Sale Of Business Tax

In this article, I’ll describe the impact of taxes when selling a business. Tax bills when buying or selling a business can be massive. Skillful planning and execution can significantly minimize the tax consequence. The IRS taxes treat different asset classes at different rates, hurting the buyer or seller. What you pay in taxes will depend partly on how the assets are categorized for the sale of the company. It will be taxed as ordinary income or capital gains. The rate will also depend on the tax rate of the individual.

Minimizing taxes from the sale of a business involves strategic planning and potentially utilizing various techniques and structures. However, it’s important to note that tax laws and regulations can change, and seeking advice from a tax professional or financial advisor is crucial for personalized guidance. Here are some general strategies:

1. Consult with a Tax Professional: Before selling the business, engage with tax advisors or CPAs specializing in business sales. They can guide your situation and help you navigate tax implications.

2. Utilize Qualified Small Business Stock (QSBS): Under specific conditions, selling qualified small business stock may qualify for beneficial tax treatment, potentially allowing for exclusion or reduction of the capital gains from the sale.

3. Consider Timing: The timing of the sale can impact tax liability. Depending on the business structure and your situation, selling the business in a particular tax year might be more advantageous.

4. Structuring the Deal: Structuring the sale as an asset sale or a stock sale can have different tax implications. Asset sales might provide benefits like allocating the purchase price to different assets, potentially reducing the overall tax burden.

5. Utilize Section 1202 Exclusion: This section of the tax code can exclude up to a certain percentage of the gain from selling qualified small business stock, subject to specific requirements.

6. Use a Section 1031 Exchange (Like-Kind Exchange): If you intend to reinvest the proceeds, you might consider a like-kind exchange to defer capital gains taxes. This strategy allows for the deferral of capital gains taxes by reinvesting in a similar asset within a specified time frame.

7. Employ an Installment Sale: By spreading the sale proceeds over multiple years via an installment sale, you may reduce the immediate tax impact and potentially lower the overall tax rate.

8. Maximize Deductions: Before the sale, maximize deductions related to the business to reduce the taxable income and, consequently, the tax liability.

9. Utilize Retirement Accounts: If eligible, consider rolling over some sale proceeds into tax-advantaged retirement accounts to defer immediate tax consequences.

10. Estate Planning Strategies: Considering estate planning can also be beneficial. Gifting shares before the sale or utilizing trusts can reduce the overall tax burden.

Asset Sale

It will be assumed that the sale of the business will be an asset sale.  In an asset sale, the seller retains possession of the legal entity, and the buyer purchases individual company assets, such as equipment, fixtures, leaseholds, licenses, goodwill, trade secrets, trade names, telephone numbers, and inventory. Asset sales generally do not include cash, and the seller typically retains long-term debt obligations. This is commonly referred to as a cash-free, debt-free transaction. Normalized net working capital is also typically included in a sale. Net working capital often includes accounts receivable, inventory, prepaid, accounts payable, and accrued expenses.

Allocation of Business Sales Price

The best allocation for the seller is usually the worst for the buyer, so this may be a point of negotiation. There must be agreement on what is going to be intangible assets like goodwill and tangible assets like equipment. The buyer and seller determine asset allocations for the seven asset classes defined by the IRS tax codes, include:

Class I – Cash or equivalents

Class II – Actively traded personal proper

Class III – Accounts receivable and debt instruments as defined by IRS

Class IV – Inventory

Class V – Furniture, fixtures, equipment, land, vehicles

Class VI – Non-compete clause, trademarks, intellectual property

Class VII – Goodwill

Business Buyer Position

The IRS allows buyers to “step up” the company’s depreciable basis in its assets by allocating a higher value for assets that depreciate quickly (like equipment, which typically has a 3-7 year life) and by allocating lower values on assets that amortize slowly (like goodwill, which has a 15-year life). This reduces taxes sooner and improves the company’s cash flow during the vital first years. Additionally, buyers prefer asset sales because they more easily avoid inheriting potential liabilities, especially contingent liabilities, such as product liability, contract disputes, product warranty issues, or employee lawsuits.

Business Seller Position

For sellers, asset sales generate higher taxes because while intangible assets, such as goodwill, are taxed at capital gains rates, other “hard” assets can be subject to higher ordinary income tax rates. Federal capital gains rates are currently 20% at the time of this writing for earnings above $445,851. Ordinary income tax rates depend on the seller’s tax bracket.

A Sample Allocation

Assume a total sale price of $1,000,000. Here’s a potential allocation:

• Goodwill: $600,000 (60%) – Maximizes capital gains treatment.
• Equipment and FF&E: $200,000 (20%) – Reflects fair market value, considering depreciation recapture.
• Non-Compete Agreement: $50,000 (5%) – Minimizes ordinary income tax.
• Inventory: $50,000 (5%) – Minimizes ordinary income tax.
• Real Property: $100,000 (10%) – Reflects fair market value, balancing capital gains and recapture rules.

Best Allocation

60% of the allocation above would be taxed on ordinary income. 40% would be taxed at the capital gains rate.be at would only subject 10% of the sales price to ordinary income. 90% would be taxed at the lower capital gains rate. The seller should allocate the purchase price to goodwill and intellectual property as much as possible. The buyer would like the equipment allocated at the highest possible to benefit from depreciation tax benefits. The best allocation depends on whether you are buying or selling a business.

Understanding The Sale of Business Tax

Understanding the sale of business tax is different for the buyer and seller. Understanding the tax liabilities is essential before agreeing to a deal’s structure.  The applicable tax laws change all the time when selling a business. It’s essential to use knowledgeable professionals familiar with the type of transition that will likely occur with the sale of your business.  Click here to schedule a free call with us if you have any questions about tax bills when selling a business. Always consult your tax advisor familiar with your financial situation before making any decisions.