Understanding Tax Issues When Selling a Business

Tax issues can be a complicated matter no matter what field you are in. Countries usually have different tax laws depending on what kind of economic structure they operate in. In the context of business, selling it can be a success for the entrepreneur because that means it has grown to the point where someone is willing to pay good money for it. However, the sale of the business entails taxes, which can be trickier than just individuals trying to understand what taxes they have to pay for the whole year.

What is important to keep in mind here is that selling a business in itself is considered an income source, and therefore, you will be earning money. Naturally, the government will have to deduct a certain portion from the income, which is the tax due.

Things to Consider

There is a myriad of things to consider when you want to sell your business, whether it’s planning for a smooth transition from one owner to another or the company rules and regulations that might be modified once administration changes. The structure of the business can also change; however, the majority of those who buy businesses from entrepreneurs usually settle with the exact same operations to be able to generate income as soon as possible.

In terms of taxes, you should note that there are certain tax deductions that you can take advantage of so you get more money in your pocket once the transaction is done.

1. Business Valuation

Most business owners and entrepreneurs don’t even know the real value of their business. It is crucial that you perform a business valuation before you decide the price range at which you are willing to sell your business to others.

Business valuation includes the current resources or assets being used, the business’s selling point, as well as the whole potential income that each product can generate all year. Naturally, selling a business usually starts with negotiation, and it is at this point that knowing your business’s value will play an important role in order for you not to get ripped off during the negotiations. This way, you have a benchmark in mind, and you can ensure that you won’t be on the losing end of the bargain.

This is not only useful during a full-scale sale between a seller and buyer. Business valuation is also important in certain instances such as company mergers or consolidation, or in establishing partnerships. This is logically the first thing to do when you’re planning to sell your business; knowing your business’s worth, you will have more leverage during negotiations.

2. Capital Gains

Most of the taxes you’ll be dealing with in terms of selling your business will come from your capital gains tax. Capital gains tax is the tax payable on the sale of your capital property, that is, properties that are not intended for sale in the regular course of your business, such as properties, investments, and the like. For example, if you bought an investment in 2013 and sold it in 2022 at a much higher value, then a capital gain occurs since you sold your investment for more than what you paid for it. This gain is being taxed since you are gaining income from the transaction.

Once capital gains tax is due, the total payment you have to make will be calculated according to how much money you made on that deal. Keep this in mind because when totaling the whole asset of your business, capital gains tax will greatly affect how much you’re going to pay in total. Other taxes, however, are usually taken from ordinary income.

3. Installment Sales

An installment sale is when the business's buyer will have to pay an installment payment past the sale date. This will have to be separated and broken down in the tax report so it doesn’t get mixed up with regular income tax, as the taxes taken from installment sales can only be considered capital gains tax.

This method essentially works by spreading out the income through the whole year, thus lowering the whole tax liabilities on the seller.

4. Hiring Experts

Most people, including entrepreneurs, don’t know the specifics of taxation. This is why it’s important that during a transaction, especially with something as big as the sale of a whole business, a tax expert’s help is enlisted to ensure that the proper taxes will be paid and certain taxes are minimized in the process. It can be an intimidating thing to try and navigate the process of taxation, but there are CPAs and other professionals out there to help with the whole process.

How to Report the Proceeds from a Business Sale

All reports about the business sale are required by the IRS, and there are forms you are mandated to submit, together with an organized report of the whole process so the IRS can calculate and categorize all the necessary taxes. These are Form 8594, Form 4797, and Schedule D.

Form 8594

Both the buyer and the seller are required to submit this to the IRS. This is the main report that will serve as the Asset Acquisition Statement.

Form 4797

This is the Sales of Business Property form. As a seller, this is where the determination of capital gains and losses are stated.

Schedule D

This involves your personal tax return and should be used when you’re selling stock in a corporation.

Allocation of Sales Price Can Determine the Amount of Total Tax to Pay

The most important part of a transaction when selling a business is the number of tangible assets, like equipment and machinery, and intangible assets, like goodwill and brand reputation. With proper tax planning, it’s possible to defer taxes that you don’t have to pay while minimizing other taxes that you are obliged to pay.

