How to Avoid Tax on Sale of Business (Step-By-Step Guide)

Disclaimer: This article is meant only for educational purposes. It is not tax or legal advice. You should seek the guidance of a local tax expert before you make any decision regarding taxes and business sales.

Picture this scenario: you have worked very hard and built your business over time, and it's now ripe for transfer to another entity.

Your focus is on finding the right buyer and working out a favorable purchase price while you wonder: How much of this sale has to go to Uncle Sam?

If you already have this question in mind while going through the business sale journey, you might be closer than you think to deferring or minimizing some of the taxes you'll pay!

Learning how to avoid taxes when selling a business doesn't have to be a tough needle to thread. This article will discuss the different ways to maximize profits from a taxable business sale.

Let's get to it.

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TL;DR - How to Avoid Taxes When Selling a Business

The long and the short of it is that you can actually avoid paying taxes when you sell your business by using various strategies to defer or reduce taxes.

Here are some strategies to consider:

• Hold onto the business for at least a year
• Use the correct purchase price allocations
• Opt for an installment sale
• Negotiate a stock sale
• Sell the business to your employees
• Reinvest into an Opportunity Zone Fund
• Use a Charitable Remainder Trust
• Use a non-grantor trust
• Opt for rollover equity
• Relocate the business to a different state before the sale.

Give us a shot today, and we’ll help you find the best M&A team to get you the best bang for your buck when you sell your business.

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When You Sell a Business, How Is It Taxed?

The IRS imposes a capital gains tax (CGT) on a capital asset sold at a higher price than its original cost or purchase price, alongside the extra costs you have incurred to improve it.

For example, if you buy a real estate business for $10 million and later sell it for $25 million, the IRS will want a cut of the $15 million capital gains.

Besides the capital gains tax, you might also have to pay a state income tax and a federal 3.8% NIIT (Net Investment Income Tax) on capital gains.

The good thing is that not all states have the state income tax requirement on capital gains.

Additionally, if you pass away when selling your business, some states may impose an estate tax on the business sale proceeds. To avoid this, ensure your estate plan is up-to-date as you prepare to sell your business.

It's important to note that some assets, like accounts receivable or inventory, attract ordinary income tax instead of capital gains tax.

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What is the Tax Rate on the Sale of a Business?

The capital gains tax rates on business sales depend on whether you are paying short-term or long-term capital gains. Short-term CGT is charged on assets held for less than a year, while long-term CGT is for assets held for over 12 months.

The capital gains tax rate applied to short-term capital gains is similar to that of ordinary income, which is 10% in the lowest bracket. The other percentage brackets include 12, 22, 24, 32, 35, and 37 as the highest.

For example, if your ordinary income tax bracket is 37%, your short-term capital gains tax rate is 20%.

In contrast, long-term capital gains tax rates favor you more. You can expect a rate of 15% or 20%, or even 0% in some cases.

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Tax Implications of Selling a Business for Different Structures

Generally, business sale and purchase transactions fall under two sale structures—asset sale and stock sale.

These two primary structures affect the payment terms, purchase price, purchase price allocations, and how the business sale is taxed.

Let’s take a look:

Tax Implications of Selling a Business Under the Asset Structure

Here's what to expect on the taxation front if you sell your business under the asset structure:

• The IRS considers the sale as selling each asset independently, assigning tax considerations for individual assets.
• Most of the assets usually attract a capital gains tax.
• Some assets, such as equipment and inventory, are taxed at ordinary income tax levels.
• Intangible assets like goodwill usually attract capital gains tax, which you pay as the seller.
• The sale usually attracts a sales tax, which the buyer pays, but you, as the seller, submit it to the government.
• If you sell an LLC you've registered as an C Corporation, you'll pay corporate tax on your gains. Your shareholders also pay a dividend tax on their gains and any other state income tax that may apply. (The gains are usually taxed twice—at the shareholder and corporate levels).

