If you’re planning on selling your small business in the near future, you might be struggling around this issue. What are the requirements for each tax on the sale of a business, and how can you reduce them through a tax-advantage planning?
By some accounts, more than 100,000 small- and medium-sized businesses (SMBs) are sold every year. Those sales represent more than $50 billion of value — and $50 billion of tax liability for business owners. For that reason, it is critical to understand and take advantage of the unique tax advantages available when you sell your business.
This article will help you get started, with a guide to the biggest tax breaks for selling a small business, how to capitalize on them, and the benefits and risks of each.
3 Strategies to Reduce Your Taxes on the Sale of A Business
1. Sell via a Charitable Remainder Trust
With a Charitable Remainder Trust (CRT), you can sell your highly appreciated business and pay no taxes today.
How does it work? You start by transferring some or all of your ownership in your business to the trust (of which you are in control as trustee and beneficiary). Then, when you’re ready, you sell the business. The CRUT is a tax-exempt entity, so it (and you) will owe no taxes when you sell any appreciated asset, including business shares, via the trust. You get to reinvest all of the proceeds from your sale, instead of sending a large chunk to the federal and state governments. You’ll receive annual distributions from the trust, and when the trust ends, whatever is left goes to a charity of your choice.
When might a CRT make sense for a business sale?
- If you are interested in reinvesting the proceeds in a diversified portfolio of assets
- You don’t need access to all of the proceeds from the sale immediately
What are the key tradeoffs?
Up-front liquidity: You can only withdraw a percentage of trust assets every year — typically between 5 and 15% of the trust’s value, according to an IRS-approved formula
2. Use an installment sale
Say you sell a business for a $250,000 profit. If you file your tax return with an extra $250,000 in taxable income in a single year, you can expect to pay taxes on it now. There are two problems with that approach: You will you owe those taxes very soon — this coming April — and your effective tax rate will be much higher than usual because you have much more taxable income, all realized this year.
There is an alternative, though, even if you don’t want to pursue a tax-exempt trust: You can use what’s called an “installment sale” to spread the profits over many years. How this works is that you offer “seller financing” — essentially, you offer the buyer an installment plan, and they pay you a down payment this year and then pay off the remainder of the sale price over time.
Critically, with an installment sale, you only have to pay income taxes on the amount the buyer pays you in a given year. If the payments are spread out over a long period, you can reduce your marginal tax rate significantly. Plus, you get to charge the buyer interest.
There are two main risks: First, you are becoming a lender. If the buyer fails to make the installment payments, you may have to foreclose on the business, and you likely won’t recover everything you’re owed. And second, you are receiving smaller payments over time, so you won’t be able to reinvest the proceeds and capture additional investment growth (though you will get those interest payments, which can make up for at least some of that growth).
When might an installment sale make sense for a business sale?
- You are not worried about the buyer’s credit risk and can manage the additional overhead of collecting on a loan and managing the related accounting and tax work
- You don’t need access to the majority of the proceeds up front
What are the tradeoffs?
- Credit risk: You are effectively taking on lender risk, plus additional work that most individuals aren’t used to managing
- You need the buyer to cooperate and use your financing
- It means you aren’t diversifying your investments, and you can’t redeploy your capital into assets that might grow over the course of the installment period.
3. Invest in Opportunity Zone Funds
In 2017, the U.S. government designated many distressed areas as Opportunity Zones in an effort to drive investment in housing, small businesses, and infrastructure in those regions.
When you invest in Opportunity Zones with the capital gains from the sale of an appreciated asset, you can take advantage of a number of tax benefits, including complete tax deferral until 2026, a tax rate reduction of between 10 and 15%, and full tax exemption on gains that happen within the Opportunity Zone investment.
When might an Opportunity Zone investment make sense?
You want to sell your business and reinvest in real estate without the overhead of managing the real estate yourself. (Opportunity Zone investments are typically done through an established institutional fund.)
What are the key tradeoffs?
- You do not gain any liquidity up front
- You have to reinvest in real estate — in specific distressed areas, to be precise — and can’t diversify your investments
- Opportunity zones are a new investment class with uncertain returns and concerns that the asset class has been over-invested in.
Small- and medium-sized businesses are a critical source of wealth building for many American families, and they offer many tax advantages. Schedule a time to chat with our team or get started setting up your tax-advantaged account (at no cost and with no commitment).
- Form 6252 Installment Sale Income
- Taxes When Selling A Business: Everything You Need to Know
- How to Avoid Capital Gains Tax on Real Estate
We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard to access tax advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.