When You Sell a Business How Is It Taxed?

Selling a business is a big deal that can bring in a lot of money. But, it also means you have to think about taxes. Knowing how taxes work for business sales is key for both sides to get the most out of their deal. The tax rules depend on the sale type, how the price is split, and the tax status of the parties involved.

Business sales can be either asset sales or stock sales. Each type has its own tax rules. In an asset sale, the seller gives specific business assets to the buyer. In a stock sale, the buyer gets the seller's company shares. Sellers might want a capital gains tax, but buyers might want to get a better deal on the assets they buy.

It's important to plan taxes well to keep more money from the sale. Using special tax rules, doing tax-free reorganizations, or setting up ESOPs can help. By smartly setting up the sale and splitting the price, both sides can save on taxes and keep more of the sale's value.

Key Takeaways

• Business sales can be structured as asset sales or stock sales, each with different tax consequences
• Asset sales allow buyers to depreciate acquired assets and generate tax deductions
• Stock sales generally result in capital gains tax treatment for sellers
• Tax planning strategies such as QSBS, tax-free reorganizations, and ESOPs can help minimize tax liabilities
• Proper allocation of purchase price among assets is crucial for optimizing tax positions for both buyers and sellers

Understanding the Basics of Business Sales Taxation

Taxes are a big deal when you sell a business. Over 100,000 small and medium-sized businesses are sold each year. This adds up to more than $50 billion. Sellers face a tax range of 15% to 40% on capital gains, depending on their tax bracket.

Ordinary income tax rates usually don't apply to business sales. But, some assets like inventory and accounts receivable might be taxed at up to 37%. Goodwill and intellectual property, however, are taxed at lower capital gains rates.

Business owners can use different strategies to lower their taxes. Some ways include:

• Using a Charitable Remainder Trust (CRUT) to delay taxes on an appreciated business
• Structuring the sale as an installment sale to spread profits and lower taxes
• Investing capital gains in Opportunity Zone Funds for tax benefits
• Using the Qualified Small Business Stock (QSBS) exemption for businesses under $50 million in assets

It's key to know the difference between long-term and short-term capital gains. Long-term gains, for assets held over a year, are taxed between 0% and 20%. Short-term gains are taxed at higher rates for assets held under a year.

Some states, like California, have their own capital gains tax. But, states like Florida, Texas, and Nevada don't have a state income tax. This makes them more appealing for business sales from a tax standpoint.

Asset Sale vs. Stock Sale: Tax Implications for Sellers

When selling a business, the tax impact can change a lot. It depends on if it's an asset sale or a stock sale. For C corporations, double taxation is a big worry in asset sales. The company is taxed on the gain, and then the shareholders are taxed again when they get the money as dividends. This can lead to a total tax of about 50% of the sale profit.

But, pass-through entities like LLCs, partnerships, and S corporations don't face extra taxes in asset sales. The gains from the sale are passed to the owners and taxed only once at their personal tax rates. Yet, it's key to remember that individual tax rates in asset sales are usually higher than the capital gains rate in stock sales.

Sellers should know about potential built-in gains (BIG) taxes for S corporations that were once C corporations. If an asset sale happens within the 10-year BIG tax recognition period, corporate-level taxes might be triggered under IRS Section 1374. This is crucial for companies that have switched from a C corporation to an S corporation recently.

Asset sales are often chosen by buyers for the stepped-up cost basis and depreciation benefits. But sellers usually prefer stock sales for their lower tax rates. In a stock sale, sellers only pay the capital gains rate on their profit, which is generally lower than ordinary income tax rates. About 30% of all deals are stock sales, with bigger deals more likely to be stock sales.

The choice between an asset sale and a stock sale depends on the seller's business structure and personal situation. It's wise to talk to tax experts and legal advisors. They can help sellers understand the complex tax issues and make choices that reduce their tax bills.

Buyers' Perspective: Asset Sales and Depreciation Benefits

Buyers often choose asset sales because they can claim big tax deductions. They can spread the cost of buying assets like equipment and inventory over time. This helps reduce their taxes and improves their cash flow later on.

For example, if a buyer pays $10 million for a business, they can split it. They might put $3 million into equipment and $7 million into goodwill. This way, they can get tax breaks on the equipment right away and spread out the goodwill over 15 years.

