Disclaimer: The following information is intended to be a high-level overview of the taxable effects of a sale of a small business. It should not be viewed as tax guidance. You should consult a certified professional accountant (CPA) to understanding the tax liability you could incur from your sale in the context of your personal and business financial and tax situation and how you could reduce your tax obligation when selling your business.
Taxes are an important consideration in the sale of any small business. Here’s why: Proceeds owners receive from the sale are taxed as income. Quite often, large income payouts result in sizable tax bills.
Certain strategies can help you reduce your tax liability when selling your business. In this article, you’ll learn some of the most common tactics, though they may not all suit your business. Be sure to discuss them with your CPA before proceeding.
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Tactic 1: Avoid a lump sum payment
One of the best ways to save on taxes is to avoid taking the payment for your business in full and, instead, set up a payment plan for your buyer. Typically offered through seller financing, many savvy business owners arrange loans for buyers to borrow a portion of the purchase price and repay it with interest over a defined period of time.
One benefit of this arrangement is that it allows sellers to spread the income they’d receive from the sale over a period of several years. This move, which can help you decrease your total yearly income, might place you in a lower tax bracket and reduce your overall tax obligation on the sale.
Pro tip: As an added benefit, you may collect interest on financing you offer your buyer, which can help you come out even further ahead.
You can learn more about seller financing in our article, Smart Play: Seller Financing.
Tactic 2: Focus on capital gains
Sellers can also reduce their tax liability by ensuring that a portion of their business’s sales price is categorized as capital gains, which are taxed at a lower rate than other forms of income.
Capital gains are profits that owners earn from the sale of a business asset. With the help of an appraiser or tax expert, you’ll consider whether each asset being sold qualifies for capital gains or ordinary income. Those that qualify for capital gains must be further categorized as either a short-term or long-term capital gain. While it requires a great deal of work and negotiation with buyers (who often benefit more from ordinary income classifications than capital gains), this practice can result in significant tax savings for sellers.
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Tactic 3: Consider a stock sale
Another way that sellers can reduce their tax liability is by structuring their exit as a stock sale rather than a sale of assets.
When you opt for a stock sale, you may be able to report a portion of proceeds you earn from the sale as capital gains rather than ordinary income. How this might benefit your tax situation will depend on whether your business is structured as a C-corporation or an S-corporation. Speak with an accountant to determine whether a stock sale will result in a favorable tax outcome for your unique situation.
Pro tip: Stock sales are another instance where the benefit may favor the seller over the buyer. You may need to work with the buyer to come to an agreement that benefits both parties, such as agreeing to sell for a lower price but structuring the deal so that the after-tax income is more favorable for you.
Important note: Watch out for depreciation recapture
Depreciation recapture occurs when an asset is depreciated below its market value and then is sold for a value greater than its book value. Depreciation recapture is taxed as ordinary income and cannot be spread across multiple years.
In asset sales, the difference between book value and lesser of the sale price or the original purchase price is taxed as ordinary income. But, if the asset is sold above its original cost, the difference between the purchase price and the sale price is taxed as capital gains, which may be more favorable for your tax situation. Your accountant will help you to work through this scenario if it’s relevant to you.
Thinking about how you’ll manage the proceeds of your sale? A wealth advisor can help. Speak with a wealth advisor who can help you to plan your retirement spending, taking into account your expected social security and investment income.
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