If you’re concerned about taking a tax hit when you sell your business, get a business valuation done.
The business valuation is an appraisal that can help you set your price. It can also help you estimate the tax impact ahead of time. It may also bring to light ways you can lessen that impact.
We’ll take you through all you need to know.
Learn more information about selling a business by downloading the BizBuySell Guide to Selling Your Small Business. Or if you’re buying a business, for more information download the BizBuySell Guide to Buying a Small Business.
How are Business Sales Taxed?
Business sales are taxed based on your capital gain. The capital gains tax rate will be the same as whatever tax rate you pay on your ordinary income taxes. Capital gains are treated as income.
What Is a Capital Gain?
In short, a capital gain is a profit gained from an investment. It can be a capital gain or loss. When you sell a business, the capital gain is the difference between the original cost and the sale price.
Things such as equipment depreciation can help reduce the capital gain. The cost of capital improvements may also impact the net profit.
For example, you bought a business for $200,000 and built an addition at a cost of $100,000. The purchase price for the business was $350,000. You’d owe capital gains on the $50,000.
You can have a gain or loss. Using the same example, the purchase price is $250,000. You have a $50,000 loss.
Capital Gains Tax on Selling a Business
Capital gains are taxed as ordinary income, but there’s a difference. The irs establishes short term and long term capital gains tax rates.
If you’ve held a business for less than a year, you’ll be taxed at your ordinary income tax rate with the irs. The top irs federal personal income tax rate is currently 37% for the highest tax bracket.
If you’ve held it for more than a year, you’ll be taxed at the capital gain tax rate for long term capital gains, currently 15%. Either way you would fill out IRS Form T2125. Business owners in the higher tax brackets for ordinary income should hang on to a business for more than a year, to pay the lower long term capital gains tax rate.
To ensure that you reduce your tax bill as much as you can, you can specify which portion of the sale price applies to business assets such as inventory, buildings or other capital assets.
Sometimes the buyer and business owners negotiate a gradual sale of capital assets, especially inventory. They may use an installment sale of inventory as a capital asset separate from the purchase price. These installment sale strategies can reduce the tax consequences.
7 Tax Considerations Before the Sale of a Business
There are different approaches you can take.
1 . A Stock Sale or an Asset Sale?
In a stock transaction sale, the buyer purchases stock to acquire an ownership stake in the business. A buyer can use this stock sale method for purchases involving c corporations and s corporations, for example.
An asset transaction sale involves the capital assets. A capital asset is tangible property, such as the building and equipment. By definition, a capital asset must be something that has value going forward of more than a year.
You can do an asset sale for inventory separately from the business sales price.
The guidelines for short and long-term capital gains rates apply to the stock and/or asset transaction sale.
2. Establishing Value of Business Assets
In addition to the purchase price of a business asset, such as a piece of machinery, you can include the costs associated with its installation. Such costs can include the installation, and also the training of employees.
Having records of all those associated costs can help you reduce your capital gains taxes. You can’t include maintenance costs.
3. Purchase Price Allocation
A business owner uses this allocation method to calculate fair market value typically for businesses mergers and acquisitions. PPA is commonly used to abbreviate Purchase Price Allocation.
The buyer or buyers “allocate” the purchase price amount into various assets and liabilities. The seller calculates net assets, and uses “good will accounting” to add the value of intangible assets. Intangible assets can include business name and logo, for example. A PPA is typically subject to bank reviews.
4. Type of Entity
The percentage of interest that individuals hold in businesses such as partnerships and corporations is treated as capital gain income when the individuals sell that interest.
Depending on the type of entity, the tax implications and capital gains rates vary.
C Corporation – Shareholders pay capital gains when they sell stock. They may also pay a corporate tax when the C corporation is sold.
S Corporation – When an S corporation is sold, the transaction can be structured as stock or asset sales. The corporate structure can remain intact, meaning that there are not additional corporate tax implications.
Partnership – The capital gain is due on the individuals partnership assets. An individual can sell his percentage of partnership interest to a buyer.
