Everything You Need to Know About Tax Rates Before Selling a Business

You worked hard to grow your business over the years – if not, decades – so now that you’re ready to sell, you want to do everything you can to make sure most of the money ends up in your pocket. 

At least part of this means understanding the tax rate implications when selling. 

It’s a complex transaction that can greatly affect your financial outcome. It’s influenced by the type of business entity you have, the duration of ownership and the nature of the assets being sold.

Understanding how tax rates apply to the sale of your business is crucial for maximizing your net proceeds. 

This isn’t just about paying your dues; it’s about smart planning and strategic decisions that ensure you keep as much of the sale price as possible.

Factors Influencing Tax Rates

When it comes to the tax rate applied to the sale of your business, several key factors come into play, turning what might seem like a straightforward process into a more nuanced affair. 

Let’s dive into these factors:

Type of Business Entity

Your business structure—whether it’s a sole proprietorship, partnership, LLC, S corporation, or C corporation—plays an important role in determining the tax implications of the sale. 

Each entity type is subject to different tax treatments, affecting how sale proceeds are taxed.

For example, C corporation owners might face double taxation: once at the corporate level and again on personal income from the sale. 

Sole proprietorships, partnerships, and S corporations, on the other hand, often benefit from pass-through taxation, potentially offering a more favorable tax scenario.

Duration of Ownership

How long you’ve owned your business can also impact your tax rate, especially with regard to capital gains taxes. 

Generally, assets held for more than a year qualify for long-term capital gains treatment, which typically offers lower tax rates compared to short-term gains. 

This distinction underscores the importance of timing in your exit strategy.

Nature of Assets Being Sold

The composition of your sale—whether you’re selling assets or stock—can vastly affect your tax obligations. 

Read more: Understanding Asset vs. Stock Sale

Selling assets can lead to different tax treatments for tangible and intangible assets, influencing your overall tax rate. 

Meanwhile, stock sales might be treated more favorably under capital gains tax rules but come with other considerations for buyers and sellers alike.

Let’s put this into perspective with a scenario: Imagine you’re selling an HVAC business you’ve grown from scratch. 

If your firm is structured as an LLC and you’ve owned it for over five years, your proceeds from the sale will likely be taxed as long-term capital gains, subject to lower rates than ordinary income. 

However, if part of the sale includes assets that have depreciated, this could affect the tax calculations, potentially offering opportunities for tax deductions.

It’s a complex transaction that can greatly affect your financial outcome. It’s influenced by the type of business entity you have, the duration of ownership and the nature of the assets being sold.

Key Tax Considerations for Business Sellers

Let’s spend a little more time breaking down each of these core concepts to help you understand the tax implications while selling your business.

Capital Gains Tax

At the heart of the tax considerations for business sellers is capital gains tax. 

This tax applies to the profit from the sale of non-inventory assets held longer than a year, classified as long-term capital gains. 

Short-term capital gains, from the sale of assets held for a year or less, are taxed as ordinary income. 

The distinction is crucial because long-term gains often benefit from lower tax rates, significantly affecting your take-home profit. 

Currently long-term capital gains tax rates in the U.S. could be 0%, 15%, or 20%, depending on your taxable income, whereas short-term gains could be taxed at rates up to 37%.

Income Tax

Income tax implications arise particularly when parts of the sale are treated as ordinary income. 

A common scenario involves recaptured depreciation on assets sold with the business. 

For example, if you sold business equipment that had been depreciated for tax purposes, the portion of the sale price attributed to depreciation recapture is taxed as ordinary income, not as a capital gain.

Let’s consider a tangible example to illustrate how this works: Suppose you sell a piece of machinery for $50,000 that was originally purchased for $100,000 and had been depreciated to $30,000. 

The $20,000 excess of the sale price over the depreciated value ($50,000 – $30,000) is considered recaptured depreciation and would be taxed as ordinary income. 

