Most small business owners have 75% or more of their net worth tied up in their business. Their company represents security for their retirement, their heirs, and their legacy.
We’ve all heard Benjamin Franklin’s quote, “nothing is certain except death and taxes.” In selling a business, tax planning is essential and can dictate key decisions, multi-year planning, and what you ultimately are left with post-sale, whether maximal after-tax proceeds or an unexpected overwhelming tax bill.
Key Tax Concepts When Selling a Business
The specific tax treatment of your sale depends on multiple factors. How your business is structured, the structure of the sale, and asset allocation are three critical elements that drive the resulting tax implications.
Capital Gains Tax vs. Ordinary Income Tax
Capital gains is often the key concern during a business sale. In this instance, you would fall into the long-term capital gains consideration because you’ve held your asset for more than one year. Tax rates can be 0%, 15%, or 20%, though most small business owners can anticipate the 15% rate.
Ordinary income tax would be applied to certain parts of the sale, such as inventory, accounts receivable, and depreciation recapture. Unfortunately, these tax rates can reach as high as 37% currently. It is important to note that this would be either-or, so you would not be taxed for the same portion of the sale with both the capital gains and income tax rates.
State tax can also play a role and varies by state. In Rhode Island, capital gains are taxed as ordinary income, and most would be subject to the top state rate of 5.99%. You would avoid the state’s 7% sales tax, however, which may apply to inventory and equipment as tangible goods, but not the business sale itself. Massachusetts has a different approach, with a flat 5% capital gains tax applied, though an incremental 4% millionaire’s surtax is added if income, including the sale, exceeds $1M.
Depreciation Recapture
A less discussed but important aspect of a business sale is depreciation recapture. This is where a business sells its assets, commonly equipment and vehicles, for greater than its adjusted cost basis (original purchase price minus accumulated depreciation). In this case, the IRS recaptures taxes on previously claimed depreciation deductions, resulting in this gain being taxed as ordinary income rather than at capital gains rates. Real estate is subject to recapture as well, though it is capped at 25%.
Asset Sale vs. Stock Sale – Tax Consequences
Nearly all small business acquisitions are done as asset sales, with a single-digit percentage as stock sales. There are many reasons for this, and only a few where a stock sale would happen: critical non-transferable contracts or licensing compliance.
What’s the Difference?
Asset sales are preferred for several reasons. It is the only option for certain business structures, such as sole proprietorships, partnerships, and many LLCs. The asset basis means tax treatment varies based on purchase price allocation. These sales are made as a cash-free, debt-free transaction, with assets transferring to a new entity, helping to shield the buyer from past legal consequences as well.
From a taxation standpoint, the stock sale would be advantageous to the seller, though only possible if the entity is a C-Corp or S-Corp. There may be a 10% tax savings with a stock sale, which can be drastic the larger the purchase is. However, there is not quite a loophole to push for a stock sale rather than asset sale to earn more on your exit. In such cases, it is likely the buyer would want to reduce purchase price based on their increased risk as they do not receive a preferential tax treatment regardless of sale type.
Tax Strategies to Reduce Your Liability Post-Exit
Installment Sale Approach
A deal structure that spreads payments over time can help to manage your total tax liability. This can be done through annual payments with the buyer. This doesn’t eliminate capital gains tax, but can spread out the tax liability and avoid higher tax brackets. Of course, if you need those funds immediately, it may not be worthwhile or carry a non-ideal opportunity cost in waiting.
It is common for a portion of the purchase price to be held in a seller promissory note. It appears that lenders are more frequently asking for 10% of the purchase price to share and balance overall deal risk. In these cases, you can apply interest on the note, which may help add a beneficial layer to waiting for your full payment.
1202 Qualified Small Business Stock (QSBS) Exclusion
The QSBS exclusion provides tremendous value for those who can apply it. This has grown in interest in the lower-end private equity market and most relevant for small business sales that skew towards the higher end. It does require the entity to be a C Corp and a complex web of requirements to be met, but would exempt a portion of the gains from taxes, which may dramatically affect the overall exit value.
Use of Trusts and Philanthropy
Charitable remainder trusts (CRTs) provide another method to realize tax benefits at exit. In this scenario, the seller would receive income from the proceeds of the business sale by transferring the business to the CRT prior to selling. The intention with this strategy is to avoid capital gains tax while introducing a philanthropic element.
Timing Your Exit for Tax Efficiency
When you exit can play a role in what you see post-close. While it can be difficult to strategically place an exact transition period, end-of-year or early-year provide a pivot point to consider.
End-of-year sale would mean the sale proceeds are added to your existing income of that year. This is likely to push you into a higher tax bracket.
Early-year transactions mean you start fresher with less of an existing level of income to be taxed. The actual tax load this timing causes is unique to your situation and the tax rates of that period, and whether they would rise, lower, or remain the same into the next year. While we don’t see this as a common tactic to employ, it may be worth taking into consideration if control of timing is possible.
Common Mistakes to Avoid
Mistake #1: Not providing sufficient time to planning.
Tax planning is ideally a multi-year process. In the very least, it should be part of planning for the sale. If you are scrambling to figure out what the tax implications are after the transaction occurs, you may be disturbed by how much of your exit funds will return to the IRS.
Mistake #2: Forgetting to factor in depreciation recapture
Often overlooked, depreciation is a great help when it favors you and hurtful when recapture is ignored. This may add a significant tax liability depending on your exact situation.
Mistake #3: Overlooking state tax implications.
This can be more complex if you have residence in multiple states or plan to move post-sale. Depending on local laws, you may trigger a nexus tax obligation.
Mistake #4: Not Working with Professionals
Who you work with plays a large factor in how intelligently you approach your unique tax situation. Finding the right exit planning team, one that includes a business broker or M&A advisor, a business attorney, a CPA, and a financial advisor, can make all the difference in approach and process.
Now, while each part of the team should be familiar with tax implications during a sale, your CPA and tax strategist should be most helpful in navigating complex situations, long-term tax planning, and ensuring proper protocols are followed.
Nonetheless, your broker or advisor should help with negotiations on your behalf while helping you receive top-dollar for your business, your financial advisor can implement strategies to preserve your wealth, and your business attorney should ensure agreements include reasonably favorable terms for you. Done properly, it requires a team.
Selling your business is likely the single most significant transaction of your life. If you’ve already sold one before, you know how dramatic this can be. Planning years in advance can ensure that you begin preparing the business and its tax strategy properly, as well as plans for your wealth preservation and personal life post-exit.
Want to see how much your business is worth? Try our Valuation Calculator. Enter revenue, earnings, and eight critical factors that influence the value of your company at exit.
About the Author
David is Bbg, Inc.’s managing director. He focuses on driving strategic growth and operational effectiveness. Passionate about helping others be at their best and fostering collaboration, he ensures excellence is seen in the clients we serve and the businesses we operate. Follow David on LinkedIn