5. Tax-Free Stock Exchanges
The buyer exchanges stock in his or her own company for stock owned in the company the buyer wants. The amount of stock exchanged must be between 50-100% of stock owned by the buyer.
In a variation of this, a corporation can issue stock in exchange for an amount of money or other property.
6. Income Tax Rates
The personal tax rate of the buyer may be higher than the highest long-term capital gains rate, which is currently 15%. The highest personal tax rate is currently 37%.
Although you can pay the lower tax rate on the capital gain, it is still income and can change the tax basis levied on your personal taxes.
That’s the main reason that installment sales are popular ways to sell assets. It’s not tax-free, but it spreads out the amount of income you earn.
7. State Considerations
Of course, if you own a small business you already know that taxation on a sale doesn’t end at the federal level. You’ll most likely be on the hook for state and local taxes.
What about Florida? Residents don’t pay any personal income tax there. But Florida does levy a corporate income tax. In New York City, you’ll also pay a city income tax.
Tips for Small Business Owners
As you have read, the sale of a business can be complicated. And you’d hate to work hard at a small business only to miss out on potential savings when you sell it. So knowing how to sell a business is extremely important. Here’s our best advice:
Consider Hiring a Tax Advisor for Your Business Sale
A tax advisor is invaluable. Even if you’re planning a sale a year or two from now, you should involve a tax advisor now. The advisor may direct you to take steps to change your business structure, for example.
If Your Business is a Sole Proprietorship, Sell Assets Separately
Selling assets separately is the way to go for sole proprietors. It’s a way to keep your annual earnings at a steady level and as such, keep your taxable income steady.
Consider Selling to Employees
You can sell a business entity to employees as a long-term installment sale or by using an employee stock ownership plan. You can sell to all existing employees or sell to a group of key employees.
This is a way to ensure that valued employees keep their jobs. And it’s up to them to continue job security going forward.
Think About Gifting Some of the Business Sale Money to Family
This can be tricky and create resentment. For example, let’s say that a parent and one son or daughter works in the business. Should just that one son or daughter get a gift from the sale proceeds? Or all the siblings?
Should proceeds from any future business sale be protected as to be given to direct family members only? Should terms be spelled out in premarital agreements?
Here’s where tax advisors – and legal advisors – are important. Baby boomers are reaching retirement age, and planning is essential for exit strategies involving business sales.
Structure the Deal as an Installment Sale
There are two main installment sale structures:
Cash plus Seller Financing – The buyer pays a lump sum portion of the sales price and signs a promissory note for an installment purchase.
Earn Out – The seller is paid as a “consultant” and stays with the business for 2-3 years, earning a salary.
Consider an Opportunity Zone
Within 180 days of the sale of a business, you can put the capital gains monies into a Qualified Opportunity Fund. Gains can be deferred for 5 years.
If the QOF is held for 5 years, then 10% of the gain will be excluded from taxation. If held for 7 years, an additional 5% is excluded. If ten years, all is excluded.
Do I have to pay taxes on the sale of my business?
Unless you’ve lost money, you can’t escape paying taxes on the sale proceeds. There are methods you can use to spread out the tax impact over several years, such as using installment sales for certain assets.
How much tax do I pay on the sale of my business?
You’ll pay either short or long-term capital gains rates. The short-term rate will be the same as the rate you pay based on your tax bracket. The long-term rate will be at the capital gains rate, which is currently 15%.
How do you avoid paying taxes when selling a business?
Hiring a tax advisor can save you lots of money. They know the ins and outs of the ever-changing tax codes.
You can also reduce taxes by:
Selling assets using installment sales
Gifting to family
Selling to employees
How are capital gains calculated when selling a business?
The amount of capital gain is calculated by subtracting the original purchase price from the current purchase price. But there are ways to reduce your tax bill with deductions, such as costs associated with capital improvements and equipment purchases.
If the business entity was held for less than a year, the tax amount is the same as the percentage levied in the owner’s personal income tax bracket. If held for more than a year, use the current capital gains tax rate, 15%.
How do I report the sale of my business on tax return?
You use IRS form T2125, the Statement of Business or Professional Activities.
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