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Taxes When Selling A Business: What You Need to Know

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 the implications you might have on taxes when selling a business. And how to take advantage of the unique tax advantaged options to sell it!

How Are Business Sales Taxed?

When it is time to sell your small business, there are a lot of things to take into account from finding a buyer, determining if you’d like to sell a majority or minority share of your business but potentially the most overlooked area is understanding the tax implications of your business sale. There are a variety of taxes on selling a business that can apply, depending on how the sale is structured and what type of business is being sold.

In most cases the primary tax you should be concerned with is the capital gains tax (in most cases income taxes won’t apply). In this article, we’ll discuss the basics of selling a small business, including how taxes are paid and which taxes may apply. We’ll also cover some tips on structuring the deal to minimize taxes owed.

What are Capital Gains Taxes on a Business Sale?

Capital gains taxes are taxes on the profit from the sale of an asset. When you sell your business, the capital gain is the difference between the selling price and your “basis” in the business. The basis is typically the original cost of acquiring the business, plus any improvements made to it over the years. If you have owned the business for a long time, or the business has significantly improved, your capital gain may be large.

Fortunately the capital gains tax rate is typically lower than the income tax rate, but it’s important to understand how this tax applies when you’re selling your business and what you can do to lower it. Capital gains taxes are only owed on the portion of the sale price that is above your basis in the business (if you sell your business for less than your basis, there is no capital gains tax owed). The capital gains tax rate starts at 15% but can go as high as 40% if you are in the highest tax bracket.

Here’s a quick example about the capital gains tax you face when selling a business. Devon, a client of ours who owns an insurance company in California, was planning to sell his company for $3 million and expected to owe about $1.1 million in capital gains taxes on the sale of his business, only leaving him with $1.9 million from his life’s work. With Valur’s help he was able to structure the deal to avoid taxes when selling his business and reinvest the entire $3m, which is expected to create an additional $11m for Devon and his family over the course of their lives.

Considerations for Small Business Owners: How to Structure the Deal to Avoid Taxes

It’s important to structure the deal in a way that minimizes taxes for selling a business. A couple of simple upfront steps can create life-changing wealth for you. There are 3 common approaches:

1. Sell Via a Charitable Remainder Trust

With a Charitable Remainder Trust, or other CRUTs, 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 CRUT 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

Consider checking out our CRUT overview. And if you’d like to learn even more, take a look at a customer case study and our calculator, with which you can estimate the expected return on investment from a CRUT.

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 on buying your business. 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 on the sale of the business.

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 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 key 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 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.

FAQs

Do you get taxed for selling a business?

Yes, taxes are typically owed on the sale of a business. The primary tax you should be concerned with is the capital gains tax. The capital gains tax rate is typically lower than the income tax rate, so it’s important to understand how this tax applies when you’re selling your business. Capital gains taxes are only owed on the portion of the sale price that is above your basis in the business. If you sell your business for less than your basis, there is no capital gains tax owed.

If I sell my business how much tax will I pay?

This is a difficult question to answer without knowing more about your specific situation. Generally, you will owe capital gains taxes on the sale of your business. The capital gains tax on sale of a business starts at 15% but can go as high as 40% if you are in the highest tax bracket. However, there are a number of ways to structure the sale to reduce that

Is there an exemption from capital gains taxes on the sale of a small business?

There is an exemption from capital gains taxes on the sale of a small business, known as the Qualified Small Business Stock (QSBS) exemption. To qualify for this exemption, the business must be a C-corporation and have less than $50 million in assets. The QSBS exemption applies to the entire sale price of the business, including any goodwill that is included in the sale. To learn more and see if it applies you can check out this article (link to QSBS primer)

How are capital gains calculated when selling a business?

The calculation of capital gains on the sale of a business is relatively straightforward. You simply multiply the gain (the proceeds from the sale minus your basis in the business) by the capital gains tax rate. So, for example, if you sell your business for $5,000,000 and have a basis of $500,000, your capital gain would be $4,500,000. At a capital gains tax rate of 30%, you would owe $1,350,000 in taxes on the sale.

How is goodwill taxed when selling a business?

Goodwill is not a tax-deductible expense, so it is included in the total sale price of the business. The capital gains tax when selling a business applies to the entire appreciation above the basis, including the goodwill.

What is basis in a business for tax purposes?

Basis in a business for tax purposes is the amount of money that you have invested in the business. This includes the purchase price, plus any improvements or additions that you have made to the business. When you sell the business, you will calculate your gain or loss by subtracting your basis from the sale price. If you sell the business for more than your basis, you will owe capital gains taxes on the gain. If you sell the business for less than your basis, there is no capital gains tax owed.

Conclusion

Now that you understand the basics of taxes when selling a business, it’s time to sit down and think through your situation and the ways you can structure the sale in order to minimize taxes owed, so it’s important to find the right solution for you. Valur can help you navigate these waters and make sure you’re getting the most out of your hard-earned business.

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About Valur:

We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy. Schedule a time to chat with our team and learn more about how we can help you!