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.
However, the expected taxes on selling a business can significantly reduce your sale proceeds, which can be discouraging.
In this guide, we explore the various taxes you must pay and how to reduce your tax burden through tried-and-tested methods.
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.
Consult with us at Exitwise today to maximize your sale proceeds!
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.
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.
The Internal Revenue Service (IRS) classifies the tax into two categories:
Short-term capital gains tax applies to assets the owner has held for 12 months or less before the sale.
The 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.
For instance, if you have a 37% ordinary income tax rate, your short-term capital gains tax caps at 20%.
On the other hand, the long-term capital gains tax on the sale of a business applies if you've held the business for over 12 months.
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.
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.
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.
The states that do not have a capital gains tax include Wyoming, Nevada, Alaska, Texas, South Dakota, Florida, 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.
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, a 20% capital gains tax rate applies if your taxable income exceeds 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.
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.
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.
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 avoid 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.
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 pay taxes in the year the transaction closes.
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.
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.
For instance, you may get a 15-year exemption. If you are 55 or older, retiring after the sale, and have owned the business actively and continually for 15 years or more, you may enjoy 0% capital gains tax.
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.
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.
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.
