Today, we’re going to go over the various tax considerations when selling a business. Let’s get started.
Selling a Business in One Transaction
This is a traditional sale that is completed in a single transaction. There are several pros and cons to it, and it might be the optimal solution for some sellers. However, it does create some headaches for sellers in the long run.
When you sell a business outright, you get a very large lump sum. When talking about middle-market businesses, that sum is typically around ten to fifteen million dollars.
Getting that large of a payment all at once might seem like an attractive deal, but it has some drawbacks that you have to be aware of.
The main drawback is that you’ll be on the hook for all your tax liability immediately. We’ll get into the two types of tax liability you can deal with later on, but if you end up getting a capital gains tax, that’s 15% of your payout. If you are taxed as if it’s normal income, you’ll be on the hook for 37% of what you sold your business for. That’s more than one-third of the massive payment you expected to receive. Then, you also have to consider that it limits the type of buyer you can appeal to. Many buyers rely on a seller’s agreement; this is essentially “financing”, or a payment plan between the seller and the buyer. If you only want to receive a lump sum, you’ll limit your sale to people who can pay outright.
However, there are more benefits to it, too. Besides limiting the people who can afford your business and having to pay more for taxes upfront, you can gain peace of mind knowing the business is no longer your problem, and anything that happens with it going forward is none of your concern.
Believe it or not, that can be a major benefit. Not all businesses succeed after they’re purchased, and as you’ll see soon, some sellers are greatly impacted by that risk.
In general, this is a great option if you are ready to get out, aren’t worried about maximizing your profit as much as possible, and don’t want to take any unnecessary risks. If you are looking to squeeze out every possible profit, you’ll be better off with a different option in some cases.
Using a Seller’s Note or “Seller Financing”
As we mentioned earlier, some sellers choose to use a Seller’s Note. This is an agreement that allows the buyer to pay in payments over time. This has a huge impact on your tax liability, and it’s an option that you really want to consider.
When you sell your business this way, you don’t receive the full payment all at once. You get it in installments. This means that you’re not responsible for the full tax liability all at once. Since you’re receiving smaller payments in intervals, you’re only liable for smaller tax portions with each payment. In the end, this does add up to what you would pay with one transaction, anyways. The rates for personal income and property gains are the same even with this sale method.
However, you get to defer your tax payments until each payment comes in. As long as you’re responsible enough to set aside money to cover those taxes each month, quarter, or whatever you agreed to, that means you can hold off on paying a massive sum all at once.
There are other benefits to this method besides taxes, too. You can charge your buyer interest that adds considerable value to your sale (make sure you pay taxes proportionate to that interest, though), and you can charge more for the total transaction since you’re allowing it to be paid off in payments. So, it’s not all about deferring tax payments.
Unfortunately, there is more risk with this method. Your buyer has to consistently profit from the business to afford to pay you. If they don’t manage to make the business profitable, you might not get your payments on time or at all. So, you definitely need to vet your buyers before committing to this type of sale, and sometimes, it might be safer to just do a lump sum payment.
Alright, this one isn’t exactly a sale, but it can allow you to somewhat sell the business and relieve yourself of duty.
A business merger is when your company is absorbed into another company, but it maintains its own identity. At least, it usually does.
Planning your exit with this method is a little more difficult if you want to profit, but there’s a major tax benefit you’ll enjoy if you put up with the extra work; business mergers are tax-free.
By taking the business merger method, you might not profit as much, and you might need to work a little harder to make your exit instead of simply walking away, but you won’t have to deal with any of the tax-related stress that comes from selling a business in most situations. Because of that, this can be the optimal way to sell; especially if you’re having trouble selling the business outright and don’t want to worry about the risks involved in using a Seller’s Note.
Tax Considerations Outside of the Method of Sale: How the IRS Determines Tax Liability
The way you sell your business isn’t the only factor that affects your business. There are several other factors you must consider if you want to make the taxation process go smoothly and in your favor.
In this section, we’ll explain the various ways the IRS looks at tax liability.
