Selling a small business means income, and income means income taxes. But the way you structure the deal can make a major difference in how much of the sale price goes to taxes, and how much stays with you. Here’s what you need to know about the tax implications of selling a small business.
The tax side of selling a small business has many moving parts, and as the seller, you’ll have a lot of decisions to make. However, some of those choices are restricted by the Internal Revenue Service. Other decisions will be negotiated by the buyer, since their interests can ran counter to the seller’s.
There are four main tax-related issues to keep in mind when selling a business: whether proceeds of the sale are taxed as ordinary income or capital gains; whether the sale is an all-cash deal or requires payment installments; whether the sale is one of assets or one of stocks; and whether the sale can be treated as a tax-free merger (in the case of a deal between two corporations).
Keep in mind these issues are relevant for federal income taxes. Different states have different rules and may collect more or less taxes than the IRS on the same deal.How Business Sales Are Taxed
First, to the IRS the sale of a business usually is not considered to be the sale of a single asset. Instead, with few exceptions, all the individual assets of the business are treated as if they were being sold separately.
Then there is the matter of how a sale of business assets will be taxed — as long-term capital gains or as ordinary income. The difference between the two has major tax implications.
If you sell an asset that you’ve held for more than 12 months, the proceeds will be treated as long-term capital gains. The maximum tax rate on capital gains for most taxpayers is 15%.
Proceeds treated as ordinary income are taxed at the taxpayer’s individual rate. Currently the top individual federal income tax rate is 37%, more than twice as high as the long-term capital gains tax rate.Asset Allocation
Sellers will often want the sale of as many business assets as possible to be treated as capital gains to save on taxes. However, the asset allocation decision is not entirely up to the seller.
The IRS says, for instance, that selling inventory produces ordinary income. But selling capital assets held for more than a year creates a long-term capital gain.
Within these boundaries, there is some flexibility. For example, the buyer often wants as much of the price as possible allocated to costs that can be deducted or assets that depreciate. This, in turn, can reduce the new owner’s tax bill.
It’s this potential conflict between buyer and seller that makes allocation of assets an important part of negotiations. A seller may offer concessions on price or terms of the deal to get a more favorable allocation.Deal Structure
In addition to asset allocation, the deal’s structure can affect the tax bill. If the seller agrees to take the price in installments, for instance, they can defer paying taxes until the payments are received.
Buyers may end up paying more when they don’t have to pay everything upfront. And the seller may also be able to charge interest, in addition to saving on taxes. Installment sales do add more risk, though, because the new owner must run the business well enough to produce profits to make payments.Corporate Stock Sales
Sales of sole proprietorships, partnerships and LLCs have to be treated as sales of separate assets. When a corporation is sold, however, the deal can be presented as a stock sale rather than a sale of assets.
This is important because if the corporation sells its assets, the proceeds will be taxed twice — once when the corporation pays taxes and again when its shareholders file individual returns.
In contrast, a stock sale gets taxed once, saving on taxes for the seller.
The buyer, however, often wants an asset sale because it presents more opportunities for depreciation deductions. This is another area that can lead to more negotiations between the buyer and the seller.Tax-Free Corporate Mergers
If one corporation is buying another corporation, the deal can be done by exchanging stock. Under the right circumstances, this can mean no taxes at all.
The IRS has specific rules about tax-free stock exchanges. For example, there can’t be any cash involved — it has to be strictly an exchange of stock.The Bottom Line
The way taxes are handled during the sale of a business depend on the type of business entity being sold — namely whether it’s a sole proprietorship, partnership, LLC or corporation. It also matters what type of entity is buying the business, which assets are included and how the deal is structured. All this is governed by a complex set of IRS rules.Tips for Selling a Small Business:
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