Are you planning to sell your business soon? There are some strategies that might help you keep that hard-earned money in your bank account.
That’s where exit planning for small businesses comes in. By working with people who understand the ins and outs of the tax code, you can potentially structure your sale to help minimize your tax liability and could help maximize your take-home pay.
From taking advantage of long-term capital gains rates to exploring tax-deferred investment options, there are various ways to potentially keep more hard-earned cash in your pocket.
Tax Strategies for Selling a Business
It does little good to get a great selling price only to lose a decent portion of it to taxes, but with planning and a good tax advisor, you can possibly minimize your taxes and defer them. Your particular taxes and savings will depend on several factors, so it’s impossible to provide a one-size-fits-all answer as to what you could save; each business and transaction is unique.
However, a tax strategy may help reduce your taxes, and there are tax strategies available that provide a means that may help defer and reduce the taxes on the sale of your business. Here’s an overview of tax strategies used for business and real estate sales with a company.
Ordinary Income vs. Capital Gains
When you sell your business, you may face a significant tax bill. If you’re not careful, you may end up with less than half the purchase price in your pocket after taxes are paid. However, with some planning, reducing or deferring some of the taxes can be possible.
You may be taxed on the profit you make from selling the business. You may be able to control the timing through the terms of the deal, but the IRS will take its share at some point. The structure of your business has notable tax implications. The most common business structures are:
- Limited Liability Companies (LLCs)
- Partnerships
- S Corporations
- C Corporations
The first three (LLCs, Partnerships, and S Corporations) listed above are considered pass-through entities, in which individual business owners pay taxes on the company’s profits and any profits generated from the sale of the business. Taxes are not assessed at the company level. By contrast, tax implications with C Corporations can be more complex.
Asset Sale vs. Stock Sale
The sale of a business can be classified in one of two ways. The first is the sale of company stock to an acquirer. The second is the sale of the company’s assets.
We usually see buyers that want to purchase assets because they may offer them significant tax benefits. In our experience, in a pass-through structure (LLC, partnership, S Corporations), we have generally seen that the seller doesn’t incur additional taxes by characterizing the sale as one of the assets rather than the company’s stock.
If you operate your business through a C Corporation, things get more complicated. In this case, it may be preferable to sell the company’s stock rather than its assets to avoid possible double taxation (at the corporate and shareholder levels).
Impact of Business Structure on Taxes
A hypothetical example would be if assets are sold for $10 million (with a cost basis of $100,000), the company would realize a $9.9 million capital gain. In this hypothetical example this would result in federal and (if applicable) state income tax that could reduce the net proceeds of the sale to approximately $7 million at the company level. (The Federal tax rate at this level of income is 37%, but some of the income would be taxed at a lower rate based on the marginal system).
The proceeds are then distributed to shareholders, who can pay a dividend tax of at least 15% plus any state income taxes on the distribution. We usually see buyers who want to purchase assets because that may offer them significant tax benefits.
Disclaimer: This hypothetical example is not intended to be taken as confirmed advice or used without consulting a qualified wealth management and tax professional.
By contrast, if only the stock is sold, that’s a direct payment to the shareholders and the transaction doesn’t involve the company directly.
Shareholders then would pay applicable federal capital gains taxes and state income taxes on the appreciated value of the shares they sold. If you own a C Corporation, it’s essential to negotiate a stock sale because it can make a significant difference in your net proceeds from the sale.
| Business Structure | Sale Type Allowed | Tax Treatment on Gains | Capital Gains Treatment | Additional Considerations |
|---|---|---|---|---|
| C Corporation | Asset or Stock Sale | Double taxation for asset sales; stock sale avoids double tax | Stock sale gains taxed at capital gains rate; asset sale gains taxed at corporate rate first, then dividends taxed for shareholders | Stock sales often preferred for sellers; C-corps may face higher tax due to double taxation |
| S Corporation | Asset or Stock Sale | Single layer of tax, but asset sale gains flow to owners | Gains typically taxed as capital gains at individual level | Allows pass-through taxation, but may face higher state taxes depending on state rules |
| LLC (Taxed as Partnership) | Asset or Membership Interest Sale | No double taxation; gains flow through to members | Gains treated as capital gains if sale qualifies | Flexible structure; asset sales often simpler, but each member’s tax situation varies |
| Partnership | Asset or Partnership Interest Sale | Single taxation with gains passing through to partners | Typically qualifies for capital gains rates on sale gains | Complex tax structure; certain assets may trigger ordinary income, not capital gains |
| Sole Proprietorship | Asset Sale Only | Gains taxed as personal income; no corporate tax layer | Generally taxed as capital gains if sale qualifies | Simple structure; full liability for business obligations lies with owner |
Understanding the Tax Implications of Selling a Business
In our experience facilitating the sale of businesses, we’ve come to understand that tax planning is one of the biggest stumbling blocks for sellers. So much so that even seasoned entrepreneurs tend to get stuck despite their extensive experience filing their company’s state tax, federal income tax, and corporate tax returns. By some accounts, more than 100,000 small and medium-sized businesses (SMBs) are sold every year.
