Small business owners often forget to consider the taxes they must pay after the sale of their businesses, resulting in lower net sales proceeds. If they proactively consult an advisor long before–even years–before the actual sale of their businesses, they reduce the tax burden or even manage to crack tax-free deals.
The IRS subjects the sale of a business, just like any other money-making transaction, to taxes. However, different factors determine the extent of taxes owed, which a business owner might have to pay on the sale of the business.
The factors impacting taxes include the type of the company, whether the business owner is selling company assets or shares of the company’s stock, and what type of capital assets they are selling.
1. Type of Company
The type of company determines how much a business owner will owe in taxes. Is it a sole proprietorship, partnership, limited liability company, S corporation, or C corporation?
Sole Proprietorship or Limited Liability Company (LLC)
Suppose a business owner sells the assets of his sole proprietorship and makes a profit: he has to pay the tax just once in the form of capital gain tax. Per the IRS, sole proprietorships and one-owner limited liability companies (LLCs) that do not elect to be treated as corporations separate from owners for tax purposes are classified as disregarded entities. In such cases, business owners of sole proprietorships and LLCs companies need not file for commercial income taxes. Instead, they pay taxes on any profits made from the capital assets reported personal income tax forms.
The tax benefits are better if your business operates as a sole proprietorship or LLC rather than a separate entity.
The IRS considers C corporation’s legal entities separate from their owners, which results in double taxation. Suppose the owners sell the company’s capital assets for a profit. In that case, they must pay a corporate tax that coincides with the commercial income tax return and a second time as capital gains tax on their share of the profit on their income tax filings.
S Corporations and Partnerships
Both partnerships and S corporations avoid double taxation. When business owners or shareholders sell assets through a partnership or S corporation, each is responsible for paying taxes through their income tax filings. The IRS does not require them to pay taxes again on the company’s income. S corporations are perfect for business owners who want to sell company shares while maintaining a single tax rate on the profits.
IRS does not allow C corporations to change their corporate status to S corporation to evade double taxation. According to IRS, C corporations must change their status two months and 15 days before starting the business’ tax year before selling any assets to qualify for a single tax.
2. Stock Sale or Asset Sale?
When someone buys stock in a company, he is buying a portion of ownership of the company. So, if he buys a significant share of stocks, he owns a larger percentage of the company. According to the Corporate Finance Institute, “Where the transaction is structured as a stock acquisition, by its very nature, the acquisition results in a transfer of the ownership of the business entity itself, but the entity continues to own the same assets and has the same liabilities.”
Company ownership also includes debts and liabilities. CFI further states that in an asset sale, “the seller remains as the legal owner of the entity, while the buyer purchases individual assets of the company, such as equipment, licenses, goodwill, customer lists, and inventory.” Most buyers prefer purchasing a company’s assets rather than stock: to avoid responsibility for the company’s liabilities and debts.
Business owners, however, prefer to sell stock that the IRS taxes at a lower rate compared to capital assets. The sellers usually offer a lower selling price to make a stock purchase more appealing for the buyers.
Although the seller must pay capital gains tax resulting from the sale of capital assets and stock, they receive a more generous tax break for selling stock because stocks are usually held longer than capital assets. The seller also gets a tax benefit from holding the stock for longer than one year.
When a company sells the stock, double taxation applies. Whereas, if an individual shareholder sells the store, they must only pay the tax in his tax filing. To mitigate their tax burdens, shareholders must sell stock to a particular buyer instead of the company selling its stock.
3. Type of Capital Assets
The IRS classifies the capital assets in three ways: real estate (i.e., real property), depreciable property, and inventory property.
A business’ tangible property includes land, buildings, and anything affixed to the land. Often businesses seeking to relocate or close down forever decide to sell their real estate separately. If the buyer purchases only the real estate, then the seller owes capital gains tax for the sale of the property in addition to taxes on any gains from the sale of the business. However, suppose the buyer purchases the entire company, including the real property. In that case, the real estate is transferred to the buyer as a part of the business, and the seller pays tax only on the profit from the sale of the company.
The depreciable property loses value over time and includes furniture, machinery, equipment, etc. Sometimes, companies sell old properties and replace them with new ones. As per IRS norms, the sale of depreciable property is treated as a gain or loss based on its current value. Usually, the value of the property sold is lower than the original value at the time of purchase. Also, if the seller held the property for more than a year, the applicable taxes would be considerably less than if the seller held the property for less than a year. Here the tax rate is based on the difference between the purchase price and the current value of the depreciable property.
