This part II of our III-part series in profitable business exits. Part II focuses on addressing taxes upon selling your business. Read Part I by clicking here.
“How can I address taxes after selling my business?
The disposition of your business is a balancing act between what your buyer wants and what you want.
Selling a business means selling a collection of tangible and intangible assets. Part of the negotiation process is agreeing on the same ‘allocation’ method, per IRS guidelines. The trouble is, from a tax perspective, what’s good for the seller is usually bad for the buyer, and vice versa. The buyer wants the highest allocation to intangible assets that can be amortized or assets that can be depreciated quickly, like machinery, equipment, computers, appliances, and furniture generally qualify
As the seller, you want to allocate as much towards capital assets as possible1 to make sure you’re taxed at capital gains rates rather than ordinary income.
The legal structure of your business also plays a role. Whether your business is structured as a sole proprietorship, partnership, limited liability company, or corporation, there are many ways to structure your business sale. There are trade-offs to consider based on how the sale is structured. It is recommended you involve a tax professional before selling your business.
Capital Assets Focus
As the seller, you want to allocate as much as possible to capital assets. That way, you’re more likely to be taxed at capital gains rates rather than ordinary income.
Here are three general guidelines regarding capital assets:
- A capital asset is an asset with a useful life longer than a year that is not intended for sale in the regular course of the business’s operation.
- They are recorded as an asset on the balance sheet and expensed over the asset’s useful life through depreciation.
- Expensing the asset over the course of its useful life helps to match the asset’s cost with the revenue it generated over the same period.
As with most tax laws and regulations from the IRS, there are exceptions. Here are some of the common rules that must be followed:
Generally, the IRS requires that each tangible asset be valued at its fair market value (FMV) in a specific order. The total FMV of all assets in a class are then added up and subtracted from the total purchase price. Repeat for each class of asset.
Intangible assets such as goodwill get the “residual value,” if there is any. Remember that FMV is in the mind of the appraiser. You still have some wiggle room in allocating your price among the various assets, provided that your allocation is reasonable and the buyer agrees to it.
Three common ways to potentially minimize taxes2
As the name implies, the business transitions to the buyer incrementally. You provide them with seller financing where they agree to make monthly payments to you in exchange for them taking ownership of your business. The IRS allows you to spread out your tax burden over the course of the installment contract. That is why those assets qualify for installment payments when you go to sell them. On the one hand, your business will be more attractive to potential buyers if seller financing is available. On the other, it can be risky to offer seller financing to a buyer. Installment sales don’t necessarily minimize taxes. An installment sale spreads the payment over several years, meaning you owe taxes on the amount you receive each year rather than the entire amount.
Sale to employees (ESOP)
Suppose your business is a C corporation and you have a longer exit time horizon. In that case, an ESOP may make sense because you already have a buyer – your employees. Selling to your employees can save you a lot of time, headache, and costs. Set a reasonable price for the sale and receive cash from the ESOP. You can then roll over the proceeds into a diversified portfolio to defer tax on the gain.
Invest in Opportunity Zones
Owners who realize capital gains on the sale of their business can defer tax on that gain if they act within 180 days of the sale by investing in a Qualified Opportunity Zone Fund (QOZ). By investing in an opportunity zone fund, you may be able to defer the taxes due on your initial gain. You can exclude up to 15% of the original gain from taxation. You may pay no tax on the growth in your investment value for your entire holding period, assuming a minimum of a 10-year hold.
Taxes will always play a role in the sale or purchase of an asset. Fortunately, there are ways to structure your tax liability to be as advantageous as possible (within the legal requirements, of course).
Did you know your business may qualify for the Employee Retention Tax Credit (ERC)? Don’t miss the deadline to file, check out our article today to learn more.
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