What are the tax implications of selling a business?

Planning for the tax implications of selling your business is an essential part of maximizing your financial outcome. Many business owners underestimate the tax impact which can lead to unexpected financial strain.  In this article, you will learn about some of the top tax considerations involved in selling a business, highlighting the importance of structuring the deal optimally to reduce tax liabilities.

This content is meant to illuminate the importance of strategic tax planning, but should not be considered tax advice. Depending on the specifics of your business and the deal other tax implications may apply than what is covered here.  You will want to ensure you get personalized tax advice from a qualified tax professional, a key member to have on your expert team.

How the sale of a business is taxed

Capital Gains vs. Ordinary Income

A business sale is taxed at ordinary income rates or capital gains rates based on the nature of the assets sold and the duration for which they were held.

Capital Gains Tax

• Sale of business stock or ownership interest: When a business is structured as a corporation and the stock is sold, the gain is usually treated as a capital gain, provided the stock was held for more than one year.
• Sale of capital assets held more than one year:  Assets such as real estate or other investments held for more than one year before the sale are subject to long-term capital gains rates.

Ordinary Income tax

• Sale of inventory or other business assets used in operations: These are taxed as ordinary income because they are part of the regular course of business activities.
• Depreciation recapture: When tangible assets, like equipment, that have been depreciated are sold, the portion of the gain equal to the depreciation previously taken is taxed as ordinary income, known as depreciation recapture.
• Assets held for less than one year: Assets sold within a year of acquisition are typically taxed at ordinary income rates because they are considered short-term capital gains.

Asset vs. Stock Sale

When selling a business, the choice between an asset sale and a stock sale carries significant tax implications for both the seller and the buyer. Sellers often lean towards a stock sale because the profits from such a sale are generally taxed as long-term capital gains, which are considerably lower than the top bracket of ordinary income at the Federal level.

Buyers, however, typically favor asset sales, where they purchase specific business assets like equipment, inventory, and customer lists. This preference is due to the tax advantage of depreciating these assets immediately, creating tax deductions that are not available in a stock sale. In a stock sale, the buyer acquires the entire company, including all assets and liabilities, and can only recover the investment through the eventual sale or liquidation of the company.

While asset sales can offer tax benefits to buyers, they often result in a higher tax burden for the seller, since some parts of the sale proceeds may be taxed at the higher ordinary income rates. The complexity and potential higher tax cost of asset sales for sellers means that sellers may want to find a buyer who is willing to offer more attractive terms or a higher valuation to compensate for the seller’s increased tax liability.

Qualified Small Business Stock (QSBS)

The Qualified Small Business Stock (QSBS) provision was established to encourage the growth of small businesses and, by extension, the broader U.S. economy, through tax incentives for individual investors in these enterprises. Noncorporate shareholders who invest in small businesses can, under certain conditions, exclude up to 100% of the capital gains from the sale of their QSBS from their taxable income.

To be eligible for QSBS status, the stock must originate from a domestic C corporation whose total assets did not exceed $50 million at any point from August 10, 1993, or from the inception of the business, up to the date the stock was issued. Additionally, the taxpayer must acquire the stock at its original issuance and hold it for a minimum of five years.

Who pays sales tax on a business sale?

In the sale of a business, the responsibility for sales tax can depend on the specific assets being transferred and the state laws governing the transaction. If the sale structure is an asset sale, sales tax may be applicable on the transfer of tangible property (like equipment, inventory, and furniture) unless a specific exemption applies. In a stock sale, typically there is no sales tax since stock transfers are not considered tangible.

Generally, the buyer is responsible for paying sales tax on the purchase of taxable business assets. However, the seller may have the obligation to collect and remit the sales tax to the state tax authority.  In some cases, the parties may negotiate who will bear the burden of the sales tax as part of the overall transaction terms.

Sales tax laws vary by state, including which assets are taxable and the applicable rates. Some states may exempt certain types of business asset sales from sales tax, while others may tax the majority of the business assets sold.

How is inventory taxed when selling a business?

When selling a business, inventory is taxed at ordinary income tax rates and is not subject to capital gains treatment. Inventory is considered property held for sale to customers by the IRS.

For the seller, the sale of inventory is taxed as ordinary income to the extent that it represents a markup over the basis.  The basis is usually the cost of acquiring the inventory. The profit on the inventory—the difference between the sale price and the basis—is taxed at the seller’s ordinary income tax rates.

After the purchase, when the buyer subsequently sells the inventory in the normal course of business, the cost of the inventory sold (which is the basis from the purchase of the business) is deducted from the sales revenue to determine the profit on the sale of that inventory, which is then taxed as ordinary income to the buyer.

The negotiation process may involve discussions on whether to value the inventory at its cost, the lower of cost or market value, or some other basis. Sellers should be aware that holding a large amount of high-value inventory at the time of sale could result in a substantial tax bill due to it being taxed as ordinary income, not capital gains.

