Tax Implications of Selling a Business

Selling your business may be the biggest decision you will ever make. The question then always is, how much money will you actually be left with after taxes? This is not an easy question to answer. Much depends on the type of business, what entity structure you have, and the type of assets your business owns. As this is a complex subject we will just get into the basics, what you need to know to make educated choices will depend on your individual situation.

So I sold my business... what will I owe the IRS?

If you owned your business as a sole proprietor...

As a sole proprietor you have been taxed every year on Schedule C as part of your personal return, and the sale will also be part of your personal return. In this situation each asset of the business must be determined separate and a portion of the overall sales price allocated to it with gain or loss determined on an item by item basis known as the residual method. Capital assets used in the business fall under capital gain or loss rules, whereas sale of inventory will create an ordinary gain or loss.

If your business was operating as a partnership...

Partnerships can be a bit messy to dissolve as passive losses reduce partnership basis, often to negative values. This can create a gain on sale, sometimes even a substantial ordinary gain. In general though, gain or loss on a partnership interest is treated as a capital gain when sold, and gain or loss on inventory is treated as an ordinary gain or loss and must be calculated separately. Although if any one partner owns 50% or more of a partnership interest, all gains on the sale of the partnership are treated as ordinary income. The residual method must be used to allocate sales proceeds to assets when calculating gain or loss from the sale.

If your business was a corporation...

Sale of stock in a corporation is taxed as a capital gain or loss, same as the sale in any publicly traded company.  This is a big advantage of owning your business as a corporation as capital gains rates are significantly lower than ordinary income, but can be a disadvantage if the sale includes a lot of inventory with value far below the cost paid. Corporate liquidations are generally treated as a sale or exchange, with gain or loss being recognized on the sale price of each asset.

The depreciation recapture trap...

For those who own business assets as a sole proprietorship or partnership, depreciation recapture can be a big issue if the allocated sale price is higher for assets than the basis left after depreciation. If you have a number of fully depreciated items included in the sale this can trigger a large tax liability. For example, let's say you have a $50,000 printing press at your business that you took a section 179 depreciation deduction on and your basis is now zero. When you sold your business $30,000 is allocated as the fair market value of this press. Because of the depreciation taken, the full $30,000 gain will now be taxed at ordinary income rates, meaning if you are in a 25% bracket you will owe $7,500 in tax on this portion of the gain. In comparison, that same $30,000 if a capital gain would only be taxed $4,500, giving a $3,000 tax savings.

Switching your business entity to an S-corp...

If you are considering selling your business down the road in a few years, you may wish to consider switching to holding your company in an S-corporation structure now. Usually you will not incur a taxable event doing so and it can prevent tax down the line. For more information on entity formation click here.

Tax-Free Reorganizations

If the business you are selling is incorporated and you are selling out to a bigger corporation, you may be able to defer gain on the sale by accepting the purchaser's stock in exchange for your stock. This new stock you will only pay tax on when sold. There are extensive rules to meet with these transactions, and if you accept any other property or cash you will need to pay tax on that portion of the sale. For more information on Tax Free Reorganizations click here.

Gain on qualified small business stock.

If the business you sell is a C corporation you may fall under the very complex rules for gain on qualified small business stock and receive a very generous 50-100% exclusion from income on these gains. The stock must be held for at least five years, the company cannot be involved in many businesses ranging from professional services to restaurants. But if you have a company that fits the narrow objectives of the law, this can be an extremely valuable loophole.

Are there other options?

There are a few other options with the sale of a business that can reduce taxes if planned for properly. If you don't need the income immediately, installment sales can be used to carry income forward into future years and spread both the capital gain and ordinary income hit out over a chosen period of time. 1031 Exchanges can also be used to exchange business assets for other business assets, however they can only be used for certain items, such as real and personal property, and cannot be used for inventory or goodwill. Still, trading a portion of your business gains for a franchise or other business entity can be a smart move to reduce tax and build a new business asset.


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