Tax Implications of Selling a Business Under Stock Structure

Here's what to expect if you sell your business through a stock sale:

• You can avoid double taxation at the shareholder and corporate levels.
• In a stock-only sale, the shareholders receive the payment directly, so you don't pay capital gains tax at the corporate level. The shareholders will pay the capital gains tax and other taxes that may apply.
• A stock sale won't attract a sales tax.
• In a statutory merger, where shareholders of the target company get stock from the acquirer but do not get a monetary gain from the transaction, they won't pay any tax. (However, they have to pay taxes for any other considerations received, such as cash or dividends.)
• A stock-for-stock exchange may be tax-free if shareholders give up 80% of their voting and 80% of their nonvoting stock solely for the voting stock of the acquirer or the acquirer's parent company.
• A stock-for-assets exchange may be tax-free if all the target company's assets are acquired solely for the acquirer’s or the parent company’s voting stock.

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How to Avoid Capital Gains Tax on Business Sale

Let's face it: capital gains tax on the sale of a business can take up a massive chunk of your hard-earned money. Here's how to avoid the tax:

1. Hold onto the Business for at least a Year

Master the timing for selling your business so you'll have held it for at least 12 months before selling it. This usually applies to new businesses or newly acquired ones.

As mentioned, businesses held for over a year are eligible for the more favorable long-term capital gains tax when sold.

2. Use the Correct Purchase Price Allocations

When you sell a company, whether a limited liability company (LLC), sole proprietorship, or partnership, through an asset sale, the IRS views the sale as if you are selling each asset individually.

Most assets attract reasonable capital gains tax rates, while others, like inventory, attract ordinary income tax.

The Asset Acquisition Statement requires placing purchase price allocations into seven classes spanning tangible and intangible assets. These classes include:

• Class 1: Cash and deposits in savings or checking accounts
• Class 2: Actively traded personal property like publicly traded shares and certificates of deposits
• Class 3: Accounts receivable
• Class 4: Stock in trade and inventory
• Class 5: Property and equipment like land and furniture
• Class 6: Intangible assets
• Class 7: Other intangible assets like going concern and goodwill.

While the buyer seeks significant allocations to assets that depreciate fast, such as equipment, you, as the seller, should seek to allocate more to asset classes that attract long-term capital gains tax rates, such as goodwill.

3. Opt for an Installment Sale

It's no secret that lump sum payments can catapult you into a higher tax bracket, which can eat massively into your proceeds, especially if you have short-term capital gains.

As a savvy entrepreneur, consider an installment sale with scheduled annual payments to defer the capital gains tax on your business sale by spreading it to several taxable years.

For this to work, you should receive at least one payment a year after the sale year, apart from the sale of account receivables or inventory.

4. Negotiate a Stock Sale

As a C Corporation, you'll want to structure your business sale as a stocks sale rather than an assets sale to avoid double taxation at the corporate and shareholder levels.

If you sell stocks only, the payment goes directly to the shareholders without any transaction involving the company, meaning you don't pay capital gains tax at the corporate level. The shareholders shoulder the capital gains tax and any other applicable taxes.

5. Sell the Business to Your Employees

If you are selling a C Corporation, you can reduce your capital gains tax liability by selling it to your employees through an Employee Stock Ownership Plan (ESOP).

This type of sale helps you kill two birds with a single stone—you don't have to look for a buyer, and you can put the money from the sale into an investment plan to defer the capital gains tax.

6. Reinvest into a Qualified Opportunity Fund

By reinvesting your capital gains from a business sale into a Qualified Opportunity Fund (QOF), you can enjoy a deferred capital gains tax payment until 31st December 2026 or until at least five, seven, or ten years of holding the gains in the QOF before terminating or reducing it.

For the Opportunity Zone tax break to work, you must reinvest the capital gains within 180 days of the business sale.