Let's say the tax rate is 30%. The buyer could save about $900,000 in taxes on the equipment. Plus, they'd get a yearly tax benefit of $140,000 for 15 years from the goodwill.

But, asset sales might need third-party approvals, especially for contracts or licenses. This can make the deal take longer. Sometimes, a stock sale is chosen to avoid these delays, even if it doesn't offer as many tax benefits.

Buyers need to think about the tax effects and what they need to run the business when buying it. Knowing about tax breaks from asset sales helps them make smart choices. This way, they can improve their financial situation after the purchase.

Qualified Small Business Stock (QSBS) Tax Incentives

Non-corporate shareholders can get big tax breaks with Qualified Small Business Stock (QSBS). This stock comes from a small business that meets certain criteria. It must be a C corporation in the US with assets under $50 million.

The tax savings depend on when you bought the QSBS. If you bought it after Sept. 27, 2010, you can exclude up to 100% of the gain from taxes. This also means you won't have to pay Alternative Minimum Tax (AMT) or Net Investment Income (NII) tax. For stock bought between Feb. 17, 2009, and Sept. 27, 2010, you can exclude 75% of the gain, with 7% of that amount subject to AMT. Stock bought before Feb. 17, 2009, gets a 50% exclusion, with 7% of that amount subject to AMT.

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To get these tax benefits, you must hold the QSBS for at least five years. The gain eligible for the tax break is the greater of $10 million or 10 times the stock's adjusted basis sold in the year. This applies per shareholder and per corporation.

Founders and early investors can get up to a 100% exemption on federal capital gains taxes. This is up to $10 million or 10 times the original investment, if they hold QSBS. But, some things can make you not qualify for QSBS. These include being a corporation, buying stock from the secondary market, or holding it for less than five years. The company also must meet certain asset and operational criteria to qualify.

With the average deal value for US startup acquisitions in 2022 under $200 million, QSBS tax incentives are very beneficial. They help entrepreneurs and investors who qualify. By using the Section 1202 exclusion, noncorporate shareholders can reduce their taxes when selling their QSBS.

Tax-Free Business Reorganizations: Stock-for-Stock Exchanges

The Internal Revenue Code (IRC) lists several tax-free business reorganization options. One is the stock-for-stock exchange, or "B" reorganization. This lets business owners get stock in the new company without paying capital gains taxes right away. It follows IRC Section 368 rules, making it a smart choice for selling a business.

In a "B" reorganization, the target company trades its stock for the acquiring company's voting stock. This is good for both sides, especially for keeping cash. Sellers get to keep an interest in the new company and delay capital gains taxes until they sell their shares.

To get tax-free status, a "B" reorganization must meet certain conditions:

• The exchange must be solely for voting stock in the acquiring corporation
• The acquiring corporation must get control, usually by owning at least 80% of voting power and shares
• Target corporation's shareholders must only get voting stock in the acquiring corporation

Planning a "B" reorganization for tax-deferred exchange needs careful work. Business owners should team up with tax pros and lawyers. This ensures the deal is tax-free and fits their financial plans.

Using a "B" reorganization can help business owners avoid big capital gains taxes. It also lets them keep an interest in the new company. This strategy is good for sellers and buyers, helping both sides save money for future growth.

Employee Stock Ownership Plans (ESOPs) and Tax Benefits

Employee Stock Ownership Plans (ESOPs) are great for planning your business's future. They also give big tax breaks to the sellers and the company. ESOPs let owners sell their shares to a trust for the employees. This way, the company's future is in good hands.

One key benefit of ESOPs is that sellers can delay paying capital gains taxes. If they meet certain rules, they can reinvest their money in other stocks without paying taxes right away. This helps owners grow their wealth without a big tax hit.

ESOPs also help the company itself. The money put into an ESOP can be deducted from taxes. For C corporations, this can be up to 25% of what they pay their employees. Plus, they can deduct dividends paid to the ESOP, within limits.

S corporations that are fully ESOP-owned get an even better deal. They don't have to pay federal income tax. This lets them keep more money for growth and paying off loans. The tax savings can be huge, helping the company grow faster.

Employees get a big win too. They get to own part of the company and delay taxes on their shares. As the company does well, their shares grow in value. This makes employees more loyal and less likely to leave.

