Key takeaways
Taxes can impact both the transaction and the proceeds from the sale.
Understand how federal and state taxes will apply, as well as other potential taxes, such as estate tax.
The structure of your business, the classification of the sale and the terms of the sale will all affect how the sale is taxed.
The ultimate payoff for most successful business owners is the ability to pass it on to their children or sell their business and achieve their financial objectives. In many cases, the timing of this is closely related to a planned retirement date.
The decision to step away from your business can be an emotional time and is an important transitional period if you’ve dedicated much of your life to it. You might be inclined to focus most on determining an acceptable sale price. A far more important issue is how much you’ll ultimately get to keep from the sale. The biggest variable is the tax implication of the transaction.
You might be focused on determining an acceptable sale price, but a more important issue is how much you’ll get to keep from the sale. The biggest variable is how taxes will impact the transaction.
Without proper planning, the tax implications can be significant. Here are six questions that can help you determine the tax impact of your sale.
The sale of a business usually triggers a long-term capital gain for the seller and federal capital gains taxes will apply. As an example, if you started your business 20 years ago with an investment of $100,000 and sell it today for $10 million, your long-term capital gain is $9.9 million (the selling price minus your original cost basis). A federal capital gains tax of 20% would apply, reducing the net proceeds from the sale to just over $8 million.
State income tax is also a consideration. For example, residents of California could be liable for a tax of 13.3% on the capital gain from the sale of the business. Using the example of the sale above with a capital gain of $9.9 million, the net proceeds to the seller after federal and state taxes would be $6.6 million. Some states don’t have a state income tax and conducting your sales transaction while residing in those states has obvious advantages for the seller.
The structure of the business has notable tax implications. The most common business structures are:
The first three listed above are considered pass-through entities, in which individual business owners pay taxes on the company’s profits and any profits generated from the sale of the business. Taxes are not assessed at the company level. By contrast, tax implications with C Corporations can be more complex (see below). The structure of your business will influence the type of sale that’s more beneficial for the business owners.
The sale of a business can be classified in one of two ways: an asset sale or a stock sale. An asset sale involves selling the assets of the company, while a stock sale is the sale of the company stock to an acquirer.
Buyers often want to purchase assets because that offers them significant tax advantages. In a pass-through structure (LLC, partnership, S Corporations), the seller generally won’t incur any additional taxes by characterizing the sale as one of assets rather than the company’s stock.
If you operate your business through a C Corporation, things get more complicated. In this case, it may be preferable to sell the stock of the company rather than its assets to avoid double taxation, minimizing tax implications at both the corporate and shareholder level.
For example, if assets are sold for $10 million (with a cost basis of $100,000), the company would realize a $9.9 million capital gain. This would result in federal and (if applicable) state income tax that could reduce the net proceeds of the sale to approximately $7 million at the company level. The proceeds are then distributed to shareholders, who would pay a dividend tax of at least 15% plus any state income taxes on the distribution. For the shareholders, this can bring the total tax impact of the sale to something in the vicinity of 50% of the profit from the sale.
By contrast, if it’s a stock sale, that’s a payment directly to the shareholders with no transaction involving the company directly. Shareholders then would pay applicable federal capital gains taxes and state income taxes on the appreciated value of the shares they sold. If you own a C Corporation, negotiating a stock sale will make a significant difference in your net return from the sale.
Buyers will typically seek to purchase a company’s assets for the tax benefits they can accrue, such as allowing the buyer to deduct the purchase price.
Consider a business that chooses to sell its assets for $20 million, with $5 million attributed to the value of equipment and the remainder to goodwill. The buyer can claim an immediate $5 million tax depreciation deduction and amortize the goodwill over 15 years on a straight-line basis ($1 million tax deduction each year for 15 years).
With this approach, buyers get a 100% tax deduction of their purchase (over a period of years), which reduces future taxes payable on future taxable profits. To sellers of pass-through entities (LLCs, partnerships, S Corporations), the sale of assets (as opposed to selling the stock of the company) will generally not have an adverse bearing on their tax liability from the sale. However, for owners of a C Corporation, a stock sale is critical to avoid the double taxation scenario outlined in #3 above.
In certain circumstances, it can be more efficient to structure the transaction as a stock sale. In cases where the business has material contracts that require third-party consents on the sale of assets, a stock sale may be preferred to avoid the need to secure such consents before closing the sale.
When selling your business, you can expect to be offered terms that may contain one or more of the following forms of consideration:
Note that in any transaction that’s not all cash, the seller takes on added risk; as a result, they should discount the expected value of any form of consideration other than cash.
On the other hand, if payment of a portion of the purchase price is delayed, the seller may have time to modify potential tax considerations after the sale closes. In this scenario, a potential strategy would be moving to a state with no income tax to minimize taxes payable on the receipt of future payments.
Proceeds from the sale of a business can be significant, and if a business owner dies, that could leave a sizable estate subject to tax. As you prepare to sell your business, make sure you have an up-to-date estate plan in place. Estate taxes can ultimately prove to be as much of an issue as income and capital gains taxes.
It’s notable that 12 states and the District of Columbia impose their own estate tax, which are paid in addition to any federal estate tax. The exemption levels vary and can reach as high as $13.61 million (the current federal estate tax exemption amount). The state estate tax is generally charged based on the state an individual resides in at the time of their death.
Planning for the sale of your business involves understanding the tax implications and financial complexities of the transaction. A team of professionals, including financial professionals, tax advisors and business and estate attorneys, can make a big difference in setting the stage for a successful process.
Find a financial advisor that works with business owners in your area.
While a business can be valued in several ways, there are steps you can take that may help you impact its appeal to potential buyers.
If your assets are worth over a certain amount when you die, they could be subject to estate tax. Fortunately, there are ways to reduce your tax liability and protect your hard-earned wealth for future generations.
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