Owners who are considering a business sale must understand the tax impact of the transaction. The amount of tax, and the timing of the sale, both impact the dollars received by the seller.
To prepare for a business sale, you need to understand the capital gains on selling a business, how they impact a sale, and how to reduce the tax on capital gains.
WHAT IS A CAPITAL GAIN?
What is the capital gains tax on selling a business? A capital gain tax is assessed on the sale of an asset, including the sale of a business. Most investors, for example, have paid capital gains taxes on investments. Here’s an example:
An investor buys 100 shares of IBM common stock in 2012 at $50 per share and sells the 100 shares in 2021 at $80 per share.
1. The cost basis of the stock is $50 per share, or a total of $5,000,
2. The sales proceeds total $8,000,
3. The capital gain is $8,000 less $5,000, or $3,000.
The tax paid on the $3,000 capital gain is based on capital gain tax rates. These rates differ from personal income tax rates and corporate income tax rates. In recent years, the capital gain tax rates have been lower than most income tax rates, but the tax law can change.
UNDERSTANDING TAX RATES
The capital gains tax rate for an individual depends on the taxpayer’s total amount of income. For tax year 2021, the long-term capital gain rates are 0%, 15%, and 20%, depending on total income.
Finally, long-term capital gains are taxed at a lower rate than short-term capital gains. For tax purposes, long-term is defined as a holding period of one year or longer. The IBM stock sale example would be taxed as a long-term capital gain.
HOW INCOME AND GAINS ARE TAXED
Sole proprietorship, partnerships, and other businesses are considered pass-through entities. The business income earned passes through to the personal tax return, and is taxed as ordinary income.
Asset sales, on the other hand, are taxed based on capital gains tax rates. Income taxes and capital gain taxes are paid on the personal tax return. Consult with your accountant to confirm how a capital gain will be taxed, if you sell your business.
CAPITAL GAINS ON BUSINESS SALE
What you sell has an impact on the capital gain tax calculation. An owner may sell company equity (the entire business), or sell specific business assets.
In an equity sale, the buyer purchases the book value of the business, which is calculated as assets less liabilities. Assume that an owner has a cost basis of $700,000 in a business, and the entire company is sold for $3,000,000. The capital gain tax is assessed on ($3,000,000 less $700,000), or $2,300,000.
When specific assets are sold, the owner calculates a cost basis for each asset sale. Let’s assume that a construction firm sells a piece of machinery for $300,000. The owner must determine a cost basis on the machinery to determine the capital gain.
There are some other factors to consider:
Some assets cannot be sold, because a legal agreement prevents a sale. If you have long-term contracts with customers, for example, those agreements may not be transferable to a new owner.
ASSET TAX RATE
Some assets may not be subject to capital gains rates. If you sell inventory or accounts receivable balances, the asset sales may be taxed as ordinary income, and not as a capital gain.
Once you understand how capital gains are taxed, you can work with your accountant to lower the tax liability on your business sale. You should also consult with a business broker, who can advise you throughout the sale process.
HOW TO MINIMIZE THE TAX ON A BUSINESS SALE
Find an experienced business broker, and have a discussion about your business. Explain how you do business, so the broker can uncover the true value of your company.
The broker can help you decide if you want to sell the entire business, or specific assets. Once you decide on an approach, both the broker and an accountant can discuss the tax impact of the sale. Here are some other considerations:
Minimize the assets sold that have been owned for less than a year. Long-term capital gains generate a lower tax liability.
OFFSETTING GAINS WITH LOSSES
If you have other capital losses in the same year that you sell your business, the losses will offset some of the capital gains.
Ask your accountant if you can structure an installment sale. In this case, the buyer pays a portion of the sale proceeds over a period of years, which allows you to defer the capital gain tax into future years. However, not all assets can be sold using an installment sale approach.
WORKING WITH A PROFESSIONAL BROKER
There are a number of factors to consider when you sell a business, including the tax impact. You can save time and make more informed decisions with the help of a business broker.
The experts at Raincatcher have worked on an enormous variety of business sales. We can help you analyze your business, find a buyer, and negotiate an attractive sale price.
Contact a Raincatcher brokerage expert today, and sell your business with confidence.