Taxes on Selling a Business: What You Need to Know

Since a business sale is one of the most important transactions of your life, you'll want to make the most out of it.

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However, the expected taxes on selling a business can significantly reduce your sale proceeds, which can be discouraging.

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In this guide, we explore the various taxes you must pay and how to reduce your tax burden through tried-and-tested methods.

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It's best to work with M&A experts like tax accountants to help you honor the applicable taxes and find opportunities to minimize your tax liability.

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Consult with us at Exitwise today to maximize your sale proceeds!

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When You Sell a Business, How is It Taxed?

How you are taxed when you sell a business typically depends largely on how you structure the sale.

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Below are the key sale of business tax implications to consider:

1. Capital Gains Tax on Business Sale

The capital gains tax applies to any capital asset whose selling price exceeds its base cost, which is the purchase price or cost of building it from the ground up.

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The Internal Revenue Service (IRS) classifies the tax into two categories:

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a. Short-term capital gains tax: This applies to assets the owner has held for 12 months or less before the sale.

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The short-term capital gains tax rate on the sale of a business is the same as your ordinary income tax rate, which typically ranges between 10% and 37%, based on your total income and filing status.

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For instance, if you have a 37% ordinary income tax rate, your short-term capital gains tax caps at 37%.

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b. Long-term capital gains tax: This applies if you've held the business for over 12 months.

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Depending on the amount of the sale price, the typical long-term capital gains tax rate is 15% or 20%. If you are lucky, you can even enjoy a 0% rate in some instances. As such, the long-term capital gains tax rate is more favorable.

2. Sale of Business Assets Tax Treatment

You might also want to consider the following aspects related to how assets are taxed in a business sale.

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When you structure the transaction as an asset sale, the IRS considers that you've sold each asset separately and assigns taxes accordingly:

• Most business assets trigger a capital gains tax.
• Some business assets, such as accounts receivable, inventory, and equipment, trigger an ordinary income tax.
• Goodwill is taxed at long-term capital gains tax rates.
• For an LLC that sells as a C corporation, your capital gains attract a corporate tax (the shareholders pay dividend tax and state income tax where applicable).

3. State Income Tax on Capital Gains

In some states, you may need to pay a state income tax on your capital gains besides the federal capital gains tax.

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The states that do not have a capital gains tax include Wyoming, Nevada, Alaska, Texas, South Dakota, Florida, New Hampshire, and Tennessee.

4. Federal Net Investment Income Tax

You may need to pay the federal Net Investment Income Tax (NIIT) on capital gains in some cases if it's a C corporation and the sale proceeds hit specific threshold amounts. The tax is usually called a Medicare surtax and capped at 3.8%.

5. Estate Tax in Case of Demise During a Sale

Some states may charge an estate tax on the sale proceeds if you pass on during the M&A process.

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Asset Sale vs. Stock Sale for Better Tax Outcomes

Here is a side-by-side comparison of asset and share sales:

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Factors That Impact Taxes on the Sale of a Business

Several factors define how much you pay in taxes once you sell your business. These include:

• Business Liabilities: You may have liabilities that the buyer doesn't assume, which reduces your net amount.
• Total Annual Income in the Sale Year: A significant increase in your annual income for the year in which you complete the sale can bump up your personal or corporate income tax bracket.
• Duration of Business Ownership: If you've owned the business for over a year, you typically attract lower capital gains tax rates.
• How Much Profit You Make Off of the Sale: The amount of profit you make is the capital gains. You can expect to pay more taxes as your profit increases. For example, based on the IRS’s capital gains tax article we linked to earlier, you can expect a 20% capital gains tax rate to apply if your capital gain causes your taxable income to exceed the amounts set for the 15% bracket.
• Terms of Sale: Cash at closing generally means there will be capital gains or ordinary tax payable in the year you complete the transaction. An earn-out means some taxes will be paid in the year the sale closes, while others are paid on an ongoing basis in the years the remaining payments are made.
• The State the Business Operates In: Where a state charges capital gains tax in addition to federal tax on capital gains, the overall tax liability is typically higher.

Tax Reduction Strategies for Selling a Business

You may leverage various strategies to minimize your tax burden when you sell your business. You can try the following options as you may qualify:

• Allocate More Proceeds to Intangible Assets: During purchase price allocation, negotiate to allocate more of the sale price to intangible assets to enjoy lower capital gains tax rates.
• Use an S Election for a C Corporation: If your C corporation qualifies to be an S corporation, use an S election to reclassify it as an S corporation. You can avoid the 3.8% NIIT as an S corporation if you are actively involved in the business rather than simply being a silent or passive investor.
• Take Advantage of Tax Confessions: Use tax concessions such as the Qualified Small Business Stock exemption, which offers a lower tax rate or 0% on capital gains if you meet the requirements.