For that reason, it is critical to understand the implications you might have on taxes when selling a business – and how to take advantage of the tax-advantaged options to sell it. In our experience, business owners wrongly assume they will be paying the maximum tax rate, and they can do nothing about it.
Strategies to Help to Reduce Capital Gains Tax When Selling a Business
Inflation and potential changes to tax regimes could prompt more business owners to consider selling. When doing this, you may help reduce your tax liability in multiple ways, but you need to plan ahead and, of course, consult with your tax advisors.
Installment Sales
An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. Installment sales allow you to defer the gain on the sale and report part of your gain when you receive each installment payment.
To be an installment sale, you must receive at least one payment after the tax year in which the sale occurs. You would need to report a part of your gain when you receive each payment.
You would need the help of a tax professional to use the installment method to report a loss. Any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year.
Opportunity Zones
Opportunity Zones are economic development tools that allow people to invest in distressed areas in the United States. Their purpose is to help spur economic growth and job creation in low-income communities while providing tax benefits to investors. Opportunity Zones were created under the Tax Cuts and Jobs Act of 2017.
Investors can defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than five years, there is a 10% exclusion of the deferred gain. If held for over seven years, the 10% becomes 15%.
Charitable Remainder Trusts
A charitable remainder trust (CRT) is a tax-exempt irrevocable trust designed to reduce the taxable income of individuals by first dispersing income to the trust’s beneficiaries for a specified period and then donating the remainder of the trust to the designated charity. A CRT allows a trustor to make contributions, be eligible for a tax deduction, and donate a portion of the assets. The trustor also pays income tax on the income received from the CRT.
Employee Stock Ownership Plans (ESOPs)
An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company. ESOPs provide the sponsoring company and the selling shareholder, and participants receive various tax benefits, making them qualified plans. Companies often use ESOPs as a corporate finance strategy and to align the interests of their employees with those of their shareholders.
An ESOP is also a retirement plan in that employees can take distributions when they retire or leave the company. These distributions can be rolled over into an IRA or another retirement plan.
Planning for a Tax-Efficient Business Sale
When it comes to selling your business, tax planning is crucial. We have seen it repeatedly: Some entrepreneurs typically get so caught up in the excitement of the sale that they forget to properly plan for the tax implications, which can be a costly mistake.
Establishing a Business Succession Plan
Establishing a solid business succession plan is one of the first steps in planning for a tax-efficient business sale. This means figuring out who will take over the reins once you move on.
Will it be a family member? A trusted employee? An outside buyer?
Each option comes with its own set of tax considerations. For example, if you’re passing the business down to a family member, you can take advantage of certain gift tax exemptions. But if you’re selling to an outside party, you’ll need to structure the deal in a way that helps to minimize your capital gains tax liability.
Seeking Professional Tax and Legal Advice
I know what you might think: “I can handle this tax stuff on my own.” But when selling your business, you want to take advantage of everything. We always recommend seeking professional financial, tax, and legal advice.
A good tax advisor, like a CPA, can help you take advantage of available deductions and credits.
They can also help you structure the deal in a way that helps to minimize your tax liability and helps to maximize your net proceeds. And remember legal advice. A skilled business attorney can help you draft sale documents and help protect you from any potential legal pitfalls.
Timing the Sale for Optimal Tax Benefits
Another key factor to consider when planning for a tax-efficient business sale is timing. Believe it or not, the timing of your sale can significantly impact your tax bill.
For example, if you plan to sell your business soon, waiting until the beginning of a new tax year might make sense. That way, you can defer paying taxes on the sale until the following year’s tax return.
