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There’s a lot to consider when selling a business and tax planning is at the top of the list. When you sell a business or business assets at a profit, the IRS expects to receive a cut in the form of capital gains tax. That could potentially result in a larger-than-expected tax bill. If you’re in the initial stages of planning your exit, it’s important to know how to avoid capital gains tax on a business sale.
How Is the Sale of a Business Taxed?
The sale of a business or business assets is generally subject to capital gains tax. Capital gains tax is a tax that’s assessed when you sell an asset for more than its basis, or what you paid for it. The IRS levies two types of capital gains tax: short-term and long-term.
The short-term capital gains tax rate applies to assets held for less than one year. Short-term capital gains are taxed as ordinary income. So whatever tax bracket your business normally falls into would apply when calculating short-term capital gains tax.
Long-term capital gains receive more favorable tax treatment. The long-term capital gains tax rate applies to assets held for longer than one year. The current long-term capital gains tax rates are 0%, 15% and 20%, depending on income.
When applying capital gains tax rules to the sale of a business, the IRS typically looks at the individual assets of the business. That’s assuming that your business is structured as a sole proprietorship, partnership or limited liability company (LLC). So instead of seeing your business as a single asset or entity, the IRS looks at all the assets the business owns, including:
- Real estate
- Equipment or machinery
- Property leases
- Raw materials and supplies
- Intellectual property, such as trademarks, patents and copyrights
Again, the capital gains tax rate you’ll pay on the sale of those assets depends on how long you’ve held them. It’s also important to note that certain assets, such as inventory or accounts receivable, are taxed as ordinary income rather than capital gains.
How Allocation of Sale Price Affects Taxation
When you’re working out a purchase agreement with a buyer, part of the negotiations involves choosing a sale price that applies to each tangible and intangible asset of the business. What you’ll pay in taxes for the sale of a business can hinge largely on how you allocate the sale price of individual business assets.
Here’s why that matters. The purchase price you set for each asset can determine your capital gain (or capital loss) on the asset. It also establishes the buyer’s basis for each asset that’s purchased. While that’s less important for your tax situation, it’s important to note that the buyer may also be angling for the most favorable tax treatment when negotiating prices.
In terms of how to avoid capital gains tax on business sale, you’re walking a fine line because you likely want to maximize profits while minimizing tax. Under Section 1060, the IRS offers some guidelines on how to value assets when allocating the purchase price to manage taxation. Generally, you’d allocate the purchase price to assets in this order:
- Cash and deposits held in checking or savings accounts
- Actively traded personal property, which can include certificates of deposit (CDs) and publicly traded stock shares
- Inventory and stock in trade
- Furniture, fixtures, buildings, land and other assets that don’t fit into any other asset class
- Intangible assets, other than goodwill and going concern
- Goodwill and going concern value
Again, keep in mind that the buyer will be looking to allocate more of the purchase price toward assets that will depreciate quickly as that can yield more tax benefits on their side.
How to Avoid Capital Gains Tax on Sale of Business
Can you completely avoid capital gains tax when selling a business? Not necessarily. But it’s possible to reduce the amount you may owe in capital gains tax with some strategic planning. Talking to your financial advisor or a tax professional is a good place to start. They can help you to determine if any of the following tax reduction tactics might work in your situation.
- Negotiate wisely. As mentioned, you and the buyer will have competing interests with regard to the allocation of the purchase price. Per the IRS rules, you’re better off allocating more of the price to capital assets rather than depreciating assets. So rather than rushing the negotiation process, it may be better to take your time in order to get the most favorable allocation.
- Consider an installment sale. An installment sale allows you to sell your business in phases or installments. Rather than receiving payment in full all at once, you could set up a schedule of annual payments with the buyer. That strategy doesn’t eliminate capital gains tax entirely, but it can allow you to spread out your tax liability.
- Watch the timing. If you’re selling a newer business, timing is critical as it can determine whether you pay the short-term or long-term capital gains tax rate. Holding on to the business and its assets for at least one year before selling can help you take advantage of the more favorable long-term capital gains tax rate.
- Sell to employees. If you own a C-corporation, you may be able to minimize capital gains tax by selling the business to your employees. You’d need to set up an employee stock ownership plan (ESOP) to do so. The advantage of doing so is that you don’t have to go looking for a buyer and the cash you receive from the sale can be rolled into an investment plan in order to defer capital gains tax.
- Explore Opportunity Zone reinvestment. Business owners can defer capital gains tax through December 31, 2026, by reinvesting capital gains from the sale of a business into an Opportunity Zone. To qualify for this tax break, any capital gains must be reinvested within 180 days of the sale. While this doesn’t make the capital gains tax disappear, it does allow you to defer payment.
The Bottom Line
There are lots of reasons why you might decide to sell a business. You may be ready to retire, or you might simply want to move on to a new venture. In any case, it’s important to keep tax planning in sight. Consulting with a tax expert can help you to flesh out a plan for how to avoid capital gains tax on a business sale, or at the very least minimize what you owe.
Tax Planning Tips
- Consider talking to your financial advisor about the potential financial implications of selling a business.
- In addition to planning for federal taxes on the sale of a business, it’s also important to consider what you might owe in state taxes. If you do business in a state that doesn’t assess income tax, then you might be at an advantage. But if not, then you’ll also need to consider how you can reduce the amount of tax you might owe on the sale. Again, there’s where talking to a tax professional who’s well-versed in your state’s tax laws can help.