Selling a business can be exciting and profitable. But if you aren’t careful, you can lose half or more of your profit to taxes. With deliberate planning and consideration, minimizing the taxes you owe when you sell your business is possible. We will show you what you need to do so you keep as much of your hard-earned profit as possible.
How the IRS Taxes the Sale of Your Business
To the IRS, selling a business is not treated as a single transaction. Instead, it involves all the individual aspects of a business, such as property, capital, inventory, and goodwill.
Each aspect of the sale will be taxed as either long-term capital gains or ordinary income. Assets you held for more than 12 months will be considered long-term capital gains and taxed at a federal rate of 20% for those in the highest income bracket.
Other assets will be taxed at the ordinary income rate, which can be as high as 37%. How your sale is structured and how you allocate the purchase price among the assets will determine whether you are paying the lower long-term rate or almost twice as much in ordinary income tax.
In this article, we are only discussing federal capital gains taxes, but it is important to remember that many states levy their own additional capital gains and income taxes, and you’ll need to consider that as well.
Asset Allocation
Buyers and sellers have different priorities when negotiating the allocation of assets during a sale. For example, most sellers want a larger chunk of the price to be allocated to assets to get a long-term capital gains tax rate. Buyers will want to allocate as much of the purchase price as possible to costs that they can deduct or to assets that depreciate so that they will owe less in taxes.
The IRS does specify how some aspects of the sale must be allocated, but there is flexibility. When you negotiate the sale price of your business, consider how the purchase price is allocated. You may even want to make some concessions on the sale price to get a more favorable tax liability.
The Structure of the Sale
Along with the way assets are allocated, the way you structure the sale of your business will also impact your overall tax burden. If you sell your business as a stock sale rather than an asset sale, it will save you money in taxes but will increase the tax liability for the buyer. The option of a stock sale is only available for S corporations and C corporations.
You can also choose to sell your business in installments rather than all at once to defer paying all of your taxes at one time. An installment sale comes with some risk, particularly for the buyer, so they may be hesitant to enter such an arrangement. If you use an installment sale, you’ll also have to wait to get the payout, which means that your reinvestment options will be limited. It is important to know that only capital assets can be sold in installments.
Type of Business Entity
The classification of your business will also impact the taxes you will be required to pay. If your company meets the requirements for more than one business entity, you might want to consider which entity will be more tax advantageous when selling.
- Sole proprietor: You will want to negotiate everything. Inventory sales are taxed as ordinary income, so it is to your advantage to allocate as much as you can to assets. Keep careful records of what is taxed as capital gains and what is taxed as income.
- Partnership: The business sale is considered an asset sale and will be taxed as capital gains. However, any gains or losses from unrealized inventory will be taxed as ordinary income, gains, or losses.
- Corporations: You can choose to sell the business as a stock or asset sale. As a seller, your taxes will be much lower with a stock sale, but buyers will want an asset sale where they can claim depreciation.
How to (Almost) Avoid Capital Gains Tax when Selling a Business
It isn’t possible to completely and legally avoid taxes when you sell your business, but there is an option that allows you to defer the payment of your capital gains taxes and significantly reduce the amount you owe. It has all the perks of an installment sale without the drawbacks. It’s called a Deferred Sales Trust, and a qualified deferred sales trust trustee or deferred sales trust tax attorney can help you customize one to your specific needs.
What is a Deferred Sales Trust?
A Deferred Sales Trust is a special form of installment sale. Instead of selling directly to a buyer, you sell to an independent, third-party trust that then sells your business to the buyer. The trust takes possession of your profits, and since you have not actually received any tangible proceeds, you don’t owe any taxes right away.
The trust gives you a promissory note outlining the repayment terms and invests your proceeds according to your risk tolerance and desires. You can choose to take your principal in regular installments, or you can opt to receive interest-only payments.
The Benefits of a Deferred Sales Trust
If you receive the profits from your sale in installments, you will only pay taxes on the portion you get paid each year. This spreads your tax liability out over time. If it prevents you from moving into a higher income bracket, it can also reduce your taxes overall. Because the buyer purchased the whole business in one transaction, they don’t carry any of the risk of a regular installment sale.
If you decide to invest all of your profits and take interest-only payments, you will simply owe regular income tax on the interest payments you receive each year. As long as your capital gains remain invested, you defer tax payments on your principal.
No matter how you structure your repayment schedule, using a Deferred Sales Trust gives you significantly more money to invest upfront. For example, if you sell your business tomorrow and make a profit of $2 million, even if it was all taxed at capital gains rates, you will owe a minimum of $400,000 in federal taxes. (That doesn’t even take into account state taxes, which can be as high as 13% in California.) If you want to reinvest your profits into another business, real estate, or Bitcoin, you only have the option of investing the $1.6 million left after taxes.
On the other hand, if you use a Deferred Sales Trust and still make $2 million on your business’s sale, you can reinvest the entire $2 million before paying any taxes. You can reinvest it in any combination of ways, but no matter how you invest it, you will make more by investing $2 million than $1.6 million.
How to Set Up a Deferred Sales Trust
While Deferred Sales Trusts are a completely legal and thoroughly tested tax strategy, they must be set up and executed correctly to succeed and avoid fines. If you think a Deferred Sales Trust might be suitable for your business sale, reach out to a deferred sales trust trustee who can do the hard work of structuring the sale to meet your needs and the requirements of the IRS.