Assuming an ordinary income tax rate of 24%, you would owe $4,800 in taxes on this portion of the sale. 

The remainder of the gain might qualify for capital gains tax, subject to different rates.

Sale Structure and Tax Implications

As discussed above, the structure of your business sale can significantly influence your tax obligations. 

Let’s delve a little deeper into a few common structures:

• Asset Sales: Often favored by buyers because they can select specific assets and avoid inheriting the seller’s liabilities. However, sellers might find themselves facing higher tax bills, as the sale of individual assets could be subject to different tax treatments, potentially leading to ordinary income tax rates on certain components of the sale.
• Stock Sales: In a stock sale, the buyer acquires the selling company’s shares, taking on both its assets and liabilities. For sellers, this can mean a cleaner break and possibly more favorable capital gains tax treatment. However, buyers might be less enthusiastic due to the inability to “step up” the basis in the business’s assets.
• Mergers and Acquisitions (M&A): M&A activities can offer various tax implications depending on whether the transaction is structured as an asset or stock deal and whether it’s a taxable or tax-free reorganization. Each scenario requires careful consideration to optimize tax outcomes.

Asset Sale vs. Stock Sale Example: Imagine you’re selling a small tech company, “Tech Innovations Inc.,” which you’ve structured as an S corporation. You have two options for the sale: an asset sale or a stock sale. Let’s explore how each affects your tax situation with hypothetical numbers. Asset Sale: You sell the company’s assets for $1 million. The assets have a book value of $600,000, meaning you have a gain of $400,000. This gain is subject to capital gains tax. If the assets include equipment that has been depreciated, part of the gain could be taxed as ordinary income due to depreciation recapture. Assuming a 20% capital gains tax rate and a 25% depreciation recapture tax rate, your tax could look something like this: Depreciated equipment gain: $100,000 (taxed at 25%) Remaining gain: $300,000 (taxed at 20%) Your total tax liability could be $25,000 (depreciation recapture) + $60,000 (capital gains) = $85,000. Stock Sale: You sell your shares in “Tech Innovations Inc.” for $1 million, realizing a $400,000 gain, as your basis in the stock is $600,000. Since this is a stock sale, the entire gain is treated as a capital gain, potentially taxed at a lower rate compared to the asset sale’s mix of capital gains and ordinary income. At a 20% capital gains tax rate, your tax would be $80,000. This simplified example demonstrates how different sale structures can impact your tax liability, emphasizing the importance of strategic planning in the sale process.

1031 Exchanges

The 1031 exchange is a powerful tool for those looking to transition their investments without the immediate tax burden typically associated with capital gains. 

Named after Section 1031 of the U.S. Internal Revenue Code, this provision allows the deferral of capital gains taxes on the sale of investment property by reinvesting the proceeds into another “like-kind” property. 

Traditionally, this has been largely utilized within the real estate sector, but its principles can apply to certain business assets as well, making it a potentially valuable strategy for business sellers.

The essence of a 1031 exchange lies in its ability to defer taxes, thereby freeing up more capital for immediate reinvestment. 

This can be particularly advantageous for business owners looking to shift their investment focus or expand into new areas without the immediate tax expense diminishing their capital. 

However, it’s important to note that the rules around what constitutes “like-kind” can be complex and the IRS’s regulations strict. 

Ensuring that the assets being exchanged meet the criteria and that all procedural requirements are meticulously followed is crucial for the exchange to qualify for tax deferral.

Consider a business owner who sells a manufacturing facility and wishes to move into a different sector within the industry. 

If the proceeds from the sale are reinvested into a similar facility or related business asset considered “like-kind,” this transition can potentially be achieved in a tax-efficient manner, preserving capital for investment in the new venture.

Section 1202 – Qualified Small Business Stock

Section 1202 of the Internal Revenue Code is a gem for entrepreneurs and investors in small businesses, offering significant tax benefits that can greatly enhance the attractiveness of investing in and holding onto small business stock. 

