If you are thinking about moving on from your current business, you also need to be aware of tax considerations while selling your business.
Like any other transaction that earns you money, a business’s sale is considered as income. IRS classifies this as a capital gain. It also applies whether you are selling the assets of a company or shares of a company’s stock. All of this makes you liable to pay your taxes.
You may face a significant tax bill when you sell your business. However, if you are not careful, you can wind up with less than half of the purchase price in your pocket after you pay all the taxes.
But with skillful planning, it is possible to reduce or suspend at least some of these taxes. As a result, the IRS will tax you on the profit you make from selling the business. Also, you may be able to control the timing through the terms of the deal.
Ultimately, the amount of tax that you will have to pay will depend upon whether the money you made from the sale is taxed, ordinary income, or capital gains. Besides, the profit received from the business assets will most likely be taxed at capital rate gains, whereas the amount you receive under a consulting agreement will be ordinary income.
Here are the primary tax considerations you should know while selling your business.
Allocation of Sales Price Governs Tax Consequences
Let’s say that you negotiate a total price for the business. In that case, you and the buyer must agree to which part of the purchase price applies to each asset and intangible assets such as goodwill.
The allocation will determine the total amount of capital or ordinary income tax you have to pay on the sale. Please keep in mind that it will also have tax consequences for the buyer.
If something is good for the tax picture for the seller is usually bad for the buyer and vice versa. So the allocation of price to various deal components is typically an area for negotiations and compromises.
The taxable amount at issue is your profit, i.e., the difference between your tax basis and your profits from the sale. Your tax basis is usually your original cost for the asset, minus depreciation deduction claimed, minus any casualty losses claimed, and plus any add additional paid-in capital and selling expenses.
Your profits from the sale generally mean the total sales price, plus any additional liabilities the buyer takes over from you.
As the seller, you will want to allocate most of the purchase price to the capital assets that you sell with the business. You want to do that because profits from the sale of capital assets, including business property or your total business are capital gains.
Tax implications vary across different corporations and partnerships. Each entity has its specialty tax provisions that can impact a gain from a sale and consequent tax liabilities.
As one out of many scenarios, C corporations selling assets for gains would be subject to double taxation, once at the corporate level. Then again, you distribute the after-tax profits to shareholders and taxed as dividends.
Suppose the selling party was a pass-though entity, i.e., S corporation or partnership. In that case, a common problem occurs whereby some of the asset gains are taxed at ordinary rates and some at long-term capital gains rates.
The ordinary rate gain portion can come from a common tax kink. This is depiction recapture to offset the depreciation expense benefits enjoyed by the previous owner at the same standard tax benefit.
Partnerships, on the other hand, have no concept of selling stock. Moreover, even if if the intent is to buy a partnership interest, tax statutes must dictate the sale as an underlying sale of partnership assets to the owners. In fact, selling a partnership leads to ordinary income treatment on the gain in several specific areas.
Purchase Price Allocation
Another essential aspect for tax consideration while selling your business is the purchase price allocation. With asset sales, the purchase price allocation is the most heavily negotiated aspect of the transaction between the parties.
This particularly stands true for equipment-intensive industries. In these sales, the ordinary income tax aspect rises, leading to adverse tax results to the seller.
For instance, a buyer may seek to purchase manufacturing equipment with an allocation of $10 million purchase price. The benefit to the buyer is that they receive a step up in the basis of the equipment. They can even claim 100% bonus depreciation in the first year.
Interestingly, the seller may have already claimed total depreciation deductions on the equipment and still have little to no tax basis. As such, the gain to the seller on the equipment would lead to depreciation recapture. This will also lead to the ordinary 37 percent federal rate.
You would typically consider goodwill and customer-based intangibles as capital assets. IRS would tax the gain at a more favorable 20% federal capital gains rate.
You Must Follow IRS Allocation Rules
As one might expect, the IRS has set some rules for making the purchase price allocations. In other words, they require that each tangible asset be valued at its fair market value [FMV], in the following order:
- Cash and general deposit accounts. (This includes checking and savings accounts but excludes certificates of deposit).
- Certificates of deposit, US Government securities, foreign currency, and actively traded personal property, including stocks and securities.
- Accounts receivable, debt instruments, and assets that you mark to market at least annually for federal income tax purposes.
- You would include inventory and property of a kind if on hand at the end of the tax year and property held primarily for sale to customers.
- All assets that don’t fall into any other category, such as furniture, fixtures, buildings, vehicles, land, and equipment, usually into this category.
- Intangible assets that other than goodwill, such as copyrights and patents, fall into this category.
- Goodwill and going concern value.
What Are The Next Steps?
You add and subtract the total FMV of all assets. You can do so in a class from the total purchase price before shifting on to the next class. Consequently, intangible assets such as goodwill get the “residual value,” if there is any.
But remember that the FMV is in the mind of the appraiser. You can still have some wiggle room in allocating your price among various other assets, provided that your allocation is fair and the buyer agrees to it.
Furthermore, your odds are even better if a third-party appraiser supports your allocation. For that, you must engage a professional tax agency during tax season. They will help with the many tax considerations while selling your business. Selling a successful business should be a happy moment and surprise-free. So if you don’t want a surprise tax bite down the road and ruin the moment, contact a tax agency near you.