When a business is sold to an individual, both the seller and buyer will have tax implications. If you’re thinking of buying or selling a business in the near future, keep these tax considerations in mind. You’ll need to look at the structure of the company to decide the best way to proceed.
Generally, the seller is focused on increasing capital gain assets for favorable tax rates. The buyer looks at the number of tangible assets that can be depreciated going forward to reduce annual tax liability. Both sides are calculating ways to determine their profit or loss on the sale of the business now and in the future. You need to know how to value a business to sell it.
In a sole proprietorship, you can negotiate everything. Each asset is sold separately and divided into seven classes allocated to the purchase price. Some assets, like cash, securities, and accounts receivables, have accurate values that match the tax basis dollar-for-dollar. But others, such as goodwill and inventory, produce ordinary income that results in tax gains and losses. Negotiation is needed to determine values. All assets are broken down as part of the purchase price on IRS Form 8594, Asset Acquisition Statement.
Partners own pieces of a business and file their taxes separately by reporting income on their personal returns. Tax laws view partnerships both as an entity and a group of partners and treat it as an asset sale. Capital gains or losses may impact the sale or purchase of a partnership interest. However, some tax items that flow between partners create unrealized receivables and inventory that may be considered ordinary income. There are two ways to structure the transaction:
- Existing partners or a new partner can purchase a partner’s interest in a cross-purchase.
- The partnership entity can purchase the interest of the partner directly as a redemption.
Choosing one method over the other may depend on the partnership or partners’ available cash or what the partnership agreement requires. Cross-purchases and redemptions create drastically different tax results for the buyer, seller, other partners, and the partnership.
Corporations are purchased and sold through either stocks or assets. Generally, sellers like to sell the stock to limit tax reporting of capital gains on the transaction. But buyers prefer an asset sale because this creates a higher basis for depreciable assets and amortization. They will need to negotiate the structure of the sale.
A seller could ask less to complete a stock sale to avoid the higher tax bill from an asset sale. The buyer might reduce the amount of transfer taxes enough to offset the depreciation of assets. Each situation has unique tax consequences and options.
If your business is a C corporation, and you plan ahead, you can sell your business to your staff through employee stock ownership plans (ESOP). This benefit plan gives employees an interest in the company. ESOPs for S corporations will not offer the owner tax deferral options, but it is possible to revoke an S election before a sale.
As an owner or seller, you have captive buyers and don’t have to waste time searching around. You set a reasonable price for the sale and receive cash from the ESOP. Seller proceeds can be rolled over into a diversified portfolio to defer tax on the gain.
Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts. They can choose to roll over their distributions in an IRA or other retirement plan or pay the current tax on capital gains.
There are additional tax savings to be had by being an S corporation. Gain on the sale of a C corporation requires the owner to report an extra 3.8% Medicare tax on investment income. However, an S corporation with an actively involved owner in the business is not subjected to this tax. C corporations planning on a sale can make an S election if they meet the requirements.
This tax structure benefits the seller’s after-tax sale proceeds and the buyer’s after-tax purchase costs.
Installment sales minimize the tax on gains by spreading them out over one or several years. If you receive any payment after the year of the sale, it becomes an installment sale automatically. The only catch is you can’t include inventory or receivables in installment sale reporting. This arrangement is also open to the risk of default, so you’ll need to do some due diligence on your buyer’s background. You will file the details on installment sales on Form 6252.
Selling this way can lower adjusted gross income, which can lower federal tax rates, allowing for significant tax savings over time. Buyers also benefit by not having to come up with a large down payment while still having full access to improve the business.
Many business owners aren’t sure what to do with their time in retirement and only want to gain some lifestyle flexibility. Sellers can consider negotiating a consulting agreement with the buyer. This offers ongoing income and the potential for continuing tax breaks in the form of a qualified business income deduction. By qualifying as a self-employed or small business owner, the seller can deduct up to 20% of business income on their taxes. The buyer gets continued support through the ownership transition and a deductible business expense.
Selling a business is complex from a legal and tax perspective. Seek advice from tax professionals and accountants to make sound business decisions. Contact us to learn how to value a business to sell, find the right buyer for your business, and negotiate deals with the best possible outcome.
Rocky Mountain Business Advisors is a business brokerage focused 100% on selling our clients’ business. As Business Brokers, we fathom it as our responsibility to apply a proven process to educate, prepare, and guide our clients through the sales process so that they can focus on managing their business while we focus on a successful sale. We bring a strong sense of urgency and tenacity to every engagement to realize the highest sales price in the shortest period of time. We bring buyers and sellers together. Contact us at 303-474-5582, https://rockymountainba.com/ , or schedule a free 15-minute consultation to learn more about the services that makes us one of the best business brokers in Denver.