Starting a business requires hard work and dedication. For many entrepreneurs and business owners, selling a business is the biggest reward because it means they have grown a company to the point where somebody else is willing to pay for it.
At Cook Martin Poulson, we work with business owners every day. One of the most common topics of conversation is taxation. Specifically, how to avoid capital gains tax when selling a business. Here's what you need to know.
Do I Have to Pay Taxes on the Sale of My Business?
When you sell a business, you make money. While you might have spent a lot of money to get your business off the ground, you probably took tax deductions and credits to offset some of those costs.
When you sell a business, you will need to pay taxes on the gain. In most cases, the proceeds are taxed at the capital gains tax rate, but some assets may be taxed as ordinary income.
How Much Tax Do I Pay on the Sale of My Business?
As we have now established that the proceeds of a business sale are taxed as capital gains, we need to determine the factors that determine the amount you will pay. Some of these factors include the following:
- Your total income for the year in which the sale is completed.
- How long you have owned the business in question.
- How much gain you will make from the sale of your business.
- Any business liabilities that reduce your net proceeds.
People who are over a specified income threshold may also be required to pay a 0.9% to 3.8% Medicare tax and we will talk about how that can impact your taxes in the next section.
How Are Business Sales Taxed?
Business sales are taxed based on how much gain the owner(s) receives on the sale. Typically, a small business owner will pay for a business valuation to determine the worth of the business and how much they can reasonably expect to receive for it.
A business valuation includes the valuation of intangible assets, which include the company's name, reputation, branding, and products, and this may be included in the purchase price.
When it comes time to calculate the taxes for the sale of your business, you will need to calculate your net gains.
With a stock sale, shareholders may be required to pay capital gains tax on their gains. Corporations may be required to pay an additional corporate tax, as well.
What is Capital Gains Tax When Selling a Business?
For most of U.S. history, capital gains have been taxed at a more advantageous rate than ordinary income. The Tax Cuts and Jobs Act of 2017 retained the favorable rates for capital gains tax with some changes that affect how the rates are applied. Here's how it breaks down:
- The capital gains tax rate for long-term gains is 0% for individuals with taxable income below $40,000, married filing separately below $40,000, married filing jointly below $80,000, and head of household below $56,000.
- The capital gains tax rate for long-term gains is 15% for individuals with taxable income between $40,000 and $441,450, married filing separately between $40,000 and $248,300, married filing jointly between $80,000 and $496,600, and head of household between $53,600 and $496,050.
- The capital gains tax rate for long-term gains is 20% for individuals with taxable income above $441.450, married filing separately above $248,300, married filing jointly above $496,600, and head of household above $496,050.
Individuals with more than $200,000 in adjusted gross income ($250,000 if married and filing jointly) are also required to pay the Net Investment Income Tax (NIIT) of 3.8% on passive gains, or 0.9% on active gains.
If you have owned a business for less than a year before selling it, the proceeds will be taxed at the ordinary income tax rate.
Tax Considerations Before Selling a Business
There are some important tax considerations that you should keep in mind before selling a business. Here are seven to consider:
Sale Type: Stock Sale vs. Asset Sale
The sale of a business may be classified in one of two ways:
- A stock sale involves the sale of a majority share of stock to one or more buyers. This method can be used by S corporations and C corporations.
- An asset sale involves the sale of tangible assets, including inventory, equipment, and property, as well as intangible assets, including goodwill and customer lists. An asset sale may be transacted together with a stock sale or as a separate transaction.
Type of Business Entities
The type of business entity you sell will impact how the taxes for the sale are calculated. Here's a quick breakdown:
- For a sole proprietorship, negotiate everything and keep track of what counts as ordinary income and what counts as a capital gain. Inventory sales are taxed as ordinary income.
- For a partnership, a business sale is a capital asset transaction and is subject to capital gains tax. However, the gain or loss from unrealized inventory or receivables may be treated as an ordinary gain/loss.
- Recapturing the depreciation on the equipment is taxed as ordinary income.
- For corporations, sellers tend to prefer a stock sale because it generates capital gains tax while buyers prefer to buy assets they can later depreciate. Keep in mind that the sale of a C corporation requires payment of the NIIT of 3.8% while the sale of an S corporation does not.
If you have a C corporation that meets the requirements to be classified as an S corporation, you can use an S election to potentially save money on taxes.
Purchase Price Allocation
When a business is sold, part of the process involves the purchase price allocation, which determines how much of the purchase price will be allocated to tangible and intangible assets.
This allocation has a big impact on taxes. As a rule, it is advantageous to allocate as much of the price to certain types of intangible assets as possible since these are taxed at the more favorable capital gains tax rate.
The taxation and the laws regarding how tax is applied to business sales vary depending on where your business is located. State considerations can have a significant impact on how much tax you pay after the sale of your business.
As state laws can be just as complex as federal ones, we recommend hiring a certified tax professional to help you navigate them.
The Value of Business Assets
Deciding what value to assign to your business assets is known as business valuation. Some values, such as the cost of business equipment, real estate, and inventory, are relatively straightforward to calculate.
Valuation gets more complex when intangible assets come into the picture. When a business has a stellar reputation and a recognizable brand, it will be worth more than a similarly-sized business that lacks those assets.
Tax-Free Stock Exchanges
Selling the stock in your company does not need to result in a large capital gains tax bill. One way to defer your taxes is to engage in a tax-free stock exchange, which works only if the sale of your company is classified as a merger or acquisition.
In a tax-free exchange, the stock of one company is exchanged for the stock of another. No cash changes hands. In other words, if you sold your company and received, in exchange, an agreed-upon number of shares in the new entity, then you may not need to pay taxes until you sell those shares.
Income Tax Rates
We already noted that your personal taxable gross income has an impact on the amount of tax you will pay when you sell a business.
For any individual with taxable income above $200,000 ($250,000 if married and filing jointly), the 3.8% NIIT is applicable and must be paid upon the sale of the business.
Reducing the Taxes on Selling a Business
Having reviewed some ways to reduce your taxes when you sell a business, here's a recap to drive everything home:
- Be careful with purchase price allocation and do what you can to allocate proceeds to intangible assets to be taxed at the lower capital gains tax rate.
- Do a stock exchange to defer tax payments to a later date.
- Do an installment sale to spread out tax payments.
- Reclassify your C corporation as an S corporation by filing the appropriate tax election.
We also recommend working with a tax pro to identify potential tax deductions and credits.
How To Report the Proceeds from a Business Sale
The IRS requires you to report all proceeds from a business sale. There are three forms that you may be required to file.
- Form 8594 is the Asset Acquisition Statement, which both the buyer and seller must complete and return to the IRS.
- Form 4797 is the Sales of Business Property form that you will use to determine your capital gain or loss.
- File Schedule D with your personal tax return if you sell stock in a corporation.
You should also research your state's requirements for reporting the proceeds of a business sale and comply with them.
Hire a Tax Pro for Your Business Sale
Selling a business has significant tax implications that can be difficult to understand and navigate. While the information we have included here is a good starting point, we recommend working with an experienced tax pro to minimize your taxes on the sale of your business.
Are you preparing to sell a business? Cook Martin Poulson can help! Contact us today to schedule a consultation.