Tax Considerations When Selling a Business
What Happens When You Sell a Business?
When a business owner decides to sell his or her business, there’s a lot that goes into the process.
In many cases, it starts with an evaluation of what is involved in selling a business versus operating it under new ownership.
While selling a business means income, it should be considered that there are taxes to be paid by the business owner as well as the new owners of the business.
The following are some of the things that can affect the taxes involved in the sale of a business:
- treatment of proceeds of sale: ordinary income or capital gains
- payment made is all-in or in installments
- stock sale or asset sale
- type of entity
- fair market value of business assets
- income tax rates
- state rules and regulations
How Are Business Sales Taxed?
The proceeds of a business sale are taxed as either ordinary income or capital gains, depending on how the sale is structured.
Capital gains shall be applied for business asset sales if said asset has been held for more than one year. The current capital gains tax is at 15%.
Otherwise, the proceeds from the sale of a business will be taxed as ordinary income. The maximum income tax rate is currently at 37%.
It is a common practice among sellers to treat sales as capital gains in order to pay a lower tax rate. Doing so, however, may result in an IRS audit if done improperly.
What Are Some Of The Tax Considerations When Selling A Business?
In addition to finding a qualified buyer and negotiating a purchase price for the business, there are several tax issues associated with the sale of a business:
Payment Made Is All-in or in Installments
The type of payment structure will determine whether gain should be recognized on the sale of the business. If the whole purchase price is due at closing, then it can be assumed that a lump sum was paid and all consideration would probably need to be reported as ordinary income in the year of sale.
If installment payments are made, then capital gains treatment would apply if applicable. However, there may also be alternative minimum tax implications that need to be considered depending upon how much money remains unpaid when compared to how much was initially invested in the business by the seller.
Stock Sale vs Asset Sale
A stock transaction involves transferring the shares of a company in exchange for cash, property, or other securities. An asset sale, on the other hand, is the sale of specific assets of a company in exchange for cash, debt assumption, or other assets.
Which one is better for tax purposes? It depends.
If the business has depreciable assets such as furniture, fixtures, and equipment, then an asset sale would be more advantageous because the buyer can take a depreciation deduction for those items.
If there are no depreciable assets, then a stock sale may be preferable because it would be easier to calculate the gain or loss on the sale.
The type of entity selling the business will also have an impact on taxes. The most common entity types are sole proprietorships, partnerships, LLCs, and S corporations.
The entity type will determine how the proceeds of the sale are taxed. For example, if a sole proprietorship sells its business, the proceeds are taxed as ordinary income on the owner’s individual tax return. However, if an S corporation sells its business, the proceeds are taxed as corporate income and may be subject to a double taxation situation.
Fair Market Value of Business Assets
When selling a business, it is important to determine the fair market value of all assets being transferred. This includes tangible assets such as furniture, fixtures, and equipment; intangible assets such as copyrights and trademarks; and goodwill.
If the assets have a higher fair market value than the purchase price, then the difference will be treated as a capital gain. If the assets have a lower fair market value, then the difference will be treated as a loss.
Income Tax Rates
The income tax rates for both ordinary income and capital gains can vary depending on the state in which the business is located.
State Rules and Regulations
States also have their own set of rules and regulations when it comes to the sale of businesses. It is important to consult with an attorney or CPA in order to understand how these rules may impact the sale.
The Bottom Line
When selling a business, there are many tax considerations that need to be taken into account.
Understanding what these tax considerations will help in negotiating a sale that is advantageous for both the buyer and the seller.
Consulting with a professional is the best way to ensure that all tax implications are taken into account.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.