether the sale can be considered a merger instead of a sale.
State Versus Federal
One thing to remember is that there are different tax rules for the state level and the federal level. The information contained here is focused on the federal level. It is important for sellers to be aware of any state tax implications, as well, since this could have an impact on how much they are taxed and how much after-tax proceeds result from the sale. Every state is different.
Taxing Business Sales
With a business asset sale, it’s not that the business itself is being sold as one item. Instead, the IRS considers each of the assets as being sold in different classes. With that, the difference can be whether the assets are treated as income or capital gains. If the assets have been held for more than 12 months, they’re treated as a long-term capital gain, with a maximum tax rate of either 15% or 20% (plus a possible 3.8% net investment income tax over certain amounts). If the assets have not been held this long, they can be treated as income, with a maximum tax rate of 37% right now.
Some assets, such as intangible assets, can be treated as long-term capital gains, allowing the seller to save money on their taxes. There are, however, limitations on that. Any depreciation recapture from the sale of furniture, fixtures, and equipment, is considered income when it’s sold. Most long-term assets, however, can be considered capital gains when they’re sold, so they’re taxed at a lower rate. There is some flexibility, however, so sellers should be aware of this when determining how assets will be sold.
The Deal’s Structure
The structure of a deal can impact how much tax will be paid, if any, and whether the taxes can be deferred. If the deal is structured as an installment plan, for instance, the taxes are paid as the payments are received instead of all at once. The rules surrounding installment sales can be somewhat complicated, however, so it’s best to meticulously plan this with your tax professional well in advance.
Many CPA’s and tax attorneys would generally recommend that a seller sell his or her stock. This generally means a rather straightforward tax treatment, in that the gains are taxed above the seller’s cost basis of the stock and is generally taxed at long-term capital gains, if the stock has been held for more than a year. However, this can result in potential legal liabilities for the buyer, since the buyer is buying the entire history of the business, and can result in contingent liabilities and lawsuits, post-close. Hence, many buyers and their attorneys will simply refuse to buy the stock and instead, prefer an asset sale. There are also potential issues with the buyer’s ability to recover any costs from the sale, including depreciation and amortization from the assets and intangibles. While there can be 338(h)(10) elections to defray this problem, most small and medium-sized business sales are done as asset sales. Each situation is different, especially if there are contracts that cannot be assigned, so it is vital to get the right counselling, before settling on a deal structure.
Corporate Merging Instead of a Sale
Another way to minimize taxes for the sale of a corporation is to do a merger instead of a sale. In some instances, like where there is no cash involved for the sale, it may be possible to avoid paying taxes on the merger. When taxes do need to be paid, it’s likely they’ll be lower than if the corporation was sold.
Selling Through a Sole Proprietorship
For a sole proprietorship, each asset is considered a separate sale for tax purposes, most of which will end up being capital gains. Other assets, however, are taxed as ordinary income, which has a higher tax rate. During the sale of a sole proprietorship, there are different ways to allocate the assets during the negotiations so that it’s more beneficial tax-wise for the seller. However, this does require negotiations, as that may not be beneficial for the buyer.
A Subchapter s-corporation status could have more tax savings compared to a c-corporation status. Since an s-corporation is not double-taxed, at the corporation level and the individual level, like a c-corporation, this could lead to significant savings depending on the amount of the sale. A c-corporation, if eligible, can switch to an s-corporation before the sale to see these benefits. Generally, though, this must be done at least five years in advance of a sale.
Consider an Installment Sale
When a business is sold, taxes are generally due within a relatively short time period after the business is sold. However, if the sale is done in installments, the taxes can be deferred. There are some limitations to this, such as the sale of inventory or receivables, but it could make it easier for the seller to pay the taxes over time, instead of all at once. It is important to be aware of the risks of selling a business this way before choosing it as an option.
Reinvest the Money to Defer Taxes
When there are capital gains on the sale of a business, there are other ways to defer the taxes other than an installment sale. One of those is to reinvest in a qualified Opportunity Zone Fund. There is a limited amount of time to do this after the sale, typically 180 days, and the deferral may be limited depending on how long the new investment is held.
The taxes involved when selling a business can be complicated, even for small businesses. If you’re planning on selling your business, talking to a professional can help you determine the right way to handle the sale to minimize your taxes and help defer taxes, if possible. Contact CGK today for more information about the tax implications of selling your business or to learn more about the options available for you when you decide to sell. We will work closely with your tax professional to determine the best way to achieve the maximum amount of after-tax proceeds following the sale of your business. The tax implications for selling a business can be maximized in your favor!