How Do You Avoid Paying Taxes When Selling a Business? [Overview]
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.
TL;DR - How Do You Avoid Paying 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.
How Is the Sale of a Business 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.
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.
How to Offset Capital Gains From Sale of Business
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.
How to Minimize Taxes When 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.
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!
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.
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.
