No California small business owner likes discussing taxes, and they certainly do not enjoy paying them. However, that does not change the fact that taxes are a part of everyday life, especially in the commercial world.
Knowing the ins and outs of the tax code can be advantageous for small business owners; however, a small business typically lacks the time to study and understand all these details.
Your CPA or tax preparer may not have the time to give you the complete picture of the amount of tax you have to pay as their skill is focused on preparing and filing tax returns to keep your California small business from attracting either an IRS audit, an audit by the Franchise Tax Board (FTB) if you are in California, the California Department of Tax and Fee Administration (CDTFA) if you collect and submit California sales tax, the Employment Development Department (EDD), or some other California State agency with the legal right to examine your financial statements.
The stakes are even higher if you are a small business owner considering the sale of your California-based business.
As you may have guessed, there are taxes on selling a small business. That begs the question: if I sell my small business, how much tax will I pay?
Sell a Small Business in California, Now What?
When you sell your California small business, the Buyer will typically bring a cash down payment, which you receive at the close of escrow when the transaction closes. Federal and state taxes are then due on that money in the year the business sale closes.
As the Seller of the small business, if you provide any Seller finance, the tax is not due and payable until you receive that money, and in the year you receive it. For example, if you carry Seller Notes for 5 years and are paid monthly, the tax is not due on that money until the Buyer pays it to you, and in the year you receive the payment.
Price Allocation
One of the requirements when closing the sale of a small business is for the Seller and Buyer to agree on the Purchase Price Allocation of the business. As the owner of the business, you have been allowed to write off business expenses for tax purposes; this includes being able to depreciate hard assets or, if you bought the business previously, get a tax benefit on the goodwill of the business you purchased with a deduction called Amortization.
Now that you are selling the business, the IRS requires the Seller and Buyer to negotiate and agree on a tax structure that takes effect upon the closing of the small business sale. To report the agreed-upon tax structure, the IRS requires the Seller and the Buyer to each submit IRS Form 8594 in the year the sale of the business closes. A Seller and Buyer can each complete this form themselves, but it is typical for the CPA to assist them.
One of the things to know about selling a small business is that the Internal Revenue Service is not so much interested in the sale of your small business name, but more so in the value of your business assets.
Business assets include properties and tangible items of value that the IRS will want to tax. Therefore, both the Seller and the Buyer must separately complete and submit IRS Form 8594. In theory, you could pay less in taxes by selling your small business name or stock, but the Buyer will want to negotiate this with you, as it may leave them in a poorer tax position.
Capital Gains Tax on the Sale of a California Small Business
Another factor to consider is the capital gains tax on the sale of a small business, which leads us to capital gains tax strategies for selling a business. Without capital gains tax strategies for selling your business, you could pay the IRS and the State of California a lot of the sale price of the business. Take this into account as part of your company exit planning before selling your small business.
When you sell a small business, you will most likely have to pay some portion of the capital gains tax. Capital gains refer to the profit made from an investment. In some cases, part of the capital gains tax on the sale of a business can be avoided or reduced.
Capital gains on the sale of a small business can be reduced through the proper structuring of the Definitive Purchase Agreement. The structure of your Definitive Purchase Agreement is crucial for understanding how to avoid capital gains tax on business sales. However, bear in mind that what is beneficial for the Seller is typically not in the best interest of the Buyer, and this is part of the negotiations when selling a small business in California.
Another thing to keep in mind is that, in most cases, you will not have to pay 100% of your capital gains tax. Typically, individuals are only required to pay around 50% of their capital gains. There are other strategies, though; we will explain these shortly.
Farms, fishing businesses, and small business corporations can qualify for a significant deduction on capital gains tax. For example, if you own and sell farmland with farm equipment, tractors, etc., you may be eligible for a capital gains deduction that will exempt you from paying income tax on the sale.
How Is Goodwill Taxed When Selling a California Small Business
At this point, you might be asking yourself, How is goodwill taxed when selling a California small business? That’s a great question! The tax treatment of small business goodwill sales can significantly impact the amount of taxes you will owe after selling a business.
Find out more about how goodwill tax works when selling a California medical practice.
When someone buys a business, it typically includes an item called goodwill. The typical method for calculating the amount of goodwill involves assigning a value to all tangible assets, such as Fixtures, Furniture, and Equipment, as well as inventory and leasehold improvements. This is followed by assigning a value to intangible assets, including the covenant not to compete and Training. Finally, simply allocate the balance of the purchase price to goodwill.
If the business’s goodwill is considered personal goodwill, it is taxed at an individual shareholder level, which means the rate is more favorable. However, if it is not regarded as personal goodwill, you could incur double taxation, in which you are taxed at both the corporate level and individually. This also depends on the legal entity of the business, such as whether it is a C Corporation, an S Corporation, or an LLC.
Managing the Tax Implications of Selling a Small Business
When it comes to managing the tax implications of selling a California small business, you could consult with a tax attorney or your CPA, or both.
Introducing Mr. Ed Cotney from Olympus Tax
While these tax professionals can help you save some money, Rogerson Business Services would like to introduce you to Mr. Ed Cotney, who owns and operates Olympus Tax.
I’ve known Ed Cotney for about eight years, and when I’ve a question about how to save a California business owner some tax when selling their business, I always mention Ed Cotney and the service he provides.
Ed is an interesting guy as he has a funny accent. Well, it is probably not too funny if you were like Ed and came from Alabama.
One of Ed’s motivations in life is to help small business owners pay as little tax as possible when selling their businesses in California. Ed offers to provide consulting services to the business owner and provides a written report outlining his recommendations, which the business owner can choose to hire him.
It will require the business owner to make decisions before selling the small business, such as whether the Buyer is willing to work with the Seller or, more typically, leaving the Seller to execute some tax-saving strategies after the business sale closes.
Selling a small business does not necessarily mean that you will have to pay an arm and a leg in taxes. If you structure your sales contract properly, file everything promptly and accurately with the IRS, and consult with a professional, you should be able to save a significant amount of money.
One Final Tip
Be sure to do everything by the book so you can enjoy the gains you made from selling your business and move on to the next phase of your life.
Want to learn more in an email tutorial program? Get started on a 7-step tutorial guide showing you best practices in how to sell your California small business successfully. Link here: https://www.rogersonbusinessservices.com/sellingyourbusiness/