On the other hand, if you’re expecting tax rates to go up in the future (which, let’s face it, is always a possibility), it might make sense to accelerate your sale and lock in today’s lower rates. The bottom line is this: timing matters when it comes to helping to minimize taxes on a business sale. A skilled wealth management professional can help you make the right call based on your unique financial situation.
Navigating the Tax Complexities of Different Sale Structures
When selling a business, various deal structures exist, each with distinct implications and potential liabilities. For sole proprietorships, partnerships, or LLCs, transactions can’t be structured as stock sales since these entities lack stock; instead, owners can sell their partnership or membership interests.
For incorporated businesses, whether a C-corporation or an S-corporation, both choices are on the table. In my experience, I’ve seen buyers typically favor asset sales, while sellers prefer stock sales.
Tax Implications of an Asset Sale
In an asset sale, the seller keeps the legal entity, while the buyer acquires individual company assets, generally including:
- Equipment
- Fixtures
- Leases
- Licenses
- Goodwill
- Trade secrets
- Trade names
- Phone numbers
- And inventory.
Typically, such transactions exclude cash, with the seller retaining long-term debt, leading to a “cash-free, debt-free” sale. Normalized net working capital, which often includes accounts receivable, inventory, prepaid expenses, accounts payable, and accrued expenses, is usually part of the sale.
Why Buyers usually PREFER Asset sales
Asset sales allow buyers to increase the depreciable basis of the company’s assets within IRS guidelines. By assigning higher values to quickly depreciating assets (like equipment with a relatively short lifespan) and lower values to slowly amortizing assets (like goodwill that usually has a longer lifespan), buyers can potentially enjoy early tax benefits, and potentially enhance cash flow during crucial initial years.
Additionally, asset sales help buyers avoid inheriting potential liabilities, such as product liability, contract disputes, product warranty issues, or employee lawsuits. However, some assets, like certain intellectual property, contracts, leases, and permits, can be challenging to transfer due to assignability, legal ownership, and third-party consent issues, potentially delaying the transaction.
Why Seller’s usually DO NOT PREFER Asset sales
Asset sales often result in higher taxes for sellers. While intangible assets like goodwill are taxed at capital gains rates, tangible assets may be subject to higher ordinary income tax rates. Current federal capital gains rates range up to 20% and state cap gains rates up to almost 15% (But most states are in the 2-7% range).
Ordinary income tax rates depend on the seller’s tax bracket. For C-corporations, sellers can face double taxation: once when the corporation sells the assets and again when the proceeds are distributed to the owners.
S-corporations that were previously C-corporations may also encounter corporate-level built-in gains (BIG) taxes if the sale occurs within the 10-year recognition period as specified by IRS Sec. 1374.
Tax Implications of a Stock Sale
In a stock sale, the buyer directly purchases the seller’s shareholders’ stock, acquiring ownership of the seller’s legal entity. The assets and liabilities in a stock sale are generally similar to those in an asset sale, with unwanted assets and liabilities distributed or paid off beforehand.
Unlike asset sales, stock sales do not require separate conveyances for each asset, as the corporation holds the titles.
Why Buyers usually DO NOT PREFER Stock Sales
Stock sales prevent buyers from obtaining a stepped-up basis in assets, meaning they cannot re-depreciate certain assets. The depreciation basis remains at the book value, leading to potentially higher future taxes compared to an asset sale. Additionally, buyers assume all existing risks associated with the company’s stock, including undisclosed liabilities like:
- Future lawsuits
- Environmental issues
- OSHA violations
- And employee problems
These risks can be mitigated through representations, warranties, and indemnifications in the purchase agreement. However, stock sales can be advantageous if the company holds numerous copyrights or patents, or significant government or corporate contracts that are hard to reassign, as the corporation retains ownership.
This structure can also help maintain relationships with key vendors or customers, reducing the risk of losing critical contracts.
Why Sellers Usually Prefer Stock Sales
Sellers typically prefer stock sales because the proceeds are taxed at the lower capital gains rate, avoiding corporate-level taxes in C-corporations. Moreover, sellers are often less liable for future issues such as product liability claims, contract disputes, employee lawsuits, and obligations related to pensions and benefit plans. However, the purchase agreement can sometimes transfer these responsibilities back to the seller.
Allocating the Purchase Price
Regardless of whether you opt for an asset sale or a stock sale, a key consideration is how you allocate the purchase price among the various assets being sold. This process comes with some nuanced decisions, and you may want to consult a tax advisor to handle the sale in a tax-beneficial way while staying within the legal guidelines.