How do you record goodwill in a business sale?

Goodwill represents the intangible value of a company above and beyond its tangible assets and liabilities. In a business sale transaction, the accounting treatment of goodwill varies depending on whether the deal is structured as a stock sale or asset sale.

Does goodwill impact taxes?

For a buyer involved in a stock sale, goodwill is part of the overall investment in the company’s stock and cannot be separately identified or written off for tax purposes. Consequently, the buyer does not receive a tax deduction for goodwill in a stock purchase scenario.

In contrast, in an asset sale, the buyer allocates a portion of the purchase price to goodwill.  This allocated goodwill can be amortized, meaning it can be deducted as an expense incrementally over a 15-year period for tax purposes.

Because buyers gain a significant tax advantage from the amortization of goodwill in asset purchases, sellers will want to keep this in mind as they sign off on a letter of intent and head into negotiations..

Advantages of Stock Sales

Section 1202 – Small Business Stock Gains Exclusion

Under certain conditions, sellers of small business stock can gain a notable tax advantage through Section 1202, also known as the Small Business Stock Gains Exclusion. This provision permits the exclusion of a significant portion, and potentially all, of the capital gains from the sale of qualifying small business stock from taxable income. The criteria for this exclusion require the stock to be from a domestic C-corporation, subject to certain limitations, with the exclusion capped at the lesser of $10 million or ten times the stock’s adjusted basis.

The extent to which capital gains can be excluded depends on when the stock was originally issued. Gains that qualify for exclusion under Section 1202 are not subject to the 3.8% net investment income tax, nor do they trigger the alternative minimum tax (AMT). While this provision may not apply to every seller, it represents a significant tax-saving opportunity that should not be overlooked. Those selling stock in a C-corporation are strongly advised to consult with a Certified Public Accountant (CPA) to explore this beneficial option fully.

Tax Deferral Strategies For Small Businesses

When selling a business, you may choose to structure the deal to minimize immediate tax liabilities. One common way to do this is with an installment sale.

What is an installment sale?

If you as the seller receive at least one payment beyond the year of the sale your transaction is classified as an installment sale. This method can spread tax liability over several years, aligning income recognition with the receipt of payments, which may lead to potential tax savings and better cash flow management.

In an installment sale, interest income becomes a key consideration as it impacts the overall financial and tax implications of the deal. The seller typically charges interest on the deferred payments, which is reported as interest income and taxed as ordinary income. This interest compensates the seller for the delayed receipt of the sale proceeds and the associated risk of extending credit to the buyer.

The Internal Revenue Service (IRS) has established minimum interest rates for installment sales, known as the Applicable Federal Rates (AFR), to ensure that the seller charges a fair interest rate. Charging interest at or above the AFR prevents the transaction from being treated as a below-market loan, which could result in unfavorable tax consequences.

Interest income from an installment sale is taxed separately from the capital gains on the sale of the business assets or stock, and it can increase the seller’s overall tax liability.

Important note:  Installment sale treatment cannot be used for the sale of inventory or accounts receivable. Additionally, there exists the inherent risk of buyer default in an installment sale, which must be carefully evaluated and mitigated through thorough due diligence and potentially securing the payment with collateral or guarantees.

Unexpected Tax Consequences

While not comprehensive in nature, this list below outlines some of the unexpected tax consequences that can arise in the sale of a business.  Consult with professionals throughout your planning process and transaction to ensure you are well versed in what applies for your situation.

• State tax laws:  State tax laws vary widely and should be factored into any sale. You may have to pay state income and capital gains rates, and some states have different rules on specific programs, such as whether or not they recognize QSBS.
• Liquidating dividend:  A liquidating dividend occurs when a corporation returns capital to its shareholders as part of winding down the company, either partially or fully. Without expert guidance on a stock exchange, there may be double taxation on the sale of the business.
• Phantom Income: income that is reported for tax purposes despite the seller not actually receiving cash or tangible payment.is known as phantom income.  The seller will pay tax on income they do not yet have, such as imputed interest of a balloon note receivable or an installment sale.
• Estate tax consequences:  Depending on what you decide to do with the proceeds of the sales of the business, it will likely affect your estate taxes.  Are you planning to gift the proceeds?  Make a charitable contribution?  Consulting with an experienced wealth manager before you make these decisions can help you maximize the tax benefit.

Selling a business involves complex tax considerations that can significantly affect the financial outcome. Owners must carefully prepare for the sale by planning and consulting with a tax professional for specific advice.  Ensuring a thorough understanding of these aspects can lead to better deal structure, informed negotiations, and a more favorable financial result from the sale of a business.

At Avion Wealth, we regularly work with tax professionals to help guide business owners in making tax planning decisions that fit with their overall wealth management plan. Find out what steps to take next to ensure you will be able to sell your business while maximizing your wealth.  Schedule a call with one of our Certified Financial Planners™ today.