When you sell your business you may face a significant tax bill. In fact, if you’re not careful, you can wind up with less than half of the purchase price in your pocket, after all taxes are paid! However, with skillful planning it’s possible to minimize or defer at least some of these taxes.
The amount of tax that you will ultimately have to pay depends upon whether the money you make from the sale is taxed as ordinary income or capital gains. Profit received from the sale of the business assets will most likely be taxed at capital gains rates, whereas amount you receive under a consulting agreement will be ordinary income.
Allocation of Sales Price Governs Tax Consequences – If you negotiate a total price for the business, you and the buyer must agree as to what portion of the purchase price applies to each individual asset, and to intangible assets such as goodwill. The allocation will determine the amount of capital or ordinary income tax you must pay on the sale. It will also have tax consequences for the buyer. What is good for the tax picture for the seller is often bad for the buyer and vice versa, so the allocation of price to various components of the deal is frequently an area for negotiation and compromises. The taxable amount at issue is your profit: the difference between your tax basis and your proceeds from the sale. Your tax basis is generally your original cost for the asset, minus depreciation deductions claimed, minus any casualty losses claimed, and plus any additional paid-in capital and selling expenses. Your proceeds from the sale generally means the total sales price, plus any additional liabilities the buyer takes over from you. As the seller, you will probably want to allocate most, if not all, of the purchase price to the capital assets that were transferred with the business. You want to do that because proceeds from the sale of a capital asset, including business property or your entire business, are taxed as capital gains.
Capital Gains vs Ordinary Income – Under current law, long-term capital gains of individuals are taxed at a significantly lower rate than ordinary income. In fact, if you’ve held the asset for longer than 12 months, the maximum tax on long-term capital gains is 15 percent for qualifying taxpayers. (Taxpayers in the 10- and 15-percent tax brackets pay zero percent.)
Business structure matters – If your business is a sole proprietorship, a partnership, or an LLC, each of the assets sold with the business is treated separately. (A corporation can also take this route, but it also has the option of structuring the sale as a stock sale.) So, the formula described above must be applied separately to each and every asset in the sale (you can lump some of the smaller items together, however, in categories such as office machines, furniture, production equipment etc.). Certain assets are not eligible for capital gain treatment; any gains you receive on that property are treated as ordinary income and taxed at your normal rate. After the sale, the buyer will be able to depreciate or amortize most of the assets that were transferred. Because different types of assets are depreciated differently under IRS rules, the buyer is going to want to allocate more of the price toward assets that can be depreciated quickly, and less of the price to ones that must be depreciated over 15 years (such as goodwill or other intangibles) or even longer (such as buildings) or not at all (such as land).
Qualification to the IRS rules – That’s the basic story. But things are never that simple with the IRS. There are a number of qualifications to the rules, and issues that present planning opportunities for sellers (and buyers) of businesses.
Here are some that frequently come up:
• Ordinary income vs. capital gains. Gains on some of the assets being transferred may have to be taxed at ordinary income tax rates, rather than at the 15 percent maximum long-term capital gains tax rate.
• Installment sales. If you defer receipt of the purchase price to later years with an installment sale, you may be able to postpone paying tax on your gains until you receive them.
• Double taxation of corporations. For businesses organized as corporations, the structure of the deal as an asset or stock sale can have very different tax results.
• Tax-free reorganizations. Where one corporation is buying another, you may be able to structure the sale as a tax-free merger.
Please note that our discussion of tax aspects is a very broad overview, and presently covers only federal tax issues. It’s essential to be aware of state tax issues. In some states, sales tax may apply to asset sales; some states tax stock transfers. Also, many states and localities impose transfer taxes on real estate or other assets. For more detailed information or advice pertaining to your individual situation and your state and locality, consult your tax adviser.
Consult your Tax Adviser early in the process to ensure that your tax liability is optimized before the sale. Email me now at DanYoung@b2bcfo.com to schedule a free business assessment. You will receive a complimentary benchmarking report for your business.
Make it a Great Day!!