Tax Planning when Selling your Business
The tax implications of selling your business are huge. There are a lot of decisions to be made, and the earlier your path is established, the less likely it is that tax issues will derail your sale. In this article, we will take a high-level look at these issues, and what to do about them, and then in a future series once a month, we will look at each of these decisions in detail.
Here are the basics of tax planning when selling your business.
Your Business Structure
A huge impact on taxes when you sell your business depends largely on the structure your business operates in. If yours is a C corporation, that means that you will actually be taxed twice when selling your business. The company will pay corporate income taxes on the sale before it is dissolved, but the owner will not have access to those funds right away.
Instead, the owner of the business (you) will have to pull their share of the money out of the company, and then pay individual income taxes on this amount.
Having an S-corporation structure means you won’t double pay taxes when selling your business, but it also means that every single year, your company taxes also impact your personal tax returns. If you do business in multiple states, this means you must file taxes in every state you operate in.
In this case, it may make sense to reorganize your company before you sell, but know that if you do, the IRS may take notice and investigate if the change is too close to the actual sale. This means you need to plan ahead. There are other tax issues depending on how your company is organized so be sure to talk to your business broker and a tax professional before making this decision.
Attribution of Goodwill when Selling your Business
Once a questionable practice, thanks to a court case won in 1998 by Martin Ice Cream. Essentially what this practice lets the buyer do is attribute some of the goodwill included in the price of the business to the company itself and the rest to the owner. Then they pay the owner that portion of goodwill directly rather than including it in the business purchase transaction.
So what’s the problem? Well, owner goodwill is often tied up in relationships with vendors or customers developed over the years, and these are often tied up in non-compete clauses. That means if you sign one, the goodwill is considered the property of the company, not the owner, and the IRS will not accept any implications to the contrary.
If you are retiring, a non-compete clause may not be an issue, but if you plan to continue in business, particularly the same industry, you may not be able to use this loophole.
The dream words for any entrepreneur, the question becomes are tax-free deals even possible? Well, first it is important that you understand that tax-free in this case actually means tax-deferred. Also, these deals can be quite complicated. They require that you take 40-100% of your proceeds in buyer stock, and once you sell that stock unless you roll it immediately into other qualified investments, you will be subject to 15-35% capital gains taxes.
There are rare ways to make a tax-free deal work, but they are just that: rare. Trying to move around the corporate structure, stocks, and other things to make a deal tax free often result in IRS red flags, almost a sure sign the deal will be flagged for an audit. For the most part, just understand that both seller and buyer will pay some taxes when it is time for selling your business.
Asset vs. Stock Sale
Most small businesses are asset sales, but it is possible that there is a stock sale or a combination of assets and a stock sale. How do you determine this when it is time for selling your business? The best advice is to talk to a professional.
The point is that there are tax implications to each, and how the deal is structured will impact who can depreciate assets, who pays capital gains on the sale of them, and how these costs affect the final offer from the buyer. Talk about these things early in the process. Don’t get down to the last part of the sale process only to have this decision impact the deal negatively.
Allocation of the Purchase Price when Selling your Business
This is another topic and one that deserves an article all to itself. Essentially, when selling assets you will pay capital gain taxes, either long term capital gains rates or short term. Usually, things like intellectual property and patents will qualify for long-term capital gains rates, generally much lower than short term rates.
The kicker comes in when you allocate which percentage of the purchase prices is attached to assets. If you attach too much as the seller, you may have to “recapture” some of the depreciation you have deducted for certain assets. If you don’t allocate enough, the buyer will not be able to depreciate those assets as much in future tax scenarios, resulting in higher liability on their part.
Thus the two parties are at opposite ends when it comes to this issue, and a compromise that is reasonable and works for both parties needs to be reached.
Tax Implications of Seller Financing
In the case of smaller businesses (the one’s business brokers usually deal with), if the seller elects to carry some of the financing, they can actually defer taxes until they actually receive payments. Of course, this comes with some risk, because if the buyer fails to run the business successfully, they might never get paid that portion of the purchase price.
However, if the business is an exceptionally large one, worth over 5 million, there are some restrictions on how the owner must deal with taxes. Also, remember that certain things like depreciation recapture and the sale of certain other assets cannot be legally deferred. Talk to your tax professional and your business broker about your individual situation.
Earnout and Contingency Payments
This is a tricky tax situation because if the buyer and seller cannot come to terms on a price, they can set up earnout or contingency payments based on certain milestones. However, those are not considered installments in the traditional sense, at least not by the IRS. That means the seller tax liability is higher upfront.
If the contingency payments do not come through as expected at a later time, the seller cannot retroactively count that capital loss against the original capital gains they paid on the initial sale, only to offset a limited amount of capital gains they have in that year. That could mean big losses down the road. However, if all milestones are met, the original payment of capital gains then pays off.
Deciding whether or not to set up this kind of sale will have a lot to do with seller confidence in both the buyer and the business itself.
State and Local Taxes
One of the reasons that you need a California business broker to sell a business based in California is that the tax laws in California are different than other states, and it is important that your tax professional and business broker are based where you live, licensed, and familiar with these unique laws.
Often, these tax laws do not mirror those of the IRS perfectly, and you may have more state tax liability than you think. This is another area where consulting a professional is vital.
Pre-Sale Estate Planning
If one of your goals is to leave some of the proceeds of the sale of your business to future generations, moving that equity to a trust long before the business sells is a much better way to set up those accounts rather than trying to move after-tax gains into those trusts following a sale.
Essentially, this is another area where planning ahead will keep you from being flagged by the IRS and even penalized. A financial planner or your tax professional, one who is familiar with estate law in your state and on a Federal level is the best way to protect yourself and your assets.
Does all this sound quite complicated? It is. Selling a business can be like adding another job to your already busy schedule. That’s why when it is time for selling your business in California, your first call should be to Rogerson Business services. We’d love to help you get the process started and help you get the most out of your business sale. Contact us today!