What Tax Do I Pay When I Sell My Business?
Preparing your taxes after selling your business is no easy task. In the United States, federal taxes can be complicated enough, let alone state-specific requirements. Many different variables go into determining how much tax you will owe after the sale of your business. The type of company you sell and the type of deal you make with your buyer can influence how much you’ll have to pay in taxes, when you have to pay, and how many times you’ll be taxed.
Type of Company: What It Means For Taxes
Do you need to pay taxes once, or twice? Federal tax rules are different for different types of companies. A C corporation, for example, will need to pay corporate tax during a sale. Sellers will also need to pay taxes for any gains on their personal income taxes. For all other business types, however, a seller only needs to report income on their personal tax forms.
Sole Proprietor and Limited Liability Companies
If you sell your sole proprietor and limited liability company, you will pay taxes on the sale of your business one time. The sale of your business ownership is taxed as a one-time capital gain, and is paid on your personal income tax form. Assets sold along with the ownership of your business are taxed separately, as income.
Profits made from the sale of a C corporation are taxed twice. The first is commercial tax, filed on a corporate tax return. The second is on each owner’s or shareholder’s personal income tax. Corporations are considered their own entities in the eyes of the law, which means that any profits made on the sale of a corporation must be paid as capital gains in the business’s annual filing. Shareholders will be taxed based on the portion of the profits that they receive from the sale—not on the full amount made by the corporation.
S Corporations and Partnerships
Profits made from the sale of an S corporation or a partnership will be taxed once as a capital gain on each shareholder’s personal income tax. The profits made by the sale of an S corporation or partnership are split amongst owners or shareholders, and each is responsible for reporting their share of the earnings on their personal taxes.
How Business Sales Are Taxed
Selling a business is not as simple as selling a car or a home. In the eyes of the IRS, a business is typically a collection of assets—often sold separately. Different aspects of your business fall under different taxation laws. For example, the sale of inventory is considered income and thus taxed like traditional income. However, the sale of any capital assets held for longer than 12 months is considered a long-term capital gain.
Understanding how different aspects of your business will be taxed is important; some parts of your business may be subject to higher tax rates than others. For example, tax on long-term capital gains is taxed at a maximum rate of 20 percent. Yet, tax on inventory may be subject to federal income tax rates as high as 37 percent, which is the topmost bracket.
How Capital Gains Tax Works
If your business is healthy and profitable, it accumulates value over time. Yet, as an owner, you often cannot access this value until your business is sold. That’s because much of the value is stored in the business itself as property, physical assets, capital, and potential profitability. In the eyes of the IRS, you receive a capital gain when you sell your business and thereby liberate the financial value of your investments.
A capital gains tax is, in essence, a tax on growth. It taxes the growth in value of your investments, which are liberated at the time of sale. As far as taxes go, the capital gains tax is the most preferred amongst sellers. The maximum percentage of taxes that sellers have to pay on capital gains is substantially lower than the maximum income tax, which can reach up to 37 percent of your personal income. In contrast, the capital gains tax brackets are either zero, 15, or 20 percent, depending on the total amount of money being taxed.
But, there are a few important caveats for qualifying for capital gains tax. First, only long-term capital gains qualify for low tax rates. A long-term capital gain has accrued for over 12 months. Long-term capital gains taxes are capped at a maximum of 20 percent. Short-term capital gains are a different story, however. Any capital accrued in under 12 months is taxed as ordinary income and thereby subject to a higher tax rate.
In addition, not all profits can be taxed as capital gains. Certain categories of assets are almost always taxed as regular income, not capital gains. Things that cannot be considered capital gains include:
- Property that was purchased less than one year prior
- Inventory payments
- Payments for accounts receivable
- Personal property which depreciates
Profits from the above-listed sources have the potential to influence your tax bracket since they are counted as regular income.
Types of Deals
The type of deal you make with your buyer can influence the way you pay taxes as well as how much tax you pay in the long run. Are you offering to finance your buyer? Then your federal taxes may be partially deferred until you receive full payment. Are you selling inventory and other physical assets? You may pay a higher tax rate.
Is your buyer paying cash or paying in installments? During an installment sale, the seller, in essence, becomes a lender for the buyer. The seller agrees to make regular payments for the business over a fixed period of time, as the buyer pays for the total cost of the business in installments. Installment sales can be beneficial for a seller’s tax bill.
This type of sale allows the seller to defer some tax payments until they have received the full amount of the agreed-upon sale price. Tax breaks for installment sales are only available for capital gains income, however. As a seller, you will still need to pay income tax on material and intangible assets that do not qualify as capital gains.
Asset vs. Stock Sale
Is your buyer purchasing assets or shares of your company? Deciding whether or not you will sell assets or stocks is a vital tax decision for sellers. A sale is categorized as a stock sale if your buyer is purchasing ownership shares in your business. In an asset sale, the seller retains ownership over the legal entity of the business. The buyer purchases material and intangible assets such as property, equipment, goodwill, trade secrets, and more. A stock sale is often considered more advantageous to the seller when it comes to taxation. Profit made from a stock sale can be taxed under the capital gains tax. Assets, however, will be taxed as regular income—and subject to a higher tax bracket.
Sometimes a buyer cannot make a strong cash-on-hand offer for the total purchase of your assets. Seller financing is useful when a buyer can only commit to making payments over a designated period of time. This type of sale can have positive tax benefits for the seller. Sellers are often able to defer their tax payments until the buyer has paid the full amount owed, which allows the seller to do as they please with the regular income in the meantime. The largest downfall of this type of deal? The seller needs to have confidence that the buyer will continue to run the business in a successful and profitable way, so that the buyer will continue to make payments.