Selling a business is a huge life achievement and a major financial event. How you structure your sale and plan for taxes can save you thousands or even millions of dollars. In this blog, we will review some common mistakes business owners make when selling their company and some key capital gains tax planning strategies to maximize your returns and future investments.
Selling a business can be complex, but it doesn’t have to be intimidating. With the right strategy and the assistance of a capital gains tax consultant, you can navigate your business sale and set yourself up for a solid and profitable financial future.
Understanding the Tax Implications of Selling a Business
The taxes business owners face when selling are similar but somewhat more complex than regular asset sales. That is because the type of business and how you structure your sale will determine how you are taxed. Sellers and buyers want a sale structure that gives them the greatest tax advantages; this means you’ll need to negotiate carefully.
Types of Taxes Business Owners Face
When you sell your business, you’ll pay both capital gains tax on the assets and stock and ordinary income tax on certain sale proceeds. Capital gains tax rates are lower than income tax rates, so you will want to allocate as much as possible to assets taxed as capital gains.
Capital gains have different tax rates depending on whether they are considered long-term or short-term gains. A short-term capital gain is any profit made on an asset you’ve held for 12 months or less. Short-term capital gains are taxed at the normal income tax rate. Long-term capital gains are the proceeds earned on assets you’ve had for over a year. Long-term capital gains are taxed at 0%,15%, or 20%, depending on your income bracket.
Therefore, it is in your best interest to wait to sell your business until it is at least a year old so that you can benefit from the significantly lower long-term capital gains tax rate.
How Different Business Structures Impact Taxes
The way your business is structured will determine how it is taxed. Here’s a breakdown of the different business structures and the tax implications:
- C-Corporation—can be sold as stock or assets. If you sell assets, you’ll face double taxation: First, the corporation pays taxes on the gains from assets, and then shareholders will pay tax again once dividends from the asset sale are distributed. If it is a stock sale, you’ll only pay capital gains taxes once on the gains from the sale. If you have held the stock in the company for longer than five years, you might be eligible for the QSBS (qualified small business stock) that would exempt you from some or all capital gains taxes. We will go into the QSBS in more detail later.
- S-Corporation—can also be structured as an asset or stock sale. However, in an S-corporation asset sale, the gains pass through to the shareholders, and there is no entity-level tax. Shareholders pay income or capital gains tax depending on the type of asset sold. Inventory and accounts are taxed as income tax, while the IRS taxes goodwill, and investments as capital gains. You can also structure an S corporations sale as a stock sale, but they are not eligible for the QSBS exemption.
- LLC/Partnerships—an asset sale. Buyers prefer an LLC structure because they can take a step-up in basis on the assets. Sellers have to allocate the purchase price among all assets. The IRS taxes some assets at income tax rates (hot assets like inventory and accounts receivable) and some assets as capital gains (property, goodwill, and land, for example). An LLC provides the seller with flexibility, but it can be complicated.
Capital Gains Tax Reduction Strategies
No matter what the structure of the sale, every entrepreneur and owner wants to know how to avoid capital gains tax when selling a business. While it is impossible to legally avoid taxes entirely, several strategies allow you to defer and reduce your capital gains tax, saving you money and maximizing your future returns.
Opportunity Zones
Opportunity zones are designated low-income areas across the US created by the 2017 Tax Cuts and Jobs Act. Qualified Opportunity Funds (QOF) reinvest in these developing areas. When you reinvest your capital gains into a QOF, you can save big on capital gains taxes by deferring, reducing, or even eliminating them entirely.
When you sell your business, you have 180 days to reinvest the capital gains into a QOF and defer capital gain taxes until the end of 2026. If you hold your QOF investment for ten or more years, any additional capital gains will be excluded from capital gain tax.
For example, if you sell a business for $2 million and invest the proceeds into a qualified opportunity fund within 180 days, you won’t have to pay capital gains taxes on the $2 million until December 2026. If you keep the $2 million in the fund for 10 years, which grows to $5 million, you can cash out of the investment without paying any capital gain tax on your $3 million appreciation.
This can be a great strategy if you are prepared to invest long-term and don’t need cash flow or flexibility.