This provision allows for the exclusion of up to 100% of capital gains from the sale of qualified small business stock (QSBS) held for more than five years, subject to certain limitations and criteria. 

To qualify as QSBS, the stock must meet several requirements: the issuing company must be a C corporation with assets of $50 million or less at the time of and immediately after the stock issuance, and the corporation must engage in an active trade or business other than certain excluded activities such as investment or real estate.

State and Local Taxes

State and local taxes represent another critical layer in the complex tax landscape facing business sellers. 

The implications of SALT can vary dramatically based on the business’s location, as each state and locality has its own tax codes and regulations. 

States like Wyoming, South Dakota, and Nevada offer some of the lowest business tax burdens due to their lack of corporate and personal income taxes. 

On the other hand, states like California, with a top corporate tax rate of 8.84% and a personal income tax rate reaching up to 13.3%, and New York, with a corporate tax rate of 7.1% and a top personal income tax rate of 10.9%, present a more challenging tax environment for business sellers.

Beyond the basic tax rates, many states and localities offer credits or incentives designed to encourage business investment and growth. 

Understanding the specific tax implications and available incentives requires careful research and planning, as these factors can substantially impact the net proceeds from a business sale.

Glossary of Key Terms: 1031 Exchange: A tax-deferment strategy allowing investors to sell a property and reinvest the proceeds in a new property, deferring all capital gains taxes. Key for business owners looking to shift investment without immediate tax consequences. Capital Gains Tax: A tax on the profit from the sale of property or an investment. Long-term capital gains tax applies to assets held for more than one year and is generally lower than short-term rates. Depreciation Recapture: Taxable income resulting from the sale of an asset that has been depreciated. The difference between the sale price and the depreciated value is taxed as ordinary income. Section 1202: A section of the Internal Revenue Code providing tax benefits to investors in small businesses. Allows for the exclusion of up to 100% of capital gains from the sale of qualified small business stock held for more than five years. S Corporation: A corporation that elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders report the flow-through of income and losses on their personal tax returns.

Reporting and Compliance

Proper reporting and compliance with tax authorities are crucial components in the sale of a business. 

This process involves accurately documenting the sale, including the valuation of assets, calculation of gains or losses, and adhering to all tax filing requirements. 

Ensuring thorough compliance not only facilitates a smoother transaction process but also safeguards against potential legal and financial repercussions.

Non-compliance can lead to severe consequences, including audits, fines, and penalties. 

In extreme cases, deliberate evasion of tax obligations can result in criminal charges, highlighting the importance of meticulous record-keeping and transparent dealings with tax entities.

Moreover, maintaining compliance reinforces the integrity of the business transaction, ensuring that both buyers and sellers can proceed with confidence in the legality and financial soundness of the deal. 

Engaging with tax professionals throughout the process can provide valuable guidance, ensuring that all tax-related aspects of the sale are handled accurately and in accordance with current tax laws and regulations.

FAQs

Conclusion

Selling a business involves significant tax considerations that can greatly impact the financial outcome. 

Key factors influencing tax rates include the business entity type, duration of ownership, and the nature of assets sold. 

Long-term ownership generally qualifies for more favorable long-term capital gains rates, highlighting the importance of strategic timing in the sale process.

If you’re thinking about selling your business and want to better understand the various tax implications, reach out to Acquira today to see how our industry expats can help. 

We can help you get maximum value for all of your hard work while also preserving your legacy for your employees and wider community.

We’ll start you off with a FREE business valuation and will buy your business outright if we like what we see. 

We can also help you grow your business to a place where we will want to buy it or connect you with someone who will buy it now. 

Key Takeaways

• Business structure significantly affects sale tax rates.
• Long-term ownership usually leads to lower capital gains taxes.
• Timing the sale can maximize tax efficiency and profits.
• 1031 exchanges offer tax deferral on “like-kind” asset reinvestments.
• Section 1202 provides substantial tax relief on QSBS gains.