You Influence the Method of Taxation, but You Don’t Control it:
First and foremost, understand that you don’t control the way your business is taxed. You can’t tell the IRS “I want to be taxed on capital gains because it’s cheaper”. It doesn’t work that way.
However, you can make decisions that give you the outcome you’re looking for, and there is some wiggle room with the IRS rules.
Understanding those rules fully is the key to maximizing your profits and navigating them legally and ideally. That’s why we highly recommend getting professional help with your business sale.
Capital Gains vs. Personal Income:
This is a major factor in how heavily you’ll be taxed. Depending on the assets you’re selling, you might be taxed on your capital gains, or you might be taxed as if you just made a normal income. Getting taxed for capital gains is far more ideal than getting taxed as if you just made normal income.
This is because the capital gains tax is far lower than the personal income tax. With capital gains, you’ll only be liable for a maximum tax cost of 15% on the transaction. If that sounds steep, consider the fact that personal income can be taxed up to 37%. That is more than a third of the profit you’re earning from the business.
How does the IRS determine your liability, though?
Well, it essentially comes down to how long you had the asset. Any asset you’ve had for more than a year falls under capital gains. This is why most businesses are sold as separate assets rather than one large package. Most of the assets would count as capital gains if not all of them.
This is the most basic way that capital gains and personal income are distinguished, but there is a wiggle room for you to work with to get as many of your assets counted as capital gains as possible.
Selling as Stocks and Shares:
You don’t have to sell your business as assets. In fact, sometimes it’s inefficient to do so. In that case, you can sell it as stocks and shares. This is a decision that has to be weighed extensively before committing, because both assets and shares have their own advantages and disadvantages.
If you sell your business as assets, you’re not just taxed once. Unfortunately, you’re taxed once for the transaction, and then you’re taxed when all of your shareholders file their returns. While you’ll be eligible for capital gains taxes in most situations, that second taxation phase can be far more expensive in some cases when shareholders are involved.
If you sell your business as shares, you get the opposite experience. You won’t be qualified for capital gains taxes, because shares are treated as normal income by the IRS. However, you’ll only get taxed once.
As you’ve probably figured out, this makes the decision highly dependent on your shareholders, how much they’ll be making in returns, and whether or not it’s cheaper to just pay the personal income tax than to pay capital gains taxes AND pay taxes again when your shareholders report their profits from the sale. Obviously, that’s something that will vary depending on the situation, and we can’t recommend one route over the other unless we understand the position you’re in as a seller.
Tax deferments are possible when you accept payments for a sale. We touched on this earlier, but the concept is a little more complex.
When you sell your business in payments, you don’t defer the taxes entirely. You’ll still be paying taxes on each transaction.
Since taxes are handled in percentages, you will still end up paying 15% or 37% (depending on whether you pay capital gains or personal income taxes respectively), but you’ll be paying it over time. This offers you the same benefits it offers the buyer who doesn’t have to pay everything upfront.
You’ll be liable for much smaller tax sums at a time, and they’re spread out depending on your payment structure. This can help you with post-retirement financial management, allow you to charge more for the sale along with interest on each payment, and more. Ultimately, you can make more money AND have the taxes spread out over time.
What You Should Do to Optimize Your Tax When Selling a Business
Selling a business is an extremely complicated process. Every business has accumulated assets over the years. Whether those assets are websites, software solutions, merged companies, equipment, brand names, brand imagery, or contracts with other companies, your business’s assets are completely different from any other business’s assets. Even your share structure is different.
It’s simply too complex of a situation for us to give you a one-size-fits-all answer. What perfectly optimizes a business seller’s taxes in one situation, might cost another seller millions of dollars. On top of there being many different assets for you to sell, each of those assets can have its own complex structures and circumstances.
Because of this, we highly recommend reaching out to a professional M&A advisory service that specializes in helping business owners just like you to get the most out of every sale. Not only can they help you optimize your tax liability, but they can take you through the entire selling process and the post-sale process to ensure your life’s biggest earning event is a positive one.