Whether you are a small business owner or the owner of a large corporation, selling your business has significant tax implications. In general, selling a business is similar to selling any other major asset, which means your taxable income for the year you sell your business will have a direct impact on the taxes you owe on your federal return. However, when you work with financial experts, you can reduce these taxes for selling a business.
Selling a Business: What Are the Tax Implications?
The biggest tax implication small business owners and incorporation owners will experience after selling a business is the capital gains tax. These are taxes for selling a business that are applied to the profit that an investor makes when an asset is sold.
The capital gains tax is a tax rate that is adjusted annually based on current tax laws, which is another reason why it’s so essential to work with tax experts and financial advisors when you are selling a business.
When Do You Owe a Capital Gains Tax?
In general, the capital gains taxes for selling a business only go into effect for the year that you sell the asset. A common scenario could be selling a business in the previous tax year and then needing to file the profits of the sale as part of your federal or state tax return. When you owe a capital gains tax, you must include the entirety of the profit in your tax return for that year.
It’s important to correctly report these profits as part of your taxable income, particularly if you have held the investment for several years. Incorrectly reporting this income may trigger an IRS audit for tax evasion. If you aren’t sure how to correctly report capital gains, a CPA can help you fill in your federal tax return.
Does Your Taxable Income Affect Capital Gains Taxes?
Because investors frequently buy and sell assets, their taxable income for each year may constantly fluctuate. For a capital gains tax, the percentage rate on this tax will be dependent on the total amount of taxable income for that year and how that affects an investor’s tax bracket. If you are a high-income earner, then adding the capital gains from selling off a business will increase your taxable income, which will then increase the tax rate on your income.
For the most part, the capital gains tax rate applied to your taxable income will be taxed at 15% or 20%, depending on your income bracket. Occasionally, income levels will be adjusted to compensate for inflation rates, so the tax rate for capital gains may vary from year to year. These capital gains taxes will be reported on Schedule D of the federal tax return.
What Are Short-Term Gains?
There is one significant point in how capital gains taxes are calculated. If you have been a small business owner for less than a year or you have held certain assets for business for less than 12 months, these investments are generally considered short-term. When you sell short-term investments, the profits of the sale become short-term gains.
Short-term gains are treated differently than the profits of long-term investments. If selling your business qualifies as a short-term gain, any profits you receive from the sale will be considered ordinary income and will be taxed at the same rate as other income for that tax year. Sometimes, this may mean that the tax rate on short-term gains is higher than the tax rate on capital gains for long-term investments.
Taxes for Selling a Business: Strategies to Consider
If you manage to sell a business for significant profits, it’s understandable that you may want to minimize the taxes for selling a business. After all, minimizing capital gains taxes will also minimize the taxes you may owe to the state and federal government.
Fortunately, there are several strategies you can use to minimize this tax burden, such as deferring the capital gains tax you will owe after selling a business. Working with a CPA and CFA can help you identify the strategy that is most appropriate for your financial circumstances. The most common strategies include:
Sole Proprietorship
If you are a small business owner or your business is classified as a sole proprietorship, you can treat the sale of your small business as individual assets. Although selling most business assets can sometimes trigger capital gains taxes, selling other assets of the business, such as inventory, is considered ordinary income. By selling these business assets individually, you may be able to reduce the total capital gains taxes owed significantly.
To be sure, this strategy is all about negotiation. You will need to negotiate the sale of each business asset with the buyer and then allocate each of these assets on specific forms on your tax return. Buyers are typically willing to negotiate for selling assets individually, since this can help the buyer receive depreciated assets that will be taxed at a lower rate in the future.
Stock Assets
Another strategy to consider when selling a business is a corporate sale of stock assets. Selling the stock of your business is one way you can limit the tax reporting for capital gains on other portions of the transaction for your business sale. Selling stock assets will generally also be included in the negotiations between the seller and buyer to reduce tax responsibility.
Installment Sale
An installment sale is another strategy that can be very effective for reducing capital gains taxes. In fact, if you want to defer capital gains taxes for the long term, an installment sale is one of the most convenient strategies. For an installment sale, you can finalize the transaction through installment payments, with at least one payment occurring after the year of the sale. Selling a business with an installment sale will greatly reduce the taxable income you earn each year, which can then reduce the taxes you owe on a federal return.
Employee Stock Ownership
Business owners who sell stock to employees can also reduce capital gains taxes. The strategy is called employee stock ownership plans. If you plan to sell your business, you can offer employees stock options in advance, which will allow business owners to receive proceeds for stocks that can be invested in a diversified portfolio to reduce capital gains taxes. However, to use this particular strategy, your corporation must be classified as a C corporation.
Opportunity Zone
Finally, you can defer your capital gains taxes for the long term by reinvesting your capital gains from the sale of your business into something called an Opportunity Zone. You can use this strategy to defer and reinvest your capital gains within 180 days of the sale of your business. The strategy works best when the investment in the Opportunity Zone is recognized quickly to make the most of the tax deferral limitations.
An Opportunity Zone is essentially a tool used in economic development that allows people to invest directly in economically distressed areas of America. An Opportunity Zone allows investors to reinvest money into low-income communities to build housing while also benefiting from certain tax benefits.
The major tax implication associated with selling a business is the capital gains tax. Although capital gains taxes are the result of selling a business, there are strategies you can take to reduce these taxes. To learn more about the process of selling a business, get in contact with ASA Ventures Group today.