How Business Structure Affects Taxes When Selling Your Business
According to BizBuySell’s Insight Report, 15.03% of small business entrepreneurs are actively selling their business and 10.12% are planning to sell their businesses in 2023.
This figure may be much higher if you include small business owners who plan to sell their enterprises within the decade.
While it’s always a great feeling to finally cash out on the value you’ve built over the years, it’s important to keep in mind some of the costs that come with selling a business.
Investing in attorney, accounting, and broker fees can pay off, as they can often help you to acquire additional funds for your businesses. Along with the cost of professional fees, don't forget to plan for state and federal taxes when you are selling a business.
And the amount of business taxes you’ll pay will vary considerably depending on your business structure.
Types of Business Structures for Small Businesses and How They Affect Taxes
Many small business owners overwhelmingly prefer sole proprietorships. For every 10 non-employer businesses, seven are sole proprietorships. But there are more kinds of business structures that go beyond sole proprietorships.
The following is a list of the types of business structures and associated tax implications you should carefully consider.
Sole Proprietorship
This is a business formed by a single individual whose liability is unlimited, and the company is not separate from the owner in the eyes of the IRS.
Therefore, a sole proprietorship's income is considered the owner's income, reported on Schedule C of Form 1040, and taxed as ordinary income.
Partnership
These are businesses formed by two or more people and personal liability is unlimited unless it is a limited liability partnership. This means individual business owners can be sued for the business's debt obligations and other commitments.
A partnership is known as a pass-through entity for tax purposes. This means business-related earnings flow through to the owners. The implication is that the owners, not the business, bear the tax burden.
Limited Liability Company (LLC)
LLCs can either be single-member, formed by one person, or multi-member, created by two or more people. Both are characterized by limited personal liability. This means owners cannot be sued for the obligations and commitments of the business.
Single-member LLCs are disregarded entities for tax purposes and taxed like sole proprietorships, and multi-member LLCs are considered partnerships.
C Corporation
C corporations are formed by two or more people whose personal liability is limited. However, business-related tax obligations for C corps remain with the business itself, not the owners or members.
A significant disadvantage of C corps is that the company is taxed on its income, and the owners are again taxed on the dividend distributions—resulting in double taxation.
S Corporation
These are businesses formed by one or up to 100 U.S. citizens. The personal liability of S corp owners is limited, and they can’t be sued for the company’s obligations. S corps are pass-through entities whose tax obligations pass through to owners.
A key advantage of S corps is that its profits are not subject to the 15.3% self-employment tax the federal government charges sole proprietors, partners, and LLC members.
Even more crucially, S corps don’t incur double taxation, unlike C corps.
Capital Gains Tax When Selling a Business
When you sell your business, capital gains tax is the most common tax you’ll likely pay.
Since this tax refers to capital gains, it’s crucial to know what capital gains are.
The IRS defines capital gains as “the difference between the adjusted basis in the asset (defined as the cost to the owner) and the amount you realized from the sale.”
It’s worth remembering that capital gains can be:
- Long-term capital gains: Taxed at 0%, 15%, or 20% of the realized gain. Long-term capital gains apply if the seller holds the asset for over a year.
- Short-term capital gains: Taxed at the ordinary marginal income tax rate. Short-term capital gains apply if the seller holds the asset for less than a year.
The capital gains you’ll earn on a sale depend on the type of business sale. This is because a business sale can either be:
- Stock sale: This is a business sale where the buyer buys the shares the seller owns in the target company.
- Asset sale: This is a business sale where the buyer purchases the assets of the target company, sometimes with the liabilities, depending on the sales agreement.
The sale must be asset-based if the business you’re selling (or buying) is a sole proprietorship, limited liability company, or partnership. This is because these three business types don’t typically issue stock.
The majority of small business sales are structured as asset sales. Hence, that’s what we’ll focus on.
In assessing the tax implication of selling a business as an asset sale, not a stock sale, one thing is always key:
Allocating the purchase price correctly.
How to Allocate the Purchase Price
Once you agree on the purchase price, the IRS requires you to allocate this amount to up to seven asset classes.
According to the IRS:
- Cash should be placed in Class 1
- Certificates of deposits and actively traded investments in Class 2
- Accounts receivable in Class 3
- Inventory in Class 4
- Property and equipment in Class 5
- Copyrights and certain intangible assets in Class 6
Should the purchase price exceed the total value of assets in these six classes, the remainder should be recognized as goodwill and placed in Class 7.
Note: The amount allocated to assets in Classes 1-6 can’t exceed the fair market value on the sale date.
Why are IRS Classes Important?
Getting assets in the right classes matters because the tax rates vary between categories.
Amounts allocated to inventory and receivables are taxed at short-term capital gains rates. This can be up to 37%.
But long-term assets, like fixed assets and goodwill, benefit from long-term capital gains tax rates that max out at 20%.
To save on taxes, the seller will prefer that goodwill takes up the bulk of the allocations.
Business Structures and Taxes
Here’s a brief overview of how your business structure will determine the amount of tax you’ll pay when selling your business.
- Sole proprietorships, partnerships, and LLCs: The amount of tax to pay will depend on the class allocations. The seller will be aiming at most allocations going to goodwill because of the lower long-term capital gains tax rate.
- S corps: Selling an S corp typically isn’t an asset sale. Instead, you’re selling your stock ownership in the corporation. This comes with complex tax rules. So consult with your tax professional before selling.
- C corps: Like an S corp, selling your stock in your C corp involves many complex tax rules. You’ll definitely want to speak with your tax advisor when you’re considering selling your C corp.
Other Tax Considerations
You should consider these other taxes when planning to sell or buy a business.
State Income Taxes
One consideration to remember during a business sale is the different tax regimes across the 50 states.
Depending on your state, you may have a hefty state tax bill when you sell your company.
Depreciation Recapture
If a business sale involves the transfer of fixed assets that have been depreciated, you may need to “recapture” that depreciation as income.
Depreciation lets you reduce your taxable income by a specified dollar amount each year. But when you sell this asset for a profit, you’ll need to repay the IRS for the previous depreciation amounts you claimed in prior years.
Estate Taxes
If you own a business and you die, your estate may attract significant tax liability in the form of estate taxes. An estate tax is payable if the estate's gross value, including business assets, exceeds $12,920,000.
FBAR and 8938 Requirements for U.S. Taxpayers Living Abroad
If you’re an expat, selling your business can require additional reporting. This includes the FBAR and Form 8938 if your foreign accounts exceed applicable thresholds.
Selling your business is a huge milestone. Negotiating a fair price for your hard work is the first step. And once you and the buyer agree, consult with your tax professional to ensure you don’t pay more taxes than you need to.