The Top 4 Tax Considerations for Business Sellers
The taxation of your business sale has a huge impact on your personal finances.
Before you start the process of selling your business, you need to understand how a sale is taxed, and the strategies for reducing your tax liability.
Realized vs. Recognized Gains
The sale of a business includes different classes of assets and each asset must be classified properly in order to determine the capital gain or loss.
It is important to know that not all gains are recognized on your tax return.
Assume, for example, that you buy shares of IBM common stock for $3,000. Five years later, you sell the shares for $5,000 and generate a $2,000 gain.
You have a realized gain, because there was a buy and a sell transaction. However, the gain may not be recognized as a taxable item on your return. If you sold other shares for a $1,500 loss, for example, you can reduce the $2,000 gain by the $1,500 loss.
In a similar way, you can use strategies to reduce or defer a gain on the sale of your business. The first consideration is your business structure.
1. Business Structure
The tax impact of your business sale depends partially on your business structure.
If you operate a pass-through entity, a business sale will generate a capital gain that is taxable on your personal tax return.
Pass-through entities include:
- Sole proprietorships: You operate as an individual, and report business profit on Schedule C of your personal return.
- Partnership: Partners receive a Schedule K-1 from the partnership, which includes the partner’s share of profit and loss. The K-1 profit is reported with other income on the personal tax return.
- Limited liability companies (LLCs) and S corporations: Both of these business structures are pass-through entities. The LLC owner chooses how the LLC is taxed. An LLC may be taxed as a sole proprietorship, S corporation, or C corporation.
C corporations (C corps) are taxed differently.
Double taxation on a business sale
Both the C corp and the C corp shareholders are taxed on asset sales that generate a gain.
When you sell company assets in a C corp, the C corp files a Form 1120 tax return, and the business pays tax on the gain. When sale proceeds are paid to shareholders in the form of a dividend, the shareholders are also taxed on their personal tax returns.
If you choose a C corp business structure, you must consider the double taxation issue. The C corps may be able to carry forward net operating losses, which can be used to reduce the tax liability for a capital gain.
Many business owners use tax strategies to defer recognition of a gain on sale.
2. Tax Deferred Sales: Reorganizations
This approach requires the business owner to exchange stock in an S corp or C corp for the buyer’s company stock. The transaction must meet the requirements of Internal Revenue Code (IRC) Section 368.
Consideration refers to cash, stock, and any other assets paid to the seller. Section 368 requires that at least 50% of the consideration must be the buyer’s stock.
Continuity, business purpose
The IRS requires that the seller’s business must continue to operate. The buyer must operate the existing business, or use the seller’s assets in another business for two years after the transaction.
The sale must also serve a valid business purpose. If the buyer can use the seller’s business to grow company-wide sales and profits, the transaction meets the IRC requirements.
If the business sale meets these requirements, the seller can defer taxes on the gain.
A seller may also sell the business to an Employee Stock Ownership Plan (ESOP).
3. ESOP Planning
To benefit from an ESOP sale, you must reinvest the sale proceeds in “qualifying” securities.
As Forbes explains, an ESOP is a qualified retirement plan that must invest primarily in the stock of your company. Employees defer their compensation and invest in an ESOP, just as they would in a 401(k) retirement plan. Instead of purchasing mutual funds in other companies, the ESOP buys shares in your business.
You must start an ESOP many years before a potential sale. When properly implemented, an ESOP can accumulate enough assets to pay the owner and purchase the business.
Forbes states that: “If your company is a C Corporation, the proceeds from the sale of your stock to the company’s ESOP may be entirely tax-deferred.”
Choosing the ESOP option is complicated. You’ll have to go through due diligence, just as you would with a third-party buyer. The IRS and the Department of Labor have extensive regulation for ESOP purchases.
Finally, you can structure the sale as a qualified small business rollover.
4. Rollover Provisions: IRC Section 1045
As explained here, some C corp stock sales may meet the rollover provisions of IRC Section 1045. If the shares are classified as qualified small business stock (QSBS), the proceeds from the sale must be reinvested in another QSBS within 60 days. This allows the seller to defer recognition of the original gain on sale.
All of these strategies complicate the process of selling your business.
How Will You Be Paid?
There is more to closing the sale of your business than simply knowing the sales price. The allocation of the sales price plays an important role in determining your tax consequences.
Before you start the process of selling your business speak with your CPA and then talk with the experts at Raincatcher. They have years of experience working with business owners, and can help you evaluate the tax, legal, and operational issues of a sale.
Create a team of experts to help you plan, so you can start the sales process with confidence.