But ESOPs aren't for every company. Only C and S corporations can have them, and setting one up costs a lot. Still, for those looking to pass on ownership and save on taxes, an ESOP is a strong option.

Pre-Transaction Charitable Gifts of Stock: Tax Strategies

Business owners thinking about selling their company can save a lot on taxes. They can donate shares of stock to charities before the sale. This way, they get big tax breaks, avoid capital gains taxes, and help causes they believe in.

When to donate is key for the best tax savings. Stock donations should happen before the sale agreement is final. Donating too close to the sale date might not qualify for tax breaks, as seen in a Tax Court case.

To get tax deductions, donors need a qualified appraiser for the stock's value. The value is what a willing buyer would pay. Don't use valuations from other purposes for charitable donations.

Donor-advised funds (DAFs) are popular for tax savings in busy M&A times. They let donors get a quick tax deduction, avoid capital gains, and grow the donation tax-free. A case showed a stock donation could save $717,800 in taxes, more than a cash donation.

Donating S corporation shares can lead to taxes for charities. They might have to pay taxes on income before and after the sale. Giving to a private foundation can also have its own tax rules, like a 1.39% excise tax.

Business owners need to plan their charitable giving well. They should think about their business type, sale timing, and gift goals. With the help of tax pros and valuation experts, they can make the most of their stock donations and help important causes.

Navigating Price Allocation in Asset Sales

Selling a business through an asset sale involves complex negotiations. Buyers often focus on tangible assets like buildings and equipment. Sellers, however, want to value intangible assets like goodwill and intellectual property more.

These intangible assets can be taxed at lower rates. This makes them more attractive to sellers.

To split the purchase price among assets, the residual method is used. This method helps figure out the gain or loss from each asset. It also sets the buyer's basis in the assets.

The IRS Form 8594 is needed for asset sales. It reports the sale and purchase of business assets for tax purposes. It allocates the selling price to seven asset classes:

• Class I Assets – Cash and general deposit accounts
• Class II Assets – Actively traded personal property, certificates of deposit, foreign money, U.S. government securities, and publicly traded stock
• Class III Assets – Debt instruments, accounts receivable, and other assets
• Class IV Assets – Stock in trade, taxpayer's property held in inventory or for sale to customers
• Class V Assets – Furniture, fixtures, buildings, land, vehicles, and equipment
• Class VI Assets – All Code section 197 intangibles other than goodwill and going-concern value
• Class VII Assets – Goodwill and going-concern value

Valuing intangible assets is complex. It requires thorough due diligence and the help of valuation experts. Various valuation methods are used, including income, market, and cost approaches.

Industry-specific factors also play a big role in valuing intangible assets.

Accurate purchase price allocation is key for financial reporting and tax planning. It's important for making informed decisions in asset sales or acquisitions. Experienced professionals are needed for accurate valuations to avoid tax disputes and maximize gains.

A detailed closing process, including separate documents for each major asset, supports the agreed-upon asset values. This is important in case of an audit.

1031 Exchanges: Deferring Taxes on Real Property Sales

When selling a business with real property, sellers might use a 1031 exchange. This tax-deferral strategy lets sellers delay capital gains taxes. They do this by using the sale's proceeds to buy a similar property.

To qualify, sellers must follow certain timelines. They have 45 days after selling to find a new property. Then, they have 180 days to buy it.

Sellers can do 1031 exchanges as many times as they want. But, the Tax Cuts and Jobs Act changed things. Now, only real property can be exchanged. Personal property and corporate stock don't qualify.

In a delayed exchange, a qualified intermediary holds the sale's cash. They use it to buy the new property. Any leftover cash, called boot, is taxed.

Loans and debts on the old and new properties also matter. Using 1031 exchanges for vacation homes was tightened in 2004. But, you can still exchange them if you rent them out for a while.

Planning is key to a successful 1031 exchange. Comerica Bank, covering all 50 states, offers help. They assist with finding a qualified intermediary and navigating the exchange process.

Post-Transaction Charitable Gifts to Offset Income

When you sell a business, you might make a lot of money. This money is taxed at both regular and capital gains rates. You can use charitable donations in the same year to lower your taxes and help causes you support.

In 2023, you can deduct up to $262,000 for charitable gifts, up from $250,000 in 2022. The limit for charitable deductions also went up to $262,000. These numbers depend on your Adjusted Gross Income (AGI).