The normal transactions of selling products to customers for a profit are not taxed for capital gains. However, when a company sells a significant portion of its inventory, and the transaction is not normal, unlike its usual transactions, the IRS considers the proceeds of that sale a capital gain. Sometimes, business owners want to sell inventory at a wholesale level if they cannot sell it at the retail level. This helps them cut losses and recoup their investment, at least partially. If their expense on the inventory exceeds the cash received from selling it, they can claim the difference as a capital loss and pay no taxes.
Business owners strive to lower the tax rates when selling their companies. While selling a business tax-free is not impossible, it is undoubtedly tricky. Few business sales can avoid taxes entirely.
Suppose the buyer agrees to exchange the stock of his corporation for the supply of the seller’s company. If the deal meets specific IRS criteria for reorganization, both parties can conduct a stock exchange in which the seller need not pay taxes. As per the IRS, the seller must receive between 50 to 100 percent of the buyer’s stock to effect a tax-free deal. So, a tax-free transaction is possible by keeping it as an exchange of stock, meaning non-cash assets. However, the involvement of cash requires the seller to pay the taxes.
In the rare case of a cash sale, the seller can offer financing to the buyer, allowing the buyer to make monthly payments toward the total sale price. In this case, the addition of interest–simple, accrued, or compound–increases the total sale price, which exceeds what it would have been in a single payment deal. In effect, the buyer starts running the business, makes monthly payments to the seller, and sorts everything.
But there’s a downside. If the buyer makes a mess of the business and cannot pay the remaining monthly payments, then the seller can get a tax deferral on the monthly payments until he receives the total agreed-upon sale price. The seller must also pay taxes on the money already received, even if the buyer defaults on the payments.
In case of a buyer default, the seller may retain the company’s ownership while keeping the money the buyer already paid. This outcome might benefit the seller if the company has not lost its earning potential.
Offering seller financing involves serious considerations on the seller’s part. To reduce the risk of seller financing, the seller might sell only the capital assets and retain the company’s stock ownership.
Tax Strategies to Consider When Selling a Business
Go for an installment sale.
The seller or business owner can negotiate with the buyer payment of the sale price in installments over an agreed period lasting more than a year. So, when the seller receives even one installment after a year, it considerably minimizes the tax bite on the profit. Since the installment sale arrangement involves the risk of the buyer defaulting on payments, the seller needs to keep such a risk in consideration. Also, the installment sale may not be applied to the sale of inventory property.
Register the company as an S Corporation
As discussed earlier, an S corporation is subject to a single tax, whereas a C corporation pays double taxes. If the corporation meets the registration requirements as an S corporation, then the seller can opt for that tax advantage.
Negotiate the allocation of assets in the selling price of a sole proprietorship
In the sale of a sole proprietorship, the IRS treats each asset separately. It requires that the Asset Acquisition Statement allocate the purchase price to seven different classes of investments.
While most assets trigger capital gains and attract favorable tax rates, others like inventory produce ordinary income and are not subject to high tax rates. Usually, the seller wants to allocate assets like goodwill to capital gains taxes, whereas the buyer wants a reasonable allocation for assets like realty and equipment, meaning depreciable property. This divergence of preferences requires the seller to negotiate the allocation of assets to realize a tax benefit.
Sell to employees
A-C corporation can sell business shares to its staff through employee stock ownership plans (ESOP). It can set a price for the sale and receive cash through the ESOP. The company then rolls over the proceeds into a diversified portfolio to defer tax on the profit.
For an S corporation to use ESOP to sell business shares, it must revoke the Selection because the deferral option applies only to C corporations.
Decide on the sale of stocks or assets.
The seller must negotiate accordingly after determining which kind of sale (stock or asset) renders the most favorable tax benefits.
Sell the interest in the partnership.
The IRS treats the sale of an interest in a partnership as a capital asset transaction. It can result in a capital gain or a capital loss. Any gain or loss from inventory property is treated as ordinary gain or loss. The seller may then defer capital gain through investment in the opportunity zone.
Go for opportunity zone investment.
Sellers subject to capital gains taxes on the sale of their business may defer those taxes by reinvesting their proceeds in a qualified opportunity fund with 180 days of the sale.
Business owners need to plan early to benefit from the tax breaks allowed by the IRS. Consulting an expert advisor to identify the pain points and improve the situation can help business owners minimize their tax bills selling their businesses.