Before you decide to sell your business, you must consider the tax implications on a business sale. The amount of tax you pay will determine if you get to keep more of the proceeds made from the sale or not.
One of the crucial ways to ensure tax efficiency is to start planning the sale of the business well in advance of the date you intend to sell. This is one of the guaranteed ways to minimize tax liabilities, reduce your capital gains tax on a business sale, and uncover opportunities and other viable ways to avoid risk.
Also, you must decide if it will be a share sale or asset sale. A share or stock sale is more beneficial to you as a seller as there are often capital gains tax benefits you gain following a successful application.
Buyers often favor an asset sale because it is less risky, avoiding liabilities that come with buying the entirety of a company. Unfortunately, a seller can often expect more tax burdens through an asset sale, as a second layer of tax on distributed proceedings may creep up.
The profits you make from selling a business will be taxed as long-term capital gains at a top current federal tax rate between 15 - 20%. This is in direct contrast to ordinary income, with a top federal tax rate of about 28%, which is what you will pay if the transaction is characterized as an asset sale.
In this article, we will be elaborating on the most important tax implications when selling a business, reviewing the most tax-efficient way to sell a business, and answering frequently asked questions on tax when selling a business.
The most important tax implications when selling a business
We’ll take a look at five tax issues you have to consider before selling your business. We’ll also cover some of the relevant tax relief schemes you might want to consider to improve your chances of pocketing or re-investing more of the profits you make from the sale of your business.
1. Capital Gains Tax
The most common tax issue you’ll face when selling a business is Capital Gains Tax. Of course, all of this depends on how you characterize the sale of the business.
As previously indicated, asset sales attract a maximum federal capital gains tax rate of about 28%, but for most individuals, the tax rate on net capital gain is no higher than 15%.
Capital gains tax is calculated based on the difference between the selling price of the asset and how much you paid for it originally.
In some jurisdictions, like California, New York, Oregon, and Minnesota, selling your business assets can also trigger the maximum state capital gains tax, invariably increasing the tax burden you would have to shoulder.
On the flip side, if you characterize the sale of your company as a share sale, the maximum federal capital gains tax you have to pay may not exceed 20%. This figure also rises in locations where you are required to pay your state’s maximum CGT rate.
2. Qualified Small Business Stock (QSBS)
The QSBS is a tax relief for small businesses included in Section 1202 of the US Internal Revenue Code (IRC). It has specific eligibility requirements including holding equity of the business for five years or more. Your business must also be registered as a Domestic C corporation.
If your business falls under this category, you get to enjoy the tax benefits that come with having a significant portion of the capital gain you make from your business sale excluded from federal and state capital gain tax (where applicable).
Other requirements include the state tax rules requirement, except for states like California and Pennsylvania. States like New Jersey are known to impose extra requirements to receive a state and a federal income tax break on QSBS stock.
3. Like-Kind Exchange
The Like-Kind Exchange is a layman’s term for a Section 1031 exchange, a provision in the United States Internal Revenue Code that will allow you to defer or postpone the payment of capital gains taxes, provided you re-invest the proceeds of your assets. This includes real estate or share sales being reinvested into a similar asset that may be equal to or greater than the one you are thinking of selling.
This means that when you sell your assets and invest the proceeds into a similar asset, you will be exempted from paying tax after the first sale. If you decide to sell the second business in the future, those tax implications will kick in. You can also defer payment on the second sale if you continue with another like-kind exchange.
There is no limit on how often you can engage in this tax relief scheme, but there is a limitation on the amount of capital gain that is tax-deferred. Being up to date with the latest tax rules before proceeding with a like-kind exchange will help you avoid any tax liability. Also, know that deferring your taxes does not eliminate your tax obligations.
4. Installment Sale
If you decide on an installment sale when selling your business, you must be aware of the tax implications that come with this sale structure. For starters, this type of sale involves negotiating an agreement with the individual or corporation you are selling to. They would take ownership of the company immediately but spread out payments over the length of time stipulated in the sales agreement.
In this type of sale, you as the seller will receive at least one payment and recognize a portion of the capital gain after the tax year of the sale. This will effectively help you to lower the capital gain or income tax you have to pay once the ownership of your business changes hands or title.