We talked about capital gains tax earlier. In addition, there is also ordinary income that might be included in your overall payable tax during the sale. With that in mind, you’d want to list most of your tangible assets’ sales under capital gains because it generally has a lower tax rate than the ordinary income rate. You also have to take the duration of the asset being in your possession, as this can help you lower the tax rate further if you’ve held on to it in the long run.

Keep in mind also that if your business is under a sole proprietorship, then the income you gain during the sale will include all the assets. Otherwise, the income will only be applicable to you, such as when you sell your share of the company, or if you have stocks and bonds that are tied to it.

Some sales of shares of stocks of the corporation can be considered tax-free. This is especially true if the sale of the company is classified as a merger or acquisition. This means that there is no cash involved because the exchange is done through the exchange of stocks of two companies. To put it simply, if you sell a company in exchange for stocks of the company that’s buying, then you will not be liable for taxes until you sell those stocks in the future.

Selling to Employees

If you have an employee that is interested in having a share of the company, you can opt to sell your share to them, especially when the company is a C Corporation. This means that you’re taxed separately from all the other shareholders of the company, so it’s an easier process. C Corporations usually have employee stock ownership plans (ESOP).

This way, you have a captive buyer and don’t have to waste time looking for buyers from an outside party. You can also have a good degree of control over the price, and you can defer tax once you list it in the capital gain.

Tax Strategy and Goals

Finally, it pays to have strategic planning before selling a business. You have to make sure that you’re doing it purposely to get you one step closer to your goals as a business owner. Remember, your business is the culmination of your years of hard work. If your only goal is to keep selling businesses after growing them in years, you’re bound to have a lot of tax liabilities thrown at you, so you have to be careful with that.

Questions to Ask Before Selling Your Business

In selling a business, there are obviously going to be some hesitations, especially if the tax laws in your area of operation aren't very favorable to you. Hence, it’s important to ask several questions in terms of ensuring that you keep most of your profit even after the sale concludes. Let us have a deeper look into the questions that you need to ask before you make a decision about selling your business.

1. How will federal and state taxes apply to this sale?

As we discussed earlier, the tax can differ depending on the area. Capital gains aside, there might be some proposals that exclusively apply to your business if certain conditions are met. For example, some countries have a high capital gains tax when the business is over 15 years under the same owner. This means if you started a business 17 years ago with a total capital of $1 million and sold it for $10 million, then instead of the regular 15-20% of capital gains tax, it could balloon up to more or less 30% of the income, making the total net income of only about $7 million instead of $8 million.

With that said, it’s better to make sure that your area doesn’t have a large capital gains tax rate, especially when you’ve been growing your company for a decade or two.

2. What do the buyers want?

Buyers usually seek to buy a business that they can depreciate immediately after purchase, which means they can save a lot of money over the years. It’s better to be informed on what kind of setup the purchase will be, and at the same time consider the type of company you hold. In LLCs and partnerships, for example, the sale of assets will generally not have much of a negative impact on their tax liability.

3. What are the terms of the sale?

If you’re the seller, the most advantageous position for you will be a “cash at closing” condition where the capital gains tax will be due when the transaction closes.

However, in case the terms of the sale are not favorable to you, fear not, for you can still negotiate and set the terms yourself. You can do this by carefully allocating the assets and stocks of the company that you will agree to sell to the buyer. Buyers usually prefer an asset sale because they can create a higher base for the depreciable assets they are going to buy.

Conclusion

Tax implications when selling a business can differ from place to place, but there are some common elements among the majority of countries and states. The basic thing to consider is this: get an expert that can explain all the hard terms to you when it comes to the specifics of taxation.

Once you are able to secure a negotiation meeting, it’s important that you know the real, tangible value of your business before you hear the offer from the other party. This can affect how you allocate your assets and therefore determine the total of the taxes to pay, including ordinary taxes and capital gains taxes.

As a seller, it’s better that you list most of your company’s assets under the capital gains tax since it generally has a lower tax rate than an ordinary income tax. And finally, know the circumstances and tax laws of your own country or state so that you’re ready to pay the taxes before you put the company on the market. It’s good to reach a balance with the buyer where they can get what they paid for, but at the same time, you get to keep most of the profit, with the tax liability minimized to the lowest extent possible.