November 1, 2023

What Happens to Your Tax Liability When Selling a Business?

Selling a business is a major financial event requiring thoughtful planning and a consideration of the tax implications. The sale structure and form of payment can significantly influence the net proceeds the seller receives. Business owners must understand the potential tax liability when assessing the value of a sale. Proper planning is key to maximizing after-tax income and aligning the transaction with long-term financial goals.

Understanding the Tax Implications

When selling a business, owners must understand the tax outcomes before finalizing the transaction. The net amount received after taxes can differ substantially from the initial sales price. Sellers should explore these tax considerations early when weighing the pros and cons of a sale.

Knowing the after-tax proceeds from the sale is especially important in the context of the seller's overall financial and retirement plans. The influx of cash may be intended to fund living expenses, pay off debts, invest in new ventures, or transition into retirement. If the tax burden consumes a significant portion of the sale amount, it can impede the seller's income and lifestyle plans post-sale. Proper planning is necessary to minimize taxes and retain more of the sale proceeds.

Capital Gains Tax

One of the biggest tax factors when selling a business is capital gains tax. This tax applies to the gain realized when a capital asset, such as a business, is sold for more than its original purchase price. The capital gain is the difference between the asset's cost basis and the final sales price.

Capital gains are classified as either short-term or long-term.

Short-term capital gains apply to assets held for one year or less before being sold. These gains are taxed as ordinary income at the seller's standard income tax rate.

Long-term capital gains apply to assets held for over a year before being sold. Long-term gains benefit from preferential tax rates compared to ordinary income.

Impact on Business Owners

Capital gains taxes can claim a significant portion of the sale proceeds. The gain from selling a successful business that has substantially grown in value can push the owner into a higher tax bracket. Proper planning is necessary to minimize capital gains tax exposure.

Strategies like tax-deferred exchanges, installment sales, and strategic timing of the sale can help sellers reduce their capital gains tax burden. Business owners may also consider reinvesting some proceeds into opportunity zones or Qualified Small Business Stock to qualify for partial tax exclusions.

Tax Implications of Selling a Business

The structure of the business sale has a significant influence on the resulting tax treatment. Owners can face different tax outcomes based on whether they sell business assets or the entire entity. Understanding these nuances is critical.

Selling the assets of a proprietorship, partnership, or S corporation triggers capital gains tax on the appreciation. In contrast, selling the stock of a C corporation is taxed at the lower capital gains rate. C corporation shareholders avoid double taxation on the sale.

Allocation of Purchase Price

For sales structured as asset sales, the purchase price must be allocated across the various assets. This process directly affects how capital gains taxes are calculated. Asset classes like inventory, equipment, real estate, and intangible assets have distinct tax treatments.

The buyer and seller generally negotiate the asset allocation to align with their respective tax incentives. For instance, the buyer may prefer allocating towards depreciable assets like equipment. In contrast, the seller may want to allocate more towards assets with lower tax rates, like real estate.

Thoughtful allocation of goodwill is also essential. Since goodwill is taxed as ordinary income, sellers may minimize this allocation to reduce their tax burden.

Ordinary Income and Its Role

Ordinary income consists of regular business earnings like salaries, commissions, and income from sales of products/services. This income is subject to higher personal income tax rates than long-term capital gains from selling a business. When a business asset sale includes accounts receivable or inventory, these ordinary income components get taxed at the seller's ordinary income rate rather than the capital gains rate.

Avoiding Double Taxes

When selling a business, the type of corporate structure can significantly influence the tax implications.

C Corporations

These entities face the challenge of double taxation. Firstly, the corporation pays tax on the gains from an asset sale. Secondly, when the corporation distributes the remaining proceeds to shareholders, these distributions are also subject to taxation, typically as capital gains. This two-tiered tax structure can reduce the net proceeds that shareholders ultimately receive.

S Corporations

Unlike C corporations, S corporations have a pass-through tax structure, which means they generally avoid corporate-level taxes. Instead, income and losses are reported on individual shareholders' tax returns. When selling the business, S corporation owners can employ strategies to optimize tax outcomes. For instance, allocating more of the purchase price to assets like equipment and real estate, and less to ordinary income components, can help reduce overall tax liability. Additionally, using covenants not to compete can allow payment for goodwill to be structured as regular income, potentially offering tax advantages.

Capital Gains Tax Rate

In 2023, short-term capital gains from business sales are taxed at ordinary federal income tax levels, starting at 10% up to 37% for the highest earners. Long-term capital gains rates on capital assets range from 0% for lower-income earners to a maximum of 20% for single filers with over $459,750 in taxable income. State capital gains taxes can further apply and should be considered when planning business sales.

These maximum rates often apply when owners pay capital gains tax after selling even a small to moderately-sized business. Proper planning to minimize state taxes and stay below federal rate thresholds is important to reduce the tax burden.

Alternative Forms of Payment

Creative deal structuring can help sellers reduce their tax rates or defer tax payments. Installment sales allow taxes to be paid on gains as payment is received over time. This spreads the seller's tax liability over the years versus immediately at the closing of a stock or asset sale.

Tax-free mergers and exchanges also warrant exploration for business sales. These allow owners to exchange their business for equity in a new entity tax-free. An employee stock ownership plan (ESOP) sale offers similar tax deferral benefits.

Preparing for the Sale

Business owners should start planning early to minimize taxes and maximize sale proceeds. Engage financial, legal, and tax advisors to assess different sale structures and outcomes. Understand federal and state tax rates, including net investment income tax considerations.

Also, evaluate the buyer's objectives. Find mutually beneficial ways to allocate the purchase price and account for goodwill. Explore creative deal terms like earn-outs and installment sales to optimize after-tax proceeds.

Selling a Cash Flow: Replacing Lost Income

A key consideration for sellers is replacing the ongoing income stream provided by the business. The lump-sum payment from the stock or asset sale will eventually be depleted. Proper investment of the net proceeds after taxes is necessary to replicate the consistent cash flow.

Business owners should develop a thoughtful financial plan for after the sale. Assess your desired lifestyle, income needs, and time horizon for the sale proceeds. Explore fixed-income investments, dividend stocks, annuities, and venture capital to replace income prudently.

Incorporate required minimum distributions from retirement accounts. Also, evaluate Social Security benefits if claiming them soon. Seeking financial advisor guidance can help you navigate this major transition.

Consulting the Right People

Selling a business is extremely complex from a tax perspective. Navigating the sale requires input from an experienced team of advisors to minimize the tax burden. At SevenBridge Financial Group, our holistic planning approach helps business owners maximize their after-tax sale proceeds and align with long-term goals.

Connect with our financial professionals to begin developing your selling strategy and timeline. We help you understand the tax implications, optimize the sale structure, minimize liability, and retain more of your hard-earned profits. Partnering with the right team is essential to make the most of this life-changing event. Learn more about our services.

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