7. Use a Charitable Remainder Trust (CRT)

A Charitable Remainder Trust is an IRS-approved, unique, tax-free trust entrepreneurs use to minimize tax liability. You can sell assets inside the CRT without triggering a capital gains tax.

But even as the deal sounds too good, there's a catch—the CRT has to be the seller, which means you should have registered one and transferred the ownership and assets of your business to the CRT’s portfolio.

The one good thing you'll love about CRTs is that the beneficiary charity can be your family trust or foundation, which helps preserve your hard-earned legacy.

8. Opt for Rollover Equity

When you use a rollover equity strategy, you receive only some of the business sale money in cash and the rest as equity in the new company the buyer will run.

Rollover equity defers capital gains tax payment to the future when you can have yet another exit when your buyer decides to sell the company.

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How to Minimize Taxes on Selling a Business

You'll notice most of the strategies on how to avoid paying taxes when you sell your business involve deferred capital gains tax.

However, it's some consolation that you can reduce taxes when selling your business in a few ways, as below:

1. Use a Non-Grantor Trust

A non-grantor trust stands as a legal entity charged with handling its own taxes. You can use one to spread incomes to several beneficiaries, especially those in lower taxation brackets.

2. Relocate the Business or Part of It to a Different State

We mentioned that you could schedule part of the purchase price to payments in other years.

Delayed payments can help you alter some tax liabilities. For example, you can move to a state that doesn't charge income tax to reduce the taxes you pay once you receive future payments.

Alternatively, you can relocate your business or part of it to a different state before the sale, especially one without state income tax.

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Tax Planning Strategies Before Selling Your Business

Besides the ways we’ve explored to minimize tax liabilities, you can consider these tax strategies on how to reduce business taxes and preserve your profits:

• Optimize Your Business Structure: The type of business entity you own, whether it’s a sole proprietorship, a limited liability company (LLC), or a corporation, will affect how your sale proceeds are taxed. If you plan to exit your business in the next few years, you can restructure your business to qualify for tax incentives. For example, you can change it into a corporation to be eligible for the Qualified Small Business Stock (QSBS), which can allow you to exclude up to 100% of capital gains.
• Explore Exclusion Opportunities: You can leverage a like-kind exchange to dispose of an asset and acquire a similar one without generating a capital gains tax liability from the sale of the first asset. However, you must ensure that the asset you’re selling is an investment property. You should also purchase a similar asset within 180 days of selling the first asset.
• Use a Deferred Sales Trust (DST): You can transfer your business or stock to a third-party trustee before sale. The trustee then sells your business assets and holds the proceeds in a trust account, allowing you to avoid capital gains at the time of the sale. You can then collect installment payments from the trust, potentially lowering your annual tax liability.
• Plan the Timing of Your Sale: You can plan the best time to sell your business to minimize the tax you’ll pay. For example, you should stay informed about changes in tax laws and policies and sell your business before anticipated increases in taxes, which can save you significant amounts.
• Leverage Family Limited Partnerships (FLPs): Create a well-structured partnership to preserve your family wealth and gain several tax benefits, like income tax and estate and gift tax planning.
• Assemble the Right Team: The key is to pick a tax reduction strategy that meets your business needs. That’s why, you should work with an M&A team that includes an M&A attorney, an M&A tax advisor, and a M&A financial planner. These professionals can tailor your sales structure according to the most tax-efficient strategy. Besides, they can identify deductions that are specific to your unique situation.

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Common Challenges Business Owners Face When Selling a Business

Regardless of your motivation for selling, whether it’s for financial gain, personal goals, or health considerations, you will likely encounter several challenges throughout the sales process.

Here are the top 5 challenges and ways you can navigate them:

1. Maintaining Confidentiality

You have to maintain confidentiality throughout your business sales process. If news of your sales leaks out to the public prematurely, you can unsettle employees, lose clients or suppliers, and lose revenue.

Solution: Work with experts to help you discreetly market your business, find the right buyer, and create confidentiality agreements with potential buyers to prevent disclosure of sensitive information.

