How Understanding Tax Rules Can Maximize Profits from a Business Sale
A record number of American business owners are selling up. It pays to know what this means for your next tax return if you’re ready to close a deal.
More people than ever are looking to become their own boss in 2019, so if you’re ready to sell your business, you may find no shortage of takers. New sales records were set in 2016–2017 and these were again broken in 2018. But achieving a truly successful sale means navigating the best ways to avoid taking a hit on taxes. Here are some key things to consider before closing a deal.
The money from your business sale is subject to income tax
This is the first thing to consider in order to minimize losses to the IRS. Selling your business doesn’t mean it’s no longer a source of income because it will make you money when it changes hands.
The type of business being sold—LLC, sole proprietorship, S Corp, or partnership, etc.—affects how much tax you pay, as does selling your business as assets or as stock certificates. In any case, business owners must declare the full amount gained from the sale on their next income tax return.
Consider closing the sale through installments or deferred payments
Business owners may be reluctant to accept anything less than the entire purchase price at closing. This is understandable and removes the risk that a buyer might default on installments, but it isn’t always possible, as many deals mandate a structured, incremental buyout. It’s also not necessarily the best tax move. Accepting all sales proceeds in a single year will land you in a higher tax bracket.
Agreeing to installments over several years can lower the tax liability of your business sale since you pay much of the tax over time as you get the payments. In such a competitive buyer’s market, offering installments could also make your business more attractive to buyers who won’t have to pay everything at once.
Installments also mean you remain part of the operation until closure. This keeps the original owner around to offer advice and ensure things are being run properly, which minimizes performance risk and lowers the likelihood of the buyer defaulting on installments.
Where you live could be a tax advantage (or a liability)
Your state of residency is a benefit or a burden when selling your business because state and local income tax can be applied on top of federal taxes.
Stock sales are generally more favorable than asset sales in this scenario. If your business makes an asset sale it will typically owe taxes in the state or states where it has assets, sales, or payroll, or has gained income in the past. Stocks, on the other hand, are usually taxed in the state of residence.
This means that a business owner living in the “right” state (and choosing an all-stock sale) could avoid a significant tax bite. Of all states, only nine are exempt from income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
Business owners making an all-stock sale while living in any of those could avoid tax entirely, even if the company does business in another state. In addition, stocks are generally immune from the transfer, sales, and use taxes.
Your sale could qualify as totally tax-free
When one C or S corporation buys another, it’s possible to set the deal up as a capital gains tax-free merger. One way to do so is through a stock exchange or “corporate reorganization.”
The “buyer” and the “seller,” in this instance, can swap stocks in their respective companies until the buyer is in full possession of the other’s business. This can avoid income tax completely since a stocks-for-stocks exchange classifies as non-cash assets.
Sellers must receive a certain percent of the buyer’s stock (typically between 40 and 100 percent) for this kind of deal to go through. Two important notes here:
- Even if sellers get off tax-free on a stock exchange, they’ll still be taxed later if they choose to sell the shares.
- Federal law prohibits selling shares gained in this manner for a set period if the seller wants to hold on to that tax-free status.
For taxes filed in 2020, many taxpayers will pay 15 percent long-term capital gains tax if they’ve been holding new shares for over a year and decide to sell. The standard income tax rate will apply if they choose to sell new shares they’ve held for a shorter time.
The corporate reorganization process is complex and laid out in Section 368 (a) of the Internal Revenue Code. If your business wishes to go this route, it’s vital to speak to a qualified CPA who can guide you safely through it.
Each of the above suggestions are potential tax implications; everything has its own element of risk and there are frequently exceptions to rules. Connect with Provident CPAs to get the full picture on which sales solution will save your business the most come tax time.
Provident CPA and Business Advisors offer a wide range of services in taxes, accounting, and beyond. Our core focus is to help professionals achieve financial freedom and build a better business. Get in touch today to start strengthening your finances.