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Tax Implications of Selling Your Business

Selling a business is a significant milestone for any entrepreneur. After dedicating so much time and effort to build a successful enterprise, it can be exciting to finally reap the financial rewards. That being said, it’s crucial to consider the tax implications that come with the sale of your business.

In this article, we’ll outline the tax implications of selling your small business. By better understanding the tax rates that apply, it’s possible to minimize your overall tax liability and maximize the tax benefits that come with selling a business.

Additionally, we’ll explain the importance of working with a tax professional to ensure compliance with tax laws and regulations.

Business Sale Taxation

When selling a business, the seller may be subject to taxes on the profit or gain realized from the sale. There are several taxes to consider, namely capital gains and ordinary income tax. The tax liability for selling a company depends on the type of business entity, the portion of the purchase price allocated to various assets, the fair market value of the assets, and the tax basis of the assets.

Additionally, it’s essential to understand the tax implications for C corporations, sole proprietorships, and LLCs. Each type of business structure has its own set of rules and regulations regarding taxation, so it is important to understand them before selling your business.

Capital Gains Tax

One of the most significant tax considerations in selling a business is the capital gains tax. Capital gains are profits from selling capital assets, such as stocks, real estate, and business assets.

In simpler terms, when you sell your business, the capital gain is the difference between the sale price and the original cost of the assets (this is referred to as the tax basis). The capital gains tax rate you’ll pay depends on how long you’ve owned the assets before selling. Generally, the tax rate is lower for long-term capital gains (assets you’ve held longer than a year) compared to short-term capital gains.

For example, if you sell your business for $1 million and the tax basis of the assets sold is $400,000, the capital gain is $600,000. The long-term capital gains tax rate applies if the assets were held for more than one year.

For 2023-2024, the long-term capital gains tax rate is either 0%, 15%, or 20%, depending on the seller's income tax bracket. Business owners should consult a tax professional to determine their tax liability. Similar to how individual taxpayers are required to categorize their capital gains as short-term or long-term gains, corporations that have realized capital gains must also follow the same procedure.

Ordinary Income Tax Rates

In addition to capital gains tax, business owners may be subject to ordinary income tax rates. Ordinary income is the money earned from the sale of services or goods, such as salaries, wages, and business income. When a business is sold, a portion of the purchase price is allocated to intangible assets, such as patents, which can have a significant impact on the value of the business. If you've owned the business for less than a year, the goodwill could be taxed as ordinary income.

For instance, if you sell your business for $1 million and $200,000 is allocated to intangible assets, the portion of the sale price subject to ordinary income tax is $200,000. The federal tax rate for ordinary income varies depending on the seller's tax bracket, which ranges from 10% to 37% in 2024.

Tax-Free Sale of a Business

In some cases, the sale of a business can be tax-free, such as in the case of a like-kind exchange under Section 1031 of the Internal Revenue Code. A like-kind exchange allows the seller to defer paying taxes on the gain from the sale of a business if they use the proceeds to purchase a similar asset within a certain period.

However, for a business sale to qualify as a like-kind exchange, the assets must be of the same nature, character, or class. In other words, the seller must exchange one investment property for another, not sell a business and purchase a personal residence.

Some examples of a like-kind exchange include:

Exchanging an office building for a retail property. In this scenario, both properties are investment real estate so the transaction would qualify as a like-kind exchange.
Trading a restaurant for a hotel—both businesses can be considered to be a part of the hospitality industry and are of a similar nature

Ways to Minimize Tax Liability

While it is difficult to avoid paying taxes entirely, there are ways to minimize the tax liability of selling a business. One method is to structure the sale as an installment sale, where the purchase price is paid over a period instead of a lump sum. By accepting deferred payments through a seller-financed loan, the seller can spread the tax liability and potentially pay a lower tax rate. However, consulting with a tax professional is essential to ensure that the installment sale complies with tax laws.

Another way to minimize the tax liability of selling a business is through purchase price allocation. The purchase price should be allocated to the business's assets to reduce the tax liability.

The reason purchase price allocation works to minimize taxes is that it allows the allocation of purchase price to specific assets, each of which may be subject to lower tax rates. For example, goodwill is treated at capital gains tax rates for the seller and has the ability to be amortized by the buyer.

In this process, both parties play crucial roles. The seller should collaborate with a tax professional to determine the fair market value (FMV) of each asset and allocate accordingly. The buyer should agree with these allocations, as they have an impact on depreciation and tax deductions.

Working with a Tax Professional

Selling a business involves various tax implications that can be complex and confusing. Business owners should work with a tax professional, such as a Certified Public Accountant (CPA), to ensure compliance with tax laws and regulations. A tax professional can help the seller navigate the various tax treatments of selling a business, including the capital gains tax, ordinary income tax, and the tax implications of a stock sale versus an asset sale.

A CPA can also assist the seller in calculating the tax basis of the assets sold, determining the portion of the purchase price allocated to each asset, and advising on ways to minimize the tax liability. Additionally, a tax professional can help the seller understand the tax benefits of selling a business, such as tax deductions, investment income, and the potential for a lower tax bracket.

Conclusion

Selling a small business is a significant event for entrepreneurs, but it is crucial to consider the tax implications of the sale. The tax liability for selling a company depends on various factors, including the type of business entity, the portion of the purchase price allocated to multiple assets, and the fair market value of the assets.

It is also critical to understand the tax treatments of selling a business, including the capital gains tax, ordinary income tax, and the tax implications of a stock sale versus an asset sale. By working with a tax professional, business owners can navigate the complexities of selling a business and enjoy the financial rewards of their hard work without being burdened by a hefty tax bill.