The advisor may be able to help you:
- Determine the fair market value of each asset
- Current Inventory
- And accounts receivable
Coordinate an overarching strategy for assigning a portion of the sales price accordingly to each of the above to help minimize your tax liability. Get it wrong, and you could end up overpaying Uncle Sam.
Handling Inventory and Accounts Receivable
Another important consideration in any business sales transaction is how to handle inventory and accounts receivable. If you’re selling off the company assets, you’ll need to determine the value of your inventory and factor that into the purchase price. You’ll also need to decide whether to include accounts receivable in the sale or retain them and collect the money owed to you separately.
If you’re doing a stock sale, the buyer will typically acquire all of the company assets, including inventory and accounts receivable, as part of the deal. Again, these are complex issues that require careful planning and experienced counsel. A skilled tax professional can help you navigate the ins and outs and ensure you’re making the right moves from a tax perspective.
Follow these 6-Steps on Tax Planning When Selling a Business
1. Evaluate Your Business Structure Early
The structure of your business (LLC, partnership, S corporation, C corporation) has a significant impact on taxes during a sale. Start by assessing the tax consequences associated with your structure, and consider restructuring if advantageous. This process may take time, as some restructures can trigger immediate tax obligations.
2. Determine the Type of Sale: Asset vs. Stock Sale
Decide whether you will sell the business as an asset sale or a stock sale. Asset sales allow buyers to pick specific assets, often resulting in higher taxes for sellers. Stock sales, generally more favorable to sellers, may simplify the tax process but are less common with certain structures (e.g., LLCs).
3. Conduct a Business Valuation
Obtain a thorough valuation of your business to understand its worth. A valuation helps in setting a realistic selling price, which also impacts capital gains. Consider seeking professional assistance to ensure accurate valuation and compliance with tax requirements.
4. Implement Pre-Sale Tax Strategies
- Installment Sale: Spread the sale over several years to pay taxes gradually on gains, often reducing immediate tax burden.
- Charitable Remainder Trust (CRT): Place assets in a CRT to defer capital gains taxes and receive income distributions over time.
- Qualified Small Business Stock (QSBS) Exclusion: If eligible, consider QSBS to exclude up to 100% of capital gains for certain small business stocks.
5. Plan for State and Local Taxes
Don’t overlook state and local tax obligations. States vary widely in tax rates, so understanding state-specific rules early on can avoid costly surprises. Moving to a tax-friendly state prior to selling may be beneficial, though this step requires careful planning and consideration of residency requirements.
6. Consult with a Tax Professional
Engage with a tax advisor early in the process to review all strategies. They can provide insights on minimizing taxes specific to your sale type, structure, and state, and guide you in documentation to support your claims with the IRS.
Lessons Learned from Suboptimal Business Sales
Of course, only some business sales go so smoothly. We’ve seen plenty of cases where entrepreneurs left money on the table by failing to plan for taxes properly. One common mistake is not properly valuing and allocating the purchase price among the assets sold.
This can lead to overpaying taxes on specific assets and missing out on valuable deductions on others.
Another pitfall is failing to consider the tax implications of different deal structures. I’ve seen cases where sellers opted for a stock sale without realizing the tax advantages of an asset sale and ended up paying more in capital gains taxes. The lesson here is clear: taxes matter when it comes to selling your business.
And the more you can do to plan and structure the deal tax-efficiently, the more money you’ll end up with in your pocket. So, if you’re considering selling your business, don’t leave taxes as an afterthought. Work with a skilled team of advisors and tax professionals to create a comprehensive tax strategy to help maximize your net proceeds and potentially set you up for a successful post-sale future.
Tax Strategies for Selling A Business: Final Thoughts
Selling your business is a big deal, and you want to ensure you’re doing everything possible to keep more of that money in your pocket. By understanding the tax implications, planning, and working with a pro, you can help to minimize your taxes and walk away with a bigger chunk of change.
Remember, every business is unique, so there’s no one-size-fits-all approach. But with these tax strategies in your back pocket, the goal is for you to be on your way to a more profitable sale.
So go ahead, leap. Sell your business confidently, knowing you’ve got the tools to keep more money where it belongs – in your bank account. For more information or to work with experienced, knowledgeable professionals, schedule an assessment with our team today.
Disclaimer: The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
The information presented in this blog is the opinion of the author and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation, tax, or legal advice. Past performance is no guarantee of future performance.
