You’ve worked hard, built your business, and now it’s time to hand the reins to someone else. As you’re working through the details of finding a buyer, negotiating a purchase price, and agreeing on the terms, you may wonder: How much of this am I going to owe to Uncle Sam?
Can you minimize or defer some of the taxes that you pay? Possibly. It’s best to work with a qualified CPA or tax advisor as the rules for selling a business are complicated. But there are some things you can learn on your own to help get the best start on a financially successful sale.
What Are Capital Gains?
Sell an asset? The IRS wants a cut.
Capital gains occur when you sell an asset for more than its tax basis (often the purchase price). Examples of an asset include share of a stock, land, and of course, a business.
For example, if you purchase stock for $5,000 and sell it three years later for $8,000, the $3,000 increase is called a capital gain—and it gets taxed.
How Are Capital Gains Taxed?
Here’s the good news: Long-term capital gains are usually taxed at a lower rate than ordinary income. That is, the tax rate on the gain on the sale of an asset will often be less than the tax rate on income from your salary. Most taxpayers won’t have to pay more than 15% tax on their capital gains.
Per the IRS, if you’re in the 10% to 12% ordinary income tax bracket, your net capital gain tax rate is likely 0%, meaning you don’t pay any taxes on your capital gains. If you’re in the 37% ordinary income tax bracket, you’ll likely end up with a 20% net capital gain tax rate. In between those two tax brackets, you’ll be looking at a net capital gain tax rate of 15%.
It’s easy to see why paying capital gains tax leaves you with a lower tax bill than paying the tax rate on ordinary income. Paying primarily capital gains taxes rather than ordinary income taxes is how Warren Buffett famously has a lower tax rate than his secretary.
The key here is long-term capital gains are taxed at this tax rate. Assets that you’ve held for over 12 months qualify for the long-term rate. Any capital gains for assets that you’ve owned for less than 12 months will be taxed at the same rate as your ordinary income.
When Do You Pay Capital Gains Tax?
You’ll pay capital gains tax when capital assets from your business are sold. In the eyes of the IRS, your business usually isn’t just one big asset. It’s a collection of smaller assets that are each sold separately. (If you’re selling your share in a partnership or you’re selling a corporation, things are treated a little differently, as discussed below.)
Here’s where taxes on your business get even more complicated. Not all of the assets in your business are going to be taxed at the capital gains rate. Some of your assets may be taxed at the ordinary income tax rate, which is a higher tax rate for many people. For example, selling inventory and accounts receivable are taxed at the ordinary income tax rate.
The IRS has guidelines as to how you value each asset, though with most things there are some areas of the pricing allocation that would benefit from professional advice.
Allocation of the Purchase Price
How you allocate the purchase price among your business assets will have a direct impact on how much you pay in taxes. The allocation will determine your gain or loss on each asset and will also determine the buyer’s basis in each asset.
The IRS lays out some guidelines as to how you should allocate the purchase price.
Assets should be valued at their fair market value in the following order:
- Class 1: Cash and deposits (including checking and savings account deposits)
- Class 2: Actively traded personal property, including certificates of deposits, foreign currency, U.S. securities, and publicly traded stock
- Class 3: Accounts receivable and anything else that you mark-to-market at least annually
- Class 4: Inventory or other property held for sale to customers in the ordinary course of business
- Class 5: All other assets not included in another class. This usually includes furniture, building, land, vehicles, and equipment
- Class 6: Section 197 intangible assets, except goodwill and going concern. Licenses and trademarks are usually included here
- Class 7: Goodwill and going concern value
Different Treatment for Corporations and Partnerships
Things are treated a little differently if you’re selling your share of a partnership or your business is structured as a corporation.
Selling Your Share in a Partnership
If you’re selling your share in a partnership, you won’t need to allocate the sales price among the partnership assets. Your entire portion of the partnership is treated as one capital asset and you’ll pay capital gains tax on the amount of money you receive, above the adjusted bases (cost) of the partnership.
As a simple example, if your adjusted basis in a partnership is $15,000 and you sell your share of the partnership for $25,000, you’ll have a capital gain of $10,000. Assuming you’ve been in the partnership for longer than 12 months, you’ll be taxed using the long-term capital gains tax rate.
Selling a Corporation
When your small business is a corporation, you own stock in your company. The IRS gives you a choice when you sell the corporation: Treat it as a stock sale or sell the individual assets. Many sellers prefer to treat it as a stock sale because if you’ve owned the corporation for more than a year you’ll record the profits from the sale as a capital gain and pay the long-term capital gains tax rate.
Can You Avoid Capital Gains Tax or Reduce the Amount You Pay?
Reducing your tax bill when selling your company is a job for professionals. Bringing in expert help before you sell your business can save you a lot of money and help you make the most strategic decisions. You’ll also want to consult a CPA or tax advisor who specializes in your state tax rules. Those can be very different from the federal tax you’ll have to pay.
Some strategies you might discuss with your advisor include:
If the gain of selling your business will push you into a higher tax bracket, an installment sale could help lower the capital gains tax that you pay. With an installment sale, you receive at least one payment after the year the business is sold—the buyer has agreed to pay you in multiple annual payments, rather than at one time.
Say you sell your business as an installment sale and split the sales price into three annual payments. You’ll pay tax each year that you receive payment, spreading out your tax bill.
Not all assets in your business are eligible for the installment sales method. For example, inventory can’t be sold as an installment sale. Consult the IRS guidelines—and discuss with a tax professional—if you’re considering this strategy.
Allocation of Purchase Price
As mentioned, the capital gains tax rate is often much lower than the tax rate on ordinary income. And unless your business is a corporation or you’re selling your interest in a partnership, the IRS has you assign a value to each asset. The method of allocating the purchase price among assets is called the residual method.
How you allocate the purchase price can have an impact on how much you pay in taxes.
If your purchase price mostly includes items that are taxed at the long-term capital gains tax rate, you’ll pay less in taxes than if the purchase price includes mostly items that are taxed at the ordinary tax rate.
While some of the residual method is straightforward, there is some gray area and room for negotiation with the buyer. There may be some items where it’s in your best interest to try and categorize them as a capital gain, but that might not be what’s best for the buyer. Both you and the buyer need to use the residual method—it determines the buyer’s basis in the business and for the seller it determines how much of the purchase price is allocated to goodwill or other intangible assets.
It’s a smart idea to consult a professional and work through the purchase price allocation before finalizing the sale.
Qualify for the Long-Term Capital Gains Rate
If you’ve been in business for less than a year, you may consider waiting to sell. Remember, the long-term capital gains tax rate only applies to assets that you’ve owned for longer than one year. If you’ve owned your business for less than one year before you sell it, your profit from the sale will be taxed at your ordinary-income tax rate.
Waiting until the one year mark could lower your tax bill helping you to save more of the money that you’ve worked so hard to earn.
The Bottom Line
When you’re selling your business, understanding the tax impact of your decisions should be done before the sale is finalized. Working with a professional can help you navigate some of the complex scenarios and find a strategy that can help to reduce the amount you owe in taxes.