Small business owners often forget to consider the taxes they must pay after the sale of their businesses, resulting in lower net sales proceeds. If they proactively consult an advisor long before–even years–before the actual sale of their businesses, they reduce the tax burden or even manage to crack tax-free deals.
The IRS subjects the sale of a business, just like any other money-making transaction, to taxes. However, different factors determine the extent of taxes owed, which a business owner might have to pay on the sale of the business.
The factors impacting taxes include the type of the company, whether the business owner is selling company assets or shares of the company’s stock, and what type of capital assets they are selling.
1. Type of Company
The type of company determines how much a business owner will owe in taxes. Is it a sole proprietorship, partnership, limited liability company, S corporation, or C corporation?
Sole Proprietorship or Limited Liability Company (LLC)
Suppose a business owner sells the assets of his sole proprietorship and makes a profit: he has to pay the tax just once in the form of capital gain tax. Per the IRS, sole proprietorships and one-owner limited liability companies (LLCs) that do not elect to be treated as corporations separate from owners for tax purposes are classified as disregarded entities. In such cases, business owners of sole proprietorships and LLCs companies need not file for commercial income taxes. Instead, they pay taxes on any profits made from the capital assets reported personal income tax forms.
The tax benefits are better if your business operates as a sole proprietorship or LLC rather than a separate entity.
The IRS considers C corporation’s legal entities separate from their owners, which results in double taxation. Suppose the owners sell the company’s capital assets for a profit. In that case, they must pay a corporate tax that coincides with the commercial income tax return and a second time as capital gains tax on their share of the profit on their income tax filings.
S Corporations and Partnerships
Both partnerships and S corporations avoid double taxation. When business owners or shareholders sell assets through a partnership or S corporation, each is responsible for paying taxes through their income tax filings. The IRS does not require them to pay taxes again on the company’s income. S corporations are perfect for business owners who want to sell company shares while maintaining a single tax rate on the profits.
IRS does not allow C corporations to change their corporate status to S corporation to evade double taxation. According to IRS, C corporations must change their status two months and 15 days before starting the business’ tax year before selling any assets to qualify for a single tax.
2. Stock Sale or Asset Sale?
When someone buys stock in a company, he is buying a portion of ownership of the company. So, if he buys a significant share of stocks, he owns a larger percentage of the company. According to the Corporate Finance Institute, “Where the transaction is structured as a stock acquisition, by its very nature, the acquisition results in a transfer of the ownership of the business entity itself, but the entity continues to own the same assets and has the same liabilities.”
Company ownership also includes debts and liabilities. CFI further states that in an asset sale, “the seller remains as the legal owner of the entity, while the buyer purchases individual assets of the company, such as equipment, licenses, goodwill, customer lists, and inventory.” Most buyers prefer purchasing a company’s assets rather than stock: to avoid responsibility for the company’s liabilities and debts.
Business owners, however, prefer to sell stock that the IRS taxes at a lower rate compared to capital assets. The sellers usually offer a lower selling price to make a stock purchase more appealing to the buyers.
Although the seller must pay capital gains tax resulting from the sale of capital assets and stock, they receive a more generous tax break for selling stock because stocks are usually held longer than capital assets. The seller also gets a tax benefit from holding the stock for longer than one year.
When a company sells the stock, double taxation applies. Whereas, if an individual shareholder sells the store, they must only pay the tax in his tax filing. To mitigate their tax burdens, shareholders must sell stock to a particular buyer instead of the company selling its stock.
3. Type of Capital Assets
The IRS classifies capital assets in three ways: real estate (i.e., real property), depreciable property, and inventory property.
A business’ tangible property includes land, buildings, and anything affixed to the land. Often businesses seeking to relocate or close down forever decide to sell their real estate separately. If the buyer purchases only the real estate, then the seller owes capital gains tax for the sale of the property in addition to taxes on any gains from the sale of the business. However, suppose the buyer purchases the entire company, including the real property. In that case, the real estate is transferred to the buyer as a part of the business, and the seller pays tax only on the profit from the sale of the company.
The depreciable property loses value over time and includes furniture, machinery, equipment, etc. Sometimes, companies sell old properties and replace them with new ones. As per IRS norms, the sale of depreciable property is treated as a gain or loss based on its current value. Usually, the value of the property sold is lower than the original value at the time of purchase. Also, if the seller held the property for more than a year, the applicable taxes would be considerably less than if the seller held the property for less than a year. Here the tax rate is based on the difference between the purchase price and the current value of the depreciable property.
The normal transactions of selling products to customers for a profit are not taxed for capital gains. However, when a company sells a significant portion of its inventory, and the transaction is not normal, unlike its usual transactions, the IRS considers the proceeds of that sale a capital gain. Sometimes, business owners want to sell inventory at a wholesale level if they cannot sell it at the retail level. This helps them cut losses and recoup their investment, at least partially. If their expense on the inventory exceeds the cash received from selling it, they can claim the difference as a capital loss and pay no taxes.
Business owners need to plan early to benefit from the tax breaks allowed by the IRS. Consulting an expert advisor to identify the pain points and improve the situation can help business owners minimize their tax bills by selling their businesses