How To Reduce Capital Gains Tax When Selling a Business

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.

If you don’t already fully understand the process of selling, we put together an article on how the M&A auction process will help to maximize exits. You can read all about selling your business here.

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 public market 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.

What is Your Cost Basis in Your Business?

While the stock example is straightforward as you have a cash outlay to invest in the stock, the basis of a business that you have started may not be so straightforward.

Your cost basis in your business is your original cost of buying it (if applicable) plus any incremental expenses you have reinvested back into the business to purchase more assets and make improvements.

The higher your basis is, the less of the purchase price is subject to capital gains tax upon exit.

Understanding Capital Gains Tax Rates

The capital gains tax rate for an individual depends on the taxpayer’s total amount of income. For tax year, the long-term capital gain rates are tiered from 0%, 15%, and 20%, depending on total income size.

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 over one year. The IBM stock sale example would be taxed as a long-term capital gain.

What is Goodwill?

In a purchase agreement, the purchase price is typically assigned to the various assets of the company that is being purchased. This means that There is a portion of the purchase price assigned to each asset for its value. The remainder of the purchase price is called “Goodwill” which is seen as an intangible asset. The formula for goodwill is: 

Purchase Price + Liabilities – Assets

How Ordinary Income and Capital Gains are Taxed

LLCs and S corps are both considered pass-through entities. This means that the business income earned passes is not taxed at the corporate level. Ordinary income in these entities is passed through to the personal tax return, and is taxed as ordinary income.

Goodwill on the sale of business sales can be taxed at long-term capital gains tax rates.

This means that businesses with a high level of tangible assets (tractors, manufacturing equipment, etc.) will still have to pay ordinary income tax on the purchase price that is assigned to each of those assets.

For pass-through entities, both ordinary income tax and capital gain taxes are paid on the shareholder’s personal tax returns.

At Raincatcher, we typically introduce our clients to tax attorneys in advance of an exit so that we can work to structure deals to mitigate tax liability. We always advise speaking to a capable attorney with regards to tax.

Related Content

Read up on the various ways that brokers and M&A advisors help market deals to strategic and financial sponsors here.

How to Minimize Your Tax Burden on the Sale of a Business

Below are some of the ways our clients and their legal advisors have come up with to minimize, defer, or in some cases eliminate capital gains tax. 

Consider rollover equity

Rolling over equity in essence means that you are foregoing receiving some of your business sale proceeds in cash, instead you are taking equity in the new company that the buyer is forming. This may allow for you to have a second exit event (in a different taxable year) down the road when the buyer elects to sell.

Your accountant may be able to utilize much of this rollover equity to mitigate your tax liability by deferring it to a future payment.

Offsetting Gains with Losses

If you have other capital losses elsewhere in your portfolio, you can sell those in the same year that you sell your business. Harvesting some of these losses will offset some of the capital gains.

Explore Opportunity Zone reinvestment

Sellers of businesses 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. Note that will not eliminate the capital gains burden. However, it does allow you to defer it until that asset is sold. Similar to a 1031 exchange in real estate

Related Content

We put together another helpful article on all of the documentation needed in a business transaction.

Working With an M&A Advisor and M&A Attorney

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 capable M&A advisor like the team at Raincatcher.

In addition to being able to market your business for a competitive price, we will be able to introduce you to other professionals that are needed to maximize your proceeds such as capable tax advisors and M&A attorneys.