Working with tax accountants can be a great way to reduce your taxes. They can help you identify and leverage potential tax credits and deductions, among other strategies.

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Qualified Small Business Stock Rules to Lower Tax Liability

A significant benefit that sellers of Qualified Small Business Stock (QSBS) have is the QSBS exclusion under Section 1202 of the Internal Revenue Code (IRC). This provision offers appealing tax benefits to eligible sellers.

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It can exclude up to 100% of federal capital gain tax on a sale, saving you a fortune.

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Here are the eligibility requirements to qualify for tax benefits:

Rules at Company Level

The business issuing the stock must:

• Be a domestic C corporation or an LLC that has elected to be taxed as a C corporation under the ‘Check-the-box’ rules.
• Have gross assets not exceeding $75 million at and immediately after issuance.
• Have at least 80% of its total assets used in qualified trades or business.
• Be a qualified trade or business.

Rules at Shareholder Level

To claim QSBS exclusion, an individual shareholder must:

• Be a non-corporate taxpayer.
• Have acquired the stock directly from the corporation.
• Have held the stock for the minimum required holding period, which is 5 years if issued before the OBBBA Act, 3 years if issued after.
• Respect the per-issuer cap, i.e., $10 million/$15 million or 10x basis.
• Have received the stock through qualifying transactions.

State Level QSBS Conformity

Requirements at the state level vary. Most states allow 100% exclusion of gains on QSBS, but a few do not. The 1202 is a federal provision that leaves states free to either decouple or confirm, in whole or in part.

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States like Hawaii and Massachusetts partially conform to the QSBS exclusion.

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If you’re non-comforming, like Mississippi, Alabama, Pennsylvania, or California, your stock gains may be excluded from federal income tax but you may face a significant state tax bill.

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Alternative Path to Section 1202- For Early Sales

Selling your business before meeting the QSBS holding period can disqualify you from section 1202 tax benefits, but section 1045 offers a solution. It allows you to defer taxes on gains on the sale, provided you’ve held the stock for more than 6 months and reinvest the proceeds into new QSBS within 60 days.

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Opportunity Zone Investments After a Business Sale

Instead of handing over a significant portion of your capital gains to the IRS as taxes, you can defer and reinvest them into Qualified Opportunity Zone Investments.

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Administered via IRS guidance, these opportunity zones (distressed, economically underserved zones) are federally certified and state-designated, created by the Tax Cuts and Jobs Act of 2017. You invest in them by channeling your capital gains into a Qualified Opportunity Fund (QOF), allowing you to defer and potentially reduce taxes on the amount of eligible gains you invest.

How it works

Opportunity Zone Investments offer 3 tax benefits based on the duration you hold the investment:

1. Deferral of Original Gain: Investing the capital gain into a QOF within 180 days allows you to defer paying taxes on those gains until you sell the QOF investments or your next tax year, whichever comes first.
2. Permanent Exclusion of Appreciation: It is the most significant long-term benefit you get if you hold your QOF investments for a period of 10 years. You can step up your basis in the QOF investment to fair market value, meaning any appreciation generated from the investment is permanently excluded from federal taxation.
3. Step-up in Basis: This benefit reduces your tax liability on deferred capital gains on QOF investment held for a specific period. For instance, 5 years of holding qualify for a 10% reduction in your deferred gain; 7 years, 15%; while 10 years of holding qualify for full tax exclusion under a fair-market-value basis step-up.

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How to Avoid Capital Gains Tax on Business Sale

When it comes to avoiding taxes on selling a business, your main goal will be to offset capital gains tax, which is typically the main liability.

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Let's explore some methods you can apply, keeping in mind that deferral is more likely than total avoidance:

• If you use an asset sale, allocate more of the sale proceeds to asset classes that attract long-term capital gains tax, such as goodwill.
• Receive payment in installments by accepting at least one payment a year after the sale to spread the taxes over several years.
• Use the rollover equity option, where you receive part of the payment in stock to defer the gains until after a potential ‘second sale’ in the future.
• Use an Employee Stock Ownership Plan (ESOP) to potentially defer or avoid capital gains tax.
• Hold the business for over 12 months before selling to enjoy a more favorable long-term capital gains tax rate.

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How to Prepare for IRS Audit Risk After a Business Sale

A business sale can trigger intense scrutiny from the IRS, but with the right preparation, you can manage IRS audit risks during and after your sale.

