Even if you aren’t ready to sell a business, you should have an exit strategy in place so you can plan for a financial future when you are no longer part of your company. Part of creating this strategy is considering the role that taxes will play so that they don’t become a financial burden to you. While the future of your business will be out of your hands once you are gone, you can guarantee a certain tax outcome for yourself with proper planning.
Capital Gains Tax
As long as you’ve held your business for longer than a year, you’ll be taxed at the long-term capital gains rate, which is currently 15%, instead of your ordinary federal income tax rate. Otherwise, you would pay the current income tax rate, which is 37% for the top bracket. To make sure you reduce your tax bill as much as possible, you can specify which portion of the sale price applies to business assets. Sometimes buyers and sellers will negotiate the gradual sale of capital assets, especially inventory. They may use an installment sale of inventory as a capital asset, separate from the purchase price.
Stock or Asset Sale
Business sale transactions are generally structured as either the sale of your assets or stock in your business. Sellers typically want the sale of as many assets as possible to be treated as capital gains to save on taxes. This decision is not entirely up to the seller though. Buyers usually want as much of the purchase price as possible allocated to costs that can be deducted or assets that can be depreciated so their tax bill can be reduced. This potential conflict must be negotiated with the buyer within the deal terms. As a seller, you may choose to offer concessions on the price or other terms to get a more favorable allocation.
If you choose to sell your business based on its assets, you must determine a purchase price allocation (PPC). This requires a form to be submitted by both the buyer and the seller. The form requires an estimate of the “fair value” of all assets. Both parties must agree on a PPC before reporting to the IRS.
While inventory can be sold in installments, so can the business as a whole. If you agree to sell the business in installments, you can defer paying taxes until payments are received. This could also allow you to charge interest on the payments which could help offset the taxes. Some buyers may prefer to do this as well, as they can use future net profits to make payments to you. Others may be reluctant, because they may end up paying more if they don’t pay for the entire business upfront.
Installment sales do come with some risk. You should be careful about considering this route when selling to an unknown entity, especially if you are unsure about their ability to run the business profitably. For this reason, this type of sale would be a better option if you are considering selling to family members or to someone you know you can trust.
Type of Entity
The type of entity you use to operate your business will affect your implications and capital gains rates. If your business operates as a C corporation, you will pay capital gains and may also be subject to a corporate tax when it sells. Profits from a C corporation are taxed to the corporation when earned, then taxed to the shareholders when distributed, which creates a double tax. The sale of an S Corporation can be structured as a stock or asset sale, and not subject to additional corporate taxes.
The sales of sole proprietorships, partnerships and LLCs have to be treated as the sale of separate assets. The proceeds are then passed to the seller to be reported on their personal income taxes. The exceptions to this would be multi-member LLCs or LLCs that choose to be taxed as an S or C corporation. If you are considering converting your business from one entity to another, be aware that tax rules are structured to prevent you from improving your after-tax position in these cases.
Selling to Employees
You can sell your company to an employee or employees as an installment sale or by using an employee stock ownership plan (ESOP). If your company has an ESOP, your sale proceeds will still be subject to capital gains taxes. However, if you own a C corporation, you have the option of deferring your taxes by reinvesting in securities or other domestic companies. This can allow you to defer taxes for several years, or even decades.
If you own a C or S corporation with an ESOP, you have the option of selling shares back to the company over several years, allowing you to slowly exit the business. This doesn’t reduce your capital gains, but it allows you to spread the gain recognition out over a longer period of time. It can also help you to exit your business gradually, if that is the exit method you prefer.
If you want to pass your business down to heirs, you should start the process as soon as possible. In this situation, stock values and assets are valued on the day they are moved into a trust, so they are subject to lower tax rates. One example of a trust is a Grantor Retained Annuity Trust (GRAT), which you can use if your business is an S corporation. With a GRAT, you can control the assets until your death, receive annuity income from those shares during your lifetime, and transfer the remaining interest to your heirs. The GRAT is excluded from your estate and your heirs only pay taxes on future income.
If you are transferring your business to family during your lifetime, you will need to file a gift tax return. With a gift tax return, you have the option to pay a gift tax immediately, or reduce your lifetime gift and estate tax exemption, which is currently $12.06 million. Unless the value of your business exceeds this amount, you will not owe taxes on the gift. If you plan to eventually give your business to a family successor but the value of your business exceeds the exemption, you can also chose to gradually gift a portion of ownership interest every year. Currently, up to $16,000 can be gifted annually, without using up any of your lifetime gift and estate tax exemption.
If one corporation buys another, the deal can be done by exchanging stock. In the right circumstances, this can mean paying no tax at all. In this situation, the buyer exchanges stock in their company for stock in the company they are purchasing. The IRS has strict rules involving stock exchanges, such as preventing any cash from being involved in the deal.
You can also defer capital gains by investing in economically distressed communities known as a Qualified Opportunity Zones. You can defer gains for up to 5 years by putting the money in a Qualified Opportunity Fund. If the money is held for 5 years, 10% of the gains will be excluded from taxes. After 7 years, an additional 5% is excluded, and after 10 years, all of it is excluded.
Every business sale or transfer can have significant tax implications. These must be considered in every business owner’s exit plan. While there are some basic guidelines to go by, tax law is very nuanced, and the best strategy may not be obvious. You should consult with a CPA and a business broker before making any formal decisions. You would hate to miss out on potential savings when selling your business after working so hard to build it.
If you are working on your exit plan or getting ready to sell your business, Corporate Investment Business Brokers (CIBB) can help you with your tax planning. We provide long-term planning assistance for business owners looking to exit in the near future or in a few years and we only get paid if you sell your business. Contact us for a no-obligation consultation to find out more.
Looking to Sell a Business?
Complete the form below to find out what it’s worth with a FREE, no-obligation, 100% confidential business valuation estimate.