Selling a small business implies income, and income means taxes. But the way you structure your business can make a big difference in how much of the sale price goes towards taxes and how much you have left. This includes the structure of the sale, the contract in which the small business currently exists, whether the sale is in cash or payment based, and much more. If you have any questions about this complex financial situation, consider speaking with a financial advisor.
The Basics of Selling a Small Business
There are many moving parts to the tax aspect of selling a small business, and as a seller, you will have many decisions to make. However, some of these options are limited by the IRS. The buyer will negotiate other decisions; his interests may be contrary to the sellers.
There are four main tax issues to consider when selling a business:
If the proceeds of the sale are taxed as ordinary income or capital gains.
If the sale is a cash transaction or requires installment payments
Whether the sale can be considered a tax-free merger in the case of a business between two companies.
Whether the sale is for assets or shares.
Keep in mind that these questions are relevant for federal income tax. Different states have different rules and may charge higher or lower taxes than the IRS for the same business.
How commercial sales are taxed
First, for the Internal Revenue Service (IRS), the sale of a business is generally not considered the sale of a single asset. Instead, with a few exceptions, all of its assets are treated as if they were sold separately.
Then there is how the sale of the business will be taxed, such as long-term capital gains or ordinary income. The difference between the two has important tax implications.
If you sell an asset that you have held for more than 12 months, the capital gains will be handled as long-term capital gains. The maximum capital gains tax rate for most taxpayers is 15%.
Income considered to be normal income is taxed at the rate of the individual taxpayer. The top federal personal income tax rate is 37%, more than double the long-term capital gains tax rate.
Allocation of social assets
Sellers often want the sale of as many businesses as possible to be treated as a capital gain to save tax. However, the decision on asset allocation is not entirely at the discretion of the seller.
The IRS says, for example, that selling stocks produces normal income. But the sale of fixed assets that have been held for more than a year creates long-term capital gain.
Within these limits, there is some flexibility. For example, the buyer often wants most of the price to go to deductible costs or depreciated assets. This, in turn, can reduce the tax burden on the new owner.
This potential conflict between buyer and seller makes asset allocation an important part of negotiations. A seller may offer concessions on the price or the transaction terms to obtain a better premium.
How the contractual structure affects taxes
In addition to asset allocation, the structure of the business can affect tax collection. If the seller agrees to invoice the price in installments, you can defer paying taxes until payments are received.
Buyers can end up paying more if they don't have to pay upfront. And the seller can also charge interest, in addition to the tax savings. However, installment sales add more risk, as the new owner must run the business well enough to generate a profit to make payments.
Explanation of Corporate Stock Sales
Sales of sole proprietorships, partnerships, and LLCs should be treated as separate asset sales. However, when a business is sold, the business can be presented as a sale of stocks rather than a sale of assets.
This is important because if the company sells its assets, the profits will be taxed twice when the company pays taxes and once its shareholders file individual returns. Instead, a stock sale is only taxed once, saving the seller's tax.
However, the buyer usually wants to sell an asset because it presents more possibilities to deduct depreciation. This can lead to more negotiations between buyer and seller.
What is a "Tax-Free" Corporate merger?
If a company takes over another company, the transaction can be done through a share exchange. Under the right circumstances, this could mean there are no taxes.
The IRS has specific rules on a tax-free stock exchange. For example, money cannot be involved; it must be strictly an exchange of stock.
Bottom Line
How taxes are handled when selling a business depends on the type of business entity being sold. This applies whether you are a sole proprietorship, partnership, LLC, or corporation. It is also important to know what type of entity the business is buying, what assets are included, and how it is structured. All of this is governed by a complex set of IRS rules.
Selling a business has notable tax implications, and the best way to minimize taxes may not be obvious. Regardless of your business size, consider enlisting the help of professional tax, accounting, and financial advisors.
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Pat Raskob