It’s important to understand that you will have to pay interest plus the principal sum as a result of the delayed installmental payments.
5. State tax planning and residency considerations
When you are set to sell your business, you must know and understand the tax laws of the state where you reside, because most states have different income and capital gains tax rates.
Additionally, every state has its own rules regarding different tax relief programs. For example, California no longer recognizes or adheres to the rules and guidelines of the qualified small business stock (QSBS) provisions.
What is the most tax-efficient way to sell a business?
Here are the most tax-efficient ways to sell a business in the US.
1. Get advice and guidance from tax professionals
Nothing beats the advice and guidance of a seasoned tax professional. Including planning ahead of time, getting professional advice and guidance from tax professionals is the best way to sell your business on a tax-efficient basis.
Given the unique nature of individual business endeavors, you need the expertise of accountants and financial advisors. They will provide counsel based on the needs of your business, and help you minimize tax implications and find other opportunities.
2. You should sell shares, not assets
While both an asset sale and a share sale have unique benefits for you as a seller, the best recommendation is for you to sell your shares in the business rather than the assets of the business.
To put things in perspective, an asset sale benefits your buyer way more than it benefits you in the sense that some of the liabilities, including tax-related ones, remain with you after the sale rather than being transferred fully to the buyer.
One of the benefits you get from selling your business’s shares is that you reduce the amount of capital gains tax you have to pay, and you even end up paying fewer taxes when the dust from the sale settles.
The disadvantage here is that the buyer has more power to negotiate a lower sale price, because the buyer won’t easily take on risks and liabilities.
3. Employee Stock Ownership Plan (ESOP)
Selling your business to an Employee Stock Ownership Plan (ESOP) - a qualified defined contribution plan set up as a trust that allows the employees of a business to buy and own shares of stock in the business - is a very tax-efficient way to sell your business.
An ESOP has several tax-deferral opportunities for you as a seller. If the sale meets certain requirements, such as the ESOP owning at least 30% of the company’s shares after the sale of the company, and you invest the profits from the sale into a qualified replacement asset, you can defer certain taxes.
FAQs
Do you get taxed for selling a business?
Yes, you do. Selling a business has several tax implications including capital gains tax, and ordinary income tax, amongst other tax implications. You must plan ahead and seek professional advice to minimize the tax you’ll pay.
How much tax will I pay on the sale of my business?
How much tax you will pay after selling your business depends on a variety of factors like the structure of the sale, how much you sold the business for, as well as state and federal tax laws.
How do I avoid Capital Gains Tax when selling my business?
You can avoid paying Capital Gains Tax if you meet the criteria for exemption which is investing in qualified small business stocks. If you do not, there is a way you can reduce or defer payment of capital gains tax, and that is by exploring Like-Kind Exchange, where you use the proceeds you made from the sale of your business to purchase another similar business asset or stock.
Is there an exemption from capital gains taxes on the sale of a small business?
Yes, there is. QSBS is an exemption from capital gains taxes on the sale of a small business. However, your business must meet the criteria for qualified small business stock before you can benefit from this tax relief scheme. The requirements include the fact that QSBS is set up for individuals and trusts (not corporations), and being able to satisfy an investment holding period of a minimum of five years.
How are capital gains calculated when selling a business?
Capital gains tax is calculated as the difference between what you paid for your share or assets in a business, including commissions and other fees, and what you are selling it for. If you sell your business for more than you paid for it or invested in it, you have a capital gain which will be taxed. If the reverse is the case, you have a capital loss.
The bottom line: tax on selling a business
One of the most integral aspects of selling a business is the tax implications that come with it.
Reflectively, one of the most crucial steps you need to take before you sell your business is to prepare for the sale well in advance. Doing so will help you structure the sale, and lessen the inevitable tax burdens when selling a business. Preparing your business sale in advance will also give you time to research tax relief schemes, and seek professional advice from an accountant.
If you’d like more advice and guidance on selling a business in the US, you can read our selling guide to get a better understanding of the process.
You can also give yourself the best chance of selling your business by advertising your business for sale with us, so you can find local, national, and international buyers interested in your business’s sector.
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