It's key to know the different types of charities and their deduction limits. Public charities can be deducted up to 50% of your AGI. Other charities might have lower limits.

When giving to charity, you need to follow certain rules. For example, if you give cash or more than $250, you need to report it. Donations over $5,000 might need a special form and an appraisal.

It's important to know about rules that limit deductions. For instance, some business types can't deduct certain donations. Also, starting in 2023, you can give up to $50,000 from retirement accounts to charity.

Working with tax experts is a good idea. They can help you understand charitable deductions better. They can also make sure you follow all the rules and plan your donations wisely.

Net Investment Income Tax (NIIT) Considerations

High-income taxpayers need to think about the Net Investment Income Tax (NIIT) when selling a business. This 3.8% surtax hits certain investment income, like capital gains and dividends. It also affects rental income and passive income from businesses where you don't work.

The NIIT is based on your net investment income or how much your income is over certain limits. These limits depend on your filing status.

The MAGI thresholds for the NIIT vary based on filing status:

• $250,000 for married taxpayers filing jointly and qualifying surviving spouses
• $125,000 for married taxpayers filing separately
• $200,000 for single filers and heads of household

When selling a business, capital gains from asset sales might face the NIIT. This could raise your taxes a lot. To lessen this, you might consider an installment sale or a tax-free reorganization like a stock-for-stock exchange.

Business owners should talk to tax experts like CPAs or tax attorneys. They can figure out your MAGI and NIIT liability. These pros can also plan your taxes before the sale to keep more of your money.

Installment Sales: Spreading Tax Obligations over Multiple Years

When selling a business, owners can manage their tax liability by structuring the sale as an installment sale. This strategy allows sellers to receive proceeds over multiple tax years, potentially reducing the immediate tax burden. In an installment sale, the buyer takes immediate ownership of the business, but payments are made to the seller over more than one year, often with interest accruing on deferred payments.

By spreading out the receipt of proceeds, sellers can recognize taxable gain proportionally to the principal payments received each year. For example, if a seller receives 25% of the total sale price each year for four years, they would recognize 25% of the total gain in each of those years. This approach can help avoid a substantial tax bill in a single year, particularly when the sale results in a significant gain.

However, it's essential to carefully structure the installment sale and consider the time value of money when agreeing to deferred payments. Interest charges may apply to the deferred tax liabilities, and if the installment notes have low-interest rates, the original issue discount (OID) rules can convert some principal payments into interest, which is taxable at higher ordinary income rates of up to 37%.

To report an installment sale, sellers must use Form 6252, Installment Sale Income, in the year of the sale and for each year of the installment obligation. Gains from Section 1231 property, such as real estate used in a trade or business, are generally taxed at lower long-term capital gain rates, but may be subject to additional taxes, such as the 3.8% net investment income tax and state income taxes.

It's important to note that certain types of sales are ineligible for installment sale treatment, including:

• Sales resulting in a taxable loss
• Sales of inventory or publicly traded stock
• Sales to related parties who dispose of the property within two years
• Sales with certain security arrangements

Sellers should also be aware that if they are not dealers in the type of property sold and the balance on notes receivable exceeds $5 million, they may be subject to interest charges on deferred tax liabilities. These interest charges are considered nondeductible personal interest and must be included in taxable income, potentially taxed at ordinary rates up to 37%, with the possibility of an additional 3.8% net investment income tax and state income tax.

The Importance of Comprehensive Pre-Sale Tax Planning

Before selling a business, it's key to review your finances and taxes. Tax experts, lawyers, and financial advisors can guide you through the tax maze. They help decide the best way to sell, whether it's assets or stock, each with different tax rules.

For instance, selling stock can lead to a 20% capital gains tax plus a 3.8% net investment income tax. This is different from the 37% top federal income tax rate.

Creating a solid tax plan before selling is vital. It includes finding ways to save on taxes. For example, the Qualified Small Business Stock (QSBS) rules can exempt up to 100% of your gain if you meet certain conditions.

Also, tax-free business reorganizations and Employee Stock Ownership Plans (ESOPs) can offer big tax benefits. Giving away stock to charity before selling is another strategy to save on taxes.

Getting a detailed business valuation is also crucial. It helps set a fair price and understand the tax effects of different sale methods. With the right tax planning, you can get the most from your sale and smoothly transition to the next phase.