Installment Sales
In an installment sale, instead of receiving a lump sum payment, the buyer will pay you in regular intervals over a predetermined period, usually several years. This benefits you as a seller because you only owe capital gains tax on the portion of the sale you receive each year. By spreading your payments out over time, you defer taxes and may even pay a lower tax rate if the delayed payments keep you in a lower income bracket.
Each payment you receive is broken into three parts for tax purposes.
- Return of basis (you don’t pay taxes on this)
- Capital gains (these are taxed at the 0%, 15%, or 20% rate depending on income)
- Interest (interest is taxed as income)
Installment sales are flexible and can be structured to meet your cash flow and planning needs. However, there are drawbacks. The most significant concern is that there is a risk that the buyer will default on payments, forcing you to sue them and attempt to repossess the business.
Deferred Sales Trust (DST)
A Deferred Sales Trust (DST) takes advantage of the same section of the IRS code that allows for installment sales, but without the risk of default and with more varied and flexible investment options.
When using a DST, you sell to an independent, third-party trust instead of selling your business directly to a buyer. A deferred sales trust trustee manages the trust and works with you to determine your financial and investment goals, cash needs, and risk tolerance. The trust sells your business to the buyer and takes possession of the proceeds. At this point, you have not received any capital gains from your business sale because they are held and controlled by the trust, so you do not owe capital gain taxes.
The trust then reinvests your proceeds on your behalf. Instead of investing roughly 80% of your remaining profits after taxes, you can reinvest 100% of your gains, maximizing your future returns. The trust will pay you back in regular installments according to a schedule that meets your needs. You only owe capital gains taxes on the portion you receive each year. If you decide to take interest-only payments, you simply owe income tax on the interest payments you receive each year, while your capital gains remain fully deferred.
Unlike a regular installment sale, you do not take on the risk of the buyer defaulting. Additionally, you can reinvest in a wide variety of assets or diversify for additional financial security. The DST is effective and flexible; you can structure it to give yourself as much or as little cash flow as you need, and the trustee can alter the payment schedule and investments as your risk tolerance changes.
Common Tax Pitfalls to Avoid When Selling a Business
Now that you have a basic understanding of the tax implications when selling a business and some strategies for deferring or reducing those taxes, here are some common mistakes that business owners make when selling a business.
Failing to Plan for Taxes in Advance
Structuring a business sale takes time and serious consideration. Waiting to consider the tax implications of a sale can cause you to spend significantly more on taxes and miss out on investment opportunities. Working with a tax professional early in the sale process is crucial, especially if you want to take advantage of a tax strategy like the deferred sales trust.
Overlooking State and Local Taxes
Don’t forget about state and local taxes when planning your business sale. The federal government isn’t the only one who wants a piece of your profits. Some states, like California, levy up to 13% in additional capital gains tax. State income taxes vary from state to state as well. The taxes levied by your state might factor in how you structure your sale and allocate assets between those taxed at income tax rates and those taxed as capital gains.
Not everyone has the ability, but if you are selling a highly appreciated business in a state with high capital gains taxes and you have the option to relocate, you might save a lot of money. Just be aware that residency requirements are stringent and differ by state. As a rule, you must relocate to a tax-friendly state at least 183 days before your sale.
You’ll need to establish a bona fide residence, which usually means getting a new driver’s license, buying or renting a home, and updating your address, doctor, and community ties. You’ll also need to sever connections with your previous state. Some states are aggressive about auditing these kinds of moves and will come after you for your taxes if they think you are gaming the system.
Ignoring IRS Compliance and Reporting Requirements
The IRS is particularly watchful regarding business sales, so you need to be careful about documenting your sale and reporting the transactions.
You’ll be punished with significant fines and penalties if you don’t report your sale or underreport your earnings. Accuracy-related penalties can be up to 20% of the underpayment, while fraud penalties can be 75%.
Because the audit risk is so high when selling a business and because the IRS looks closely at allocation, alignment between the reporting of the buyer and seller, and depreciation recapture, we recommend working with a qualified tax professional. It is worth the investment in the taxes you’ll save and the penalties you’ll avoid.
Conclusion
Selling your business might be the largest financial transaction you make. It’s worth the investment to do it right. Work with a professional early in the process to avoid pitfalls, plan for your future needs, maximize your profits, and minimize your tax burden.