When you prepare to sell your business, one of the “elephants in the room” that needs to be discussed is taxes. Unfortunately, taxes can significantly reduce the amount of money that ends up in your pocket once the sale is complete.
In this article, we’ll provide a high-level overview of taxes on the sale of a business. You’ll learn how business sales are taxed and what to consider during the process, plus discover pro tips and strategies to help maximize your returns.
How Are Businesses Taxed During a Sale?
If you’re a business owner looking to sell, the term you want to be most familiar with is “capital gains.”
Practically everything your business owns is considered a capital asset. Examples can include your physical place of business (if you own it), company vehicles, and office furnishings. As the Internal Revenue Service (IRS) describes, “When you sell a capital asset, the difference between the adjusted basis in the asset and the amount you realized from the sale is a capital gain or a capital loss.” The “basis” is the cost to you, the owner. The adjusted basis accounts for things like depreciation.
During a sale of assets, everything your business owns is broken down into individual assets. For example, if you have three company vehicles, the adjusted basis and sales price is determined on each one of them individually. If you recognize a capital gain — meaning the purchase price is more than the adjusted basis — you must pay a capital gains tax.
The capital gains tax rate varies at the federal level. It is likely either 15% or 20%, though there are a few unique scenarios that apply:
- If your taxable income for the year is less than $80,000, your capital gains rate is 0%
- Your capital gains rate is 15% if your taxable income for the year is more than $80,000 but less than $441,450 for single; $496,600 for married filing jointly or qualifying widow(er); $469,050 for head of household; or $248,300 for married filing separately
- If your taxable income is greater than the thresholds listed above, your capital gains rate is 20%
- If you sell Section 1202 Qualified Small Business Stock, your max capital gains rate is 28%
- If you sell collectibles like coins or art, your max capital gains rate is 28%
- Any portion of unrecaptured Section 1250 Gain from Selling Section 1250 Real Property is taxed at a max capital gains rate of 25%
These are all considered long-term capital gains rates. If you own an asset for longer than a year, it is referred to as a “long-term” holding. If you own it for less than a year, then it’s a “short-term” holding.
Short-term capital gains are taxed as ordinary income. This means you’ll pay your ordinary income tax rate on the proceeds, which can be as much as 37% depending on your tax bracket.
As you work through the sale of your business, the Definitive Agreement and closing documents will include a Purchase Price Allocation (PPA) that specifies the value assigned to each tangible and intangible asset included in the total transaction value. The PPA will determine what tax rate is applied to each asset being sold. This can be a tricky exercise. What’s good for the seller from a tax standpoint can be bad for the buyer, and vice versa. This is an area where guidance from trusted advisors can make a big difference.
Lastly, it’s worth remembering that you also must pay taxes at the state level. The rates listed above are the federal tax rates for 2021. Capital gains taxes can vary from state to state. All but nine states tax capital gains income. This further demonstrates why it’s important to have a quality team of advisors in place during your sale, as they can determine the exact taxes you’ll pay on each one of your business assets.
How Do Taxes Vary Between Asset Sales and Stock Sales?
The process outlined above is what applies to most businesses in the lower middle market (those with revenues between $5 million and $25 million). There are also tax implications for those owners completing a stock sale, though they must also pay capital gains taxes. The tax consequences of an asset sale versus a stock sale are worth considering when preparing the sale of your business.
A stock sale is only available to those businesses that have outstanding shares. For example, a stock sale would not be possible if your company was legally structured as a sole proprietorship. C corporations and S corporations are two types of business entities that could conduct a stock sale.
Stock sales offer tax savings to sellers because the entire sale is taxed at a maximum capital gains rate of 28%, with no consideration of short- versus long-term capital gains. During a stock sale, the buyer assumes all responsibility for tangible assets, intangible assets like intellectual property and goodwill, and liabilities.
If you operate as a C Corp, you’ll want to avoid an asset sale. In these cases, business owners are subject to double taxation. The corporation pays business taxes on the assets sold to the buyer. Then, shareholders must pay taxes on their personal tax return when earnings from the sale are distributed.
If your broker advises you to set up an asset sale, your main tax consideration is when the assets were purchased. If you have only owned the asset for less than a year, you will likely have to pay short-term capital gains tax, which is equal to your income tax rate.
Asset sales could also be advantageous to buyers because of a tax law known as the “step-up clause.” Essentially, this rule allows business owners to restart the clock on depreciation. This, in turn, can create a reduction in taxable income. There are IRS rules specific to depreciation and tax treatment.
Are There Any Tips to Help Lower the Tax Bill From Your Sale?
If you’re thinking of selling your business, you may want to reconsider making large purchases within a year of your sale. Let’s say, for instance, you want to buy real estate — perhaps a warehouse that you plan on fixing up. Your buyer sees the potential in this and buys it for 25% more than what you paid. If you purchased this warehouse within a year of when you sell, you’ll need to pay the ordinary income tax rate.
Perhaps the bigger consideration is that you should start planning your exit strategy early. Business owners often wake up and decide that it’s time to move on from their company, but this can ultimately lead to a loss in value from the sale.
Planning your exit strategy early allows you to talk to a team of experts, including tax advisors and brokers, to determine the type of sale you’re going to conduct. From there, your advisor can help you come up with a strategy for your business assets (assuming you are not conducting a stock sale) that can help you maximize your tax deductions.
Even if you don’t intend to sell for a couple of years, having a strategy and plan in place can ultimately reduce your tax liability. Businesses are unique and there is no blanket tax advice that you can implement. Speaking with a trusted tax advisor can help you prepare for your sale.
Additionally, you may want to consider having annual business valuations. These can help prevent a valuation gap, which happens when you think you’re going to get more from your sale than what it’s worth on the open market. A business valuation can demonstrate the fair market value of your assets.
The valuation will also identify some pain points that are lowering the value of your business, so that you can work to improve the value until you’re satisfied and ready to sell.
Beware of Taxes on the Sale of a Business
When it comes time to sell your business, taxes should be one of the main factors you and your team focus on. The sale structure and length of time you’ve owned your assets will go a long way toward determining how much you are going to pay in taxes.
The earlier you can start talking with your team of advisors, the more time you give yourself to prepare. Your advisors can value your business and estimate what the potential tax implications will be on a sale. Even if it seems too early to do so — the more time you give yourself, the better off you will be.
If you’re looking to start this process, the team at Allan Taylor & Co. can guide you through the entire sales process, from preparing your initial exit strategy to closing the deal. Feel free to contact us to learn more.