Are you considering selling your business? Whether you are looking to capitalize on industry appreciation or are gearing up to start your next venture, you’ll want to understand the tax implications associated with business sales.
Often, business owners need to implement strategies well before the business sells to properly balance profitability and tax savings. This is why it’s important to understand tax considerations before you begin the sale process.
In this article, we’ll cover the top tax considerations to keep in mind when it comes to selling your business, including knowing your tax basis, understanding the impact of your business structure, reviewing purchase methods, and contemplating how deal structures impacts taxes.
Know Your Tax Basis
One of the most influential factors when selling a business is your tax basis. According to IRS Topic No. 703, your basis is the amount of capital invested in the business for tax purposes.
The tax basis of a business differs from general assets. For example, if you were to purchase a vehicle, your tax basis would include the cost of the vehicle, shipping, and any other fees and taxes. However, when it comes to assigning a tax basis to a business, there are other factors involved, such as past earnings, contributions, and distributions.
There are a few different ways you can calculate your tax basis. First, if your business files Form 1065, new regulations require the tax basis to be disclosed on Schedule K-1. However, if you do not file Form 1065, you can create a tax basis schedule.
First, start with your initial cost to purchase your business. This could be the cost of buying out old owners or capital infused to start the business. Then, each year, add ordinary income, business gains, other income, investment income, capital contributions, and any other type of income found on Schedule K-1 or present on your Schedule C.
Next, you will need to include subtractions, such as non-deductible expenses, distributions, capital losses, charitable contributions, and any other loss.
Why does tax basis matter? When you sell your business, you may be subject to capital gain taxes. Your taxable capital gain income or loss is determined by taking the gross selling price of the business minus your tax basis. This makes it important to calculate an accurate tax basis to minimize any potential taxes.
Understand the Impact of Your Business Structure
Another tax consideration to understand when selling your business is the structure. Businesses that have multiple owners or shareholders will need a majority vote to sell. You should have clear meeting minutes showing discussions about the sale. Failure to get the approval of a majority of owners can lead to lawsuits and issues in the sale process.
Your articles of organization or partnership agreement should outline the necessary procedures and terms for the sale of the business. However, if you are the sole owner of your company, you won’t need a majority vote before selling your business.
Regardless of your business structure, taxes associated with the sale of your business will usually be reported on your individual tax return on Schedule D. However, if ownership of your business is through a trust or another business entity, you may need to report the sale elsewhere.
Be sure you reach out to a qualified accountant to discuss the tax implications of forming a new entity and transferring ownership before a sale occurs. These processes can be complex, which is why it’s best to work with an expert to ensure you remain in compliance with the IRS and other regulatory agencies.
Review Purchase Options
The purchase structure of your business is also an important tax consideration. There are generally two different ways that buyers can purchase your business, both of which can result in different taxation.
Stock Purchase
Stock purchases are fairly straightforward, with a buyer purchasing your entire ownership percentage of the business. This leads to the acquisition of the entire entity, including all assets and liabilities. This can be a difficult method to use if minority shareholders don’t want to sell.
When you sell your entire ownership percentage under a stock purchase, you aren’t usually required to recapture depreciation. This means you have the potential to tax the entire gain at capital gain tax rates, which can be lower than your ordinary income rates, depending on the specifics of your individual return.
Asset Purchase
You can also elect to sell your business as an asset purchase, which allows buyers to choose which assets and liabilities they assume. This method can be more complex, with the new buyer required to retitle and reassign specific assets.
Certain assets are subject to depreciation recapture, which are generally taxed at ordinary income rates instead of capital gain rates. This occurs when you sell assets that have been fully or partially depreciated.
Deal Structure Considerations
The unique structure of the deal also has tax implications. Often, business sales involve multiple working components, such as seller notes, earnouts, and non-compete agreements.
For example, sometimes buyers will agree to pay an extra percentage on the purchase price if the business achieves a certain revenue or profit goal. These clauses can boost the income you receive, but will also need to be reported as taxable income in the year received.
Additionally, most buyers require sellers to sign non-compete agreements, which have consideration attached. This is dependent on your industry and the length of the non-compete agreement.
Furthermore, the terms of your sale can also be altered to help with tax implications. Installment sales can be a great way to spread your tax liability over a few years while earning interest income.
The Bottom Line
Whether you are ready to sell your business or are just considering the possibility, it’s important to understand what tax implications you can expect to encounter. Maximizing your tax savings often takes a combination of strategies based on the expected sale price and your tax basis. Work with a certified accountant to prepare for your unique tax situation and keep these considerations in mind as you plan for an exit. For more information on preparing a business for a sale, download our small business sale guide here.
