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When a business is sold, is the money considered normal income or capital gains for the individual seller?

Just trying to understand the tax consequences for the seller. Also, if the seller decided to take an earnout, or just delay his payments over a few years, would that help save on taxes owed?

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Answers (2)
William A. Price
www.growthlaw.com
Business Lawyer
DuPage County, IL

Business sales of substantially all assets or of more than 50% of the ownership interests in a business usually qualify for capital gains tax treatment. What those gains will be will depend on the legal form of your business organization, which determines your cost basis for assets sold. In corporations, you usually get your debts repaid (which can be ordinary income) and then realize whatever you paid for your shares (your cost basis) and then pay capital gains taxes on the profits. In organizations taxed as partnerships, you may have property contributions and debts assumed as a part of that basis, in addition to the cash amounts paid for the ownership interest. Once the basis is paid off, then partner gain is realized, whether in annual profits distributions or in "deemed sale" transactions.

The reason earn-outs may help is that you can often keep income received over time in a lower tax bracket than other income. Low capital gains rates make this less significant where this type of income treatment is possible. If you continue operating a personal holding company with C corporation status, that entity may have very low tax rates on realized income, and could reinvest your proceeds without paying as much as the individual tax rate would require. Take a look at a five year projection based on various earn-out and other deal structuring alternatives (such as reinvesting some of your sale profits in the company after a private equity or other outsider purchase from you, and then taking a "second bit of the apple" gain when they reach a higher value exit event) , and you will be able to determine what best suits your financial needs and tax minimization chances.

Hope this helps,

Bill Price
wprice@growthlaw.com

Mar 26, 2013
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The BAF Group LLC
MD

We are not CPAs, but getting one to answer at the height of Tax season is going to be tough. Generally, it depends (in part) on how the deal is structured. As we understand it, Capital Gains Tax is determined from the difference between your investment basis and the price paid for your business. However, other issues can affect the structure, depending upon how you were paid. If you were paid in part as a Consultant during the transition, that would be Income. If you were paid in part for a Covenant not to Compete for a certain time, that could be termed Income. If the Seller earn-outs and payments over years may be structured to delay Tax payments, but it would not necessarily save on Taxes.

You really need to speak to a CPA that not only answers these generalized questions, but knows about the specific deal and your own, personal Tax position.

Mar 26, 2013

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