If you’ve poured blood, sweat, and tears into building your business and are now looking to pass the torch to someone else, the financial implications of this transition can be daunting. An integral aspect of this process is understanding how much of the sale will be owed to the government. To ensure your hard work pays off, it’s important to understand capital gains tax and strategies to minimize or defer it. Of course, consulting with a qualified CPA or tax advisor is advised as selling a business can be a complex process.
Understanding Capital Gains Tax
The IRS takes a cut when you sell an asset for more than its tax basis, often the purchase price. This is known as a capital gain. Assets include shares of stock, land, and, of course, a business. For instance, if you buy a stock for $5,000 and sell it three years later for $8,000, the $3,000 increase is a capital gain and is subject to tax.
Long-term capital gains, from assets held for over 12 months, are usually taxed at a lower rate than ordinary income. This is why, for example, Warren Buffet has a lower tax rate than his secretary. On the other hand, capital gains from assets held for less than 12 months are taxed at the same rate as ordinary income.
Paying Capital Gains Tax
Capital gains tax is applied when capital assets from your business are sold. Your business isn’t a single asset in the eyes of the IRS, but a collection of smaller assets sold separately. However, not all assets in your business will be taxed at the capital gains rate. Some, such as inventory and accounts receivable, will be taxed at the ordinary income tax rate, which for many people is higher.
Allocating the Purchase Price
How you allocate the purchase price among your business assets directly impacts your tax liability. IRS guidelines outline how to value each asset based on its fair market value in a specific order. The allocation process can significantly influence your tax liability and warrants professional advice.
Special Considerations for Corporations and Partnerships
Selling a corporation or a partnership share has unique tax implications. In a partnership, your entire share is treated as one capital asset, and you’ll pay capital gains tax on any amount you receive beyond the adjusted basis. When selling a corporation, you can either treat it as a stock sale or sell individual assets. Treating it as a stock sale is often advantageous if you’ve owned the corporation for more than a year, allowing you to pay long-term capital gains tax on the profits from the sale.
Strategies to Reduce Capital Gains Tax
You can leverage certain strategies to reduce your capital gains tax liability. For instance, you could spread the gain of selling your business over multiple years through an installment sale, which could keep you from moving into a higher tax bracket. Allocating the purchase price wisely can also impact how much you pay in taxes, with a focus on items taxed at the long-term capital gains rate.
Lastly, waiting to sell until you’ve owned the business for at least a year can significantly reduce your tax bill.
Seek Professional Guidance
When selling your business, understanding the tax impact of your decisions is critical before finalizing the sale. Partnering with a professional can help navigate complex scenarios and devise strategies to reduce your tax liability.
Our seasoned team at IAG M&A Advisors can provide guidance on these complexities and more, helping you achieve the most financially successful sale possible.
Acquira is a business acquisition in a box service. We help entrepreneurs buy businesses and we invest in them and their chosen businesses. We are here to help ensure that each business we work with is posed to make the biggest positive impact possible for its owners, employees, and community.