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Tax Implications of Selling a Small Business

Tax Implications of Selling a Small Business

Selling a small business or company means income, and income denotes taxes. But how you structure your business can make a big difference in how much of the money gotten from the sale goes to taxes and how much you own. This includes the arrangement the small business currently exists in, the structure of the sale, whether the sale is cash or on a cash basis, and more. If you have questions (which you are expected to have) about this complex financial condition, consider speaking with a financial expert.


The Fundamentals of Selling a Small Business

The tax facet of selling a small business has many moving parts, and as a seller, you will have many decisions to make. However, some of these options are restricted by the Internal Revenue Service. The buyer will negotiate other decisions, as their interests may be against the seller.

There are four major tax issues to consider when selling a business:

  • If the sale can be assimilated into a tax-free merger in the event of an agreement between both parties.

  • If the sale involves assets or shares

  • If the sale is made in cash or requires installment payment

  • If the sale proceeds are taxed as ordinary income or capital gains

Please note that these topics are relevant to federal income tax. Different states have different laws and regulations and may charge lower or higher taxes than the IRS for the same business.


How business sales are taxed

First, for the IRS, the sale of a business is generally not considered the sale of a single asset. Instead, with few exceptions, all of the company's individual assets are treated as if sold separately.

Then there is the question of how the sale of corporate assets will be taxed: as long-term capital gains or as ordinary income. The difference between the two has significant tax implications.

If you sell a property that you have held for more than 12 months, the proceeds will be treated as a long-term capital gain. The highest share of capital gains tax for most taxpayers is 15%.

Income treated as ordinary income is taxed at the taxpayer's individual rate. Currently, the federal personal income tax rate is 37%, more than double the long-term capital gains tax rate.


Business asset allocation

Sellers usually want the sale of as many business assets as possible to be treated as a capital gain to save taxes. However, the decision to allocate the assets is not entirely up to the seller.

The IRS claims, for example, that the sale of inventory generates revenue. But the sale of capital held for more than a year creates long-term capital gain.

Within these limits, there is some flexibility. For instance, the buyer often wants as much value as possible to be allocated to deductible costs or asset depreciation. This can reduce the new owner's tax bill.

This likely conflict between seller and buyer makes asset allocation such an important part of selling a business. A seller may offer some adjustments on the price or terms of the transaction to obtain a more favorable allocation.


How Deal Structure Affects Taxes

In addition to the asset allocation, the structure of the contract can affect the tax bill. If the seller agrees to split the price, for example, they may defer payment of taxes until payment is received.

Buyers, on the other hand, may end up paying more when they don't have to pay upfront. And the seller can charge interest and save tax. Installment sales, however, add more risk because the new owner must run the business well enough to make a profit to make the payments.


Corporate stock sales

Sole proprietorship, partnership, and limited liability company sales should be treated as separate commercial sales. But, when a business is sold, the business may be presented as a stock sale rather than an asset sale.

This is vital because if the company sells its assets, the income will be taxed twice when the company pays taxes and when its shareholders file individual returns. In contrast, a sale of shares is taxed only once, saving the seller taxes.

However, the buyer often wishes to sell an asset because it presents greater opportunities to deduct depreciation. This is another area that can lead to multiple negotiations between buyer and seller.


What is a "No Tax" Corporate Merger?

If a company buys another company, the transaction can be concluded by an exchange of shares. Under the right circumstances, that could mean no tax or tax-free.

The IRS has specific rules for tax-free stock exchanges. For example, no money can be involved; it must be strictly on an exchange of stocks.


Final results

When selling a business, how taxes are handled depends on the type of business being sold. This applies whether you are an LLC, partnership, sole proprietorship, or corporation. It also matters what type of entity is buying the asset, what assets are included, and how they are structured. All of this is controlled by a complicated set of IRS rules.

Finding a financial advisor to help you manage the tax implications of selling your business doesn't have to be difficult. 

Selling a business has significant tax implications, and the best way to minimize taxes may not be obvious. Irrespective of the size of your business, consider hiring professional tax, accounting, and financial advisors.


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