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Here are steps to help you minimize audit exposure or respond confidently if the IRS audits you:

1. Understand Common Audit Triggers in a Business Sale

Several factors cause business sale tax returns to be flagged, for instance,

• High-income taxpayers: statistics show that those with income over $1 million face more scrutiny.
• Inconsistent allocation of the purchase price as stated in IRS Form 8594.
• A dramatic spike in income from one year to the next
• Complex Tax Election Errors.

2. Be Aware of the Audit Window

The IRS can initiate an audit of your tax returns within 3 years from the filing deadline. Omitting more than 25% of your gross income when declaring your tax returns extends the window to 6 years. If fraudulent activities are suspected, the timeframe is extended indefinitely.

3. Ensure Proper Purchase File Allocation

Make sure you get Form 8594 right for your asset sale. Capture the agreed allocations in the purchase agreement and use them to guide you when filling your returns. Get your tax advisor to review both your form and the buyer's before submitting.

4. Document Tax Strategies Used

Maintain a clear record of all the tax strategies applied to the sale. E.g for QSBS exclusion, retain original stock issuance documents, gross asset valuations conducted during the time of issuance, and any other relevant documents.

5. Declare All Taxable Income

Report all payments received, including earnouts, and installments are still taxable even if received after the closing. Do not omit interest components and consulting fees. The IRS has a record of your non- employment income.

6. Engage a Tax Expert

Work with a qualified tax attorney or a CPA in M&A transactions. The M&A expert supercharges your M&A process and builds a return file that can withstand an audit.

7. Respond to IRS Notices Promptly

Whenever the IRS needs clarification or additional documentation, they send a notice. Responding accurately and within the required timeframe helps close the matter amicably.

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Should You Hire Professional Help When Selling a Business?

You should definitely consider hiring professionals when selling a business:

• At Exitwise, we believe hiring the best M&A experts is the most important thing you can do to maximize the sale of your business.
• You can even get better results if you work with specialized M&A experts. We help you hire and manage top-rated M&A professionals in your industry to ensure the sale is smooth and aligns with your business goals.
• We can help you find tax accountants, wealth advisors, investment bankers, and M&A attorneys. Tax accountants are particularly helpful when it comes to managing the tax on the sale of a business.

Reach out to our team at Exitwise today to discover how to minimize tax on the sale of a business to maximize your take-home proceeds.

Tax Risks of Selling a Business Without Professional Help

Your tax accountant and other M&A experts can do more than help you understand the tax implications to look out for before and after the sale.

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They can also help you avoid the two major tax risks associated with selling a business:

• Paying too much tax unnecessarily, which can significantly reduce your take-home amount.
• Not paying the right taxes, which may get you into trouble with the IRS through potential legal cases and hefty fines.

Frequently Asked Questions (FAQs)

Here are some questions sellers often ask about taxes on a business sale:

Can Charitable Contributions Offset Taxes From a Business Sale?

Yes, charitable contributions may offset tax on a business sale. For example, a Charitable Remainder Trust (CRT) is a tax-free option that allows you to sell assets without attracting capital gains tax under certain conditions.

Do You Have to Pay Taxes Immediately After Selling a Business?

You may or may not have to pay taxes immediately after a business sale, depending on the payment terms. If cash is involved at closing, you report the capital gain and pay taxes on it in the year that the transaction closes and you receive the payment.

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You may defer business sale tax if the situation allows, such as when you receive part of the payment at least one year after the transaction closes.

Can Selling a Business Affect My Personal Income Tax Bracket?

Selling a business may affect your personal income bracket based on the sale structure and payment terms.

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For example, if part of the sale classified as ordinary income is significant, it could increase your taxable income and catapult you into a higher income tax bracket.

Are There Any Tax Exemptions for Selling a Small Business?

You may qualify for one of the many exemptions for tax on the sale of a business.

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For example, you may qualify for 100% tax exemption under the Qualified Small Business Stock rule (cited above) if you meet the following criteria as a C Corporation:

• The small business stock was purchased after the Creating Small Business Jobs Act of 2010 took effect.
• You have held the small business stock for a minimum of five years before the business sale.
• At the time you purchased the small business stock, the business's assets must have been worth below 50 million dollars.
• The business sold the stock directly to you at the time of the original issue.

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Conclusion

When considering taxes on selling a business, it's best to educate yourself enough on the types of taxes and the applicable rates.

In this guide, we have examined the key types of taxes and rates that apply to a business sale and discussed some ways to minimize your tax burden through exemptions, reductions, or deferment.

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You'll want to work with the best tax accountants and other M&A experts to help you find ways to ease the tax burden to maximize how much you take home.

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We can connect you with the best industry-specific experts to help you secure a higher take-home amount. Chat with us at Exitwise today to get started.