Tax consequences are typically not the first thing you think about when you decide to sell a small business. It’s a tough decision that often involves considering your lifestyle, changing family needs, a financial consideration, or a conflict with your partners.
While the sale of a business can have strong emotional components, you should also understand that how you structure the sale can either limit your tax liability and maximize your benefits or have the opposite effect. This guide will help former small business owners avoid receiving a shock when it’s time to file income taxes.
How to Sell Your Small Business
Selling a business can sometimes feel as daunting as running it, so it’s important to know what to expect from the process. Here are a few facts:
- First, you need to decide why you’re selling and give yourself time to prepare your financial records and make changes that could attract a buyer.
- This may include resolving tax debts and making improvements to your business structure.
- As a small business, you will most likely have an asset sale instead of a stock sale, though you will want to consider the tax implications of each.
- Get a valuation of your business from an appraiser to determine fair market value and make your asking purchase price more credible.
Unless you’re selling directly to a family member or employee, you may want to use a broker so you can stay focused on the business while the right buyer is found. For tax purposes, you’ll also want to start making a plan for the income you’ll receive.
From Capital Gains to Installment Sale: Understanding Common Terms
The sale of a business comes with its own language, and it helps to understand a few of these terms before you start structuring your sale:
- Stock Sale
The buyer and seller agree upon the purchase price for the sale of stock, and the stock is exchanged for cash. Sellers often prefer this because they may enjoy a lower tax rate.
- Asset Sale
When selling business assets like inventory and the building, the sales price has to be allocated between the assets. How you do this can have a big impact on your tax year, because the IRS taxes different assets at different rates.
- Installment Sale
This allows for payment of the business over time, which can result in a lower tax rate for the seller. Ordinary gains like depreciation recapture are recognized in the same tax year as when the sale took place, however. If those gains happen to be high, you could be left with a big tax bill — even as you wait for the next installment from your buyer.
- Ordinary Income
This includes wages, bonuses, and any other typical income you receive from working at your job.
- Capital Assets
There are three types of capital assets classified by the IRS: real property (land and buildings), depreciable property (anything that loses value over time, like chairs and computers), and inventory property (products for sale).
- Capital Gains
The income you make from selling your capital assets. This is taxed at a lower rate than ordinary income. Short-term capital gains are those you make from selling items you’ve owned for less than a year, while long-term capital gains are the profits from the sale of items you’ve held for more than a year.
Knowing the lingo is step one. Understanding how it all applies to your business and how to use it to your advantage can mean the difference between a successful sale and a very expensive tax year.
Tax Implications of Selling Your Small Business
There are many factors that determine the tax rate you’ll pay on the sale of your business. Here are some of the questions to ask to help you identify yours:
- What type of business do you have?
A sole proprietorship or limited liability company (LLC) is a “disregarded entity” per the IRS, so anything you make from the sale will be reported on your personal federal income tax return. A C corporation is meanwhile subject to double taxation after a sale because it is a separate entity.
It must thus pay taxes, and you must pay capital gains tax on your personal income tax return for your personal share of the profits. In some cases, you may be able to restructure your C corp and become an S corporation. As an S corporation, you are not subject to that double taxation.
- How are you allocating assets?
There is some flexibility, but the buyer and seller have different interests when it comes to how the assets are allocated. You might have to make concessions during the sales process that are good for the buyer’s tax purposes and less so for your own, for example. A tax advisor can help you make these decisions.
- How is the sale structured?
An installment sale may allow you to spread your tax burden out over the span of the installments, but you have to trust the buyer to continue running the business at a profit to make sure you will receive each payment as agreed upon.
- Can you avoid taxes altogether?
That would be ideal, right? In the event of a corporate merger, where stocks are exchanged directly for stocks and there is no cash involved, it is possible to have a tax-free transaction. The IRS has strict rules governing such deals, though.
Organizing your business and structuring your sale appropriately can save you a lot of money when it’s time to file your income taxes. IRS rules and regulations can seem confusing and overwhelming, but an experienced tax advisor navigates them every day. Your tax team can help you get the most from your sale, prepare you for road bumps, and eliminate nasty tax rate surprises.
Get Help Understanding the Tax Consequences of Selling Your Small Business
Selling your small business is challenging enough without managing the tax considerations by yourself. Contact Silver Tax Group today to discuss your questions about the tax consequences of selling your small business, or to speak with an expert about all your tax-related questions.