2. Employees' Insecurity

If you have employees, selling your business can cause them stress due to uncertainty about their future.

Solution: Understand when to tell employees and customers about your sale. You should also address their concerns and keep them informed about the progress.

3. Determining Your Business Value

You have to determine your business value to have a successful sale. If you overvalue your company, potential buyers can shy away, and if you undervalue it, you might experience a financial loss.

Solution: Engage a business valuation expert to evaluate your business, taking into account a detailed assessment of your cash flow, projected growth, and risk factors that determine your company’s fair market value.

4. Finding the Right Buyer

To find an ideal buyer, you should carry out careful consideration. On your own, you can leverage your industry connections and network to find potential buyers, but that isn’t enough.

Solution: Collaborate with us to find and vet a professional M&A broker who can help you identify and evaluate potential buyers. They can help you negotiate more effectively and get the best possible sale price for your business.

5. Transition Post Sale

Another challenging aspect of selling your company is relinquishing your role as the owner and disengaging from the business. Whether you’re retiring or moving on to a new phase in your career, it can be challenging to let go of your business.

Solution: Aim for a smooth transition after the sale, which may involve providing ongoing support to the new owners. You can provide them with the day-to-day management of the business until they are ready to take over entirely.

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How Can Exitwise Help With Situations Like This?

At Exitwise, we help you seamlessly find, interview, hire, and manage a fantastic merger and acquisitions team when selling your business.

You'll want your M&A team to feature competent wealth advisors, M&A attorneys, accounts or finance experts, M&A advisors, and investment bankers.

These experts can help you navigate your business sale to save taxes using tax deferment strategies or even help you get a better offer for your business. Let us help you find and manage your dream M&A team today!

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Frequently Asked Questions (FAQs)

Here are some questions you may still have on the subject.

Do Businesses Pay Capital Gains Tax?

Businesses that go on sale and make a profit off the base cost or buying price attract a capital gains tax.

Who Pays Sales Tax When Selling a Business?

Generally, the buyer pays sales tax on an asset sale of a business, and the seller submits it to the government. A stock sale does not attract a sales tax.

When Do LLCs Have to Pay Capital Gains Tax?

If your LLC is registered as a C Corporation, you pay corporate tax on capital gains from asset sales, while the shareholders’ proceeds attract dividend tax and any applicable state income tax.

If the LLC sells stocks only with payment going directly to shareholders, the shareholders pay capital gains tax and any applicable state income tax.

How Can the Structure of a Business Sale Minimize Tax Obligations?

You can minimize your tax obligations when you sell a business using a stock sales structure rather than an asset sale.

If you are a C Corporation, consider selling to your employees via an ESOP or having shareholders directly receive payments for stocks sold.

When using an asset sale approach, minimize tax obligations by allocating more price to capital assets than depreciable assets unless you are a corporation or selling your partnership interest.

What Are the Tax Implications of Selling C Corporation vs. S Corporation?

A C Corporation attracts more complex taxes than an S Corporation, which falls under the easy pass-through structure in which an individual business owner pays taxes on the company's profit or business sale profit.

How Does Estate Planning Influence Tax Liabilities When Selling a Business?

As a business owner, having an elaborate and updated estate plan can help ease dealing with estate taxes while maximizing the assets you pass on to your beneficiaries in case you die after a sale.

Can Gifting Shares to Family Members Before Selling a Business Reduce Taxes?

Gifting shares to family members before selling a business can reduce your taxes if you gift the stocks to a recipient with a lower tax bracket.

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Conclusion

Imagine the sweet relief of selling a business successfully while keeping the tax liabilities down as much as possible or deferring tax payments as long as possible!

We can help you understand the tax implications of selling a company by helping you hire and manage top-rated M&A experts who can help you value your business, negotiate a favorable price, and keep tax liabilities down.

Set up a time to chat with our M&A advisor to understand how we can help.