Selling and Business Taxes: What to Consider When Planning Your Exit

By planning ahead, you can take proactive steps to adopt fully legal strategies that minimize your tax burden when selling your business. If done correctly, this can help you achieve a more profitable exit and keep more money in your pocket after closing. To do this successfully, however, it is important to have a clear understanding of the business taxes related to selling your company. 

In this article, we discuss:

• Types of taxes you may owe when selling a business
• Share versus asset sale of a business
• Taxes for selling unincorporated businesses
• Taxes for selling incorporated businesses

 

Types of Taxes You May Owe When Selling a Business

The world of business taxes is complex. The Internal Revenue Service (IRS), maintains many rules and regulations relating to business taxation. Indeed, it requires a highly trained and experienced professional accountant to adequately navigate the business tax ecosystem. 

However, knowing the basics of business taxation can help you understand what steps you may need to take in order to plan for an exit that minimizes your overall tax liability. For starters, the structure and classification of your business and assets affect your eventual tax rate. 

 

Before we jump into the specific types of taxes you may be liable for, let’s discuss an important component of business taxation: asset allocation agreements.

“Knowing the basics of business taxation can help you understand what steps you may need to take in order to plan for an exit that minimizes your overall tax liability.”

Asset allocation agreements and how they affect business taxes

When you sell your business, you and the buyer will likely create and sign an asset allocation agreement. This is an important document, one which has significant implications for your eventual tax rate. 

For taxation purposes, business assets fall under capital assets or noncapital assets. The asset allocation agreement specifies which business assets fall into which category. This is important because capital assets and noncapital assets have significantly different tax rates. 

Capital assets are assets that have the potential to generate income for the owner for an extended period of time. This includes depreciable and real property. 

Noncapital assets, on the other hand, are assets that aren’t directly attributed to a business’s operations. Examples of noncapital assets may include but are not limited to:

• Inventory
• Personal property 
• Copyrights
• Receivables

You and the buyer designate each asset as either a capital asset or a noncapital asset. In addition, you negotiate together to allocate a value to each asset. 

“Capital assets are assets that have the potential to generate income for the owner for an extended period of time.”

As you can imagine, there is some room for disagreement over asset values. As such, the asset allocation agreement is often used to apportion the value of the assets into a more favorable arrangement for tax purposes. However, the allocation that benefits you as the seller may not benefit the buyer. Negotiations typically determine the final allocation. 

In general, there are two primary types of taxes you may be subject to when you sell. These include:

• Capital gains taxes
• Regular income taxes

Regular income taxes

All or some of the income you generate from the sale of your internet business falls under ordinary income. This means you would be subject to pay the ordinary income tax rate for your tax bracket. 

Depending on your income level tax basis, this could range from 10 to 37 percent for tax year 2023. Any single-year income of $578,125 for single filers or $693,750 for married couples would result in a top federal tax rate of 37 percent.

A business asset classified as a noncapital asset is taxed at the regular income tax rate. As we will see, the current income tax brackets are significantly higher than the capital gains tax brackets. As such, the greater the value of assets from your sale that can be classified as capital assets, the lower your tax rate will be. 

Capital gains taxes

Selling a capital asset incurs capital gains taxes. The rate can change from time to time depending on legislation. For the 2023 tax year, it currently ranges from 0 percent on the low end to 20 percent on the high end. Notice the top capital gains tax rate is far lower than the top income tax rate. 

A capital gain is the difference between the adjusted basis of an asset and the price at which you sell it. The adjusted basis is the original cost of the asset to you plus certain improvements or investments you made to the asset. Essentially, it is the gain in the value of an asset while under your ownership.

For example, let’s say you run an ecommerce business selling print-to-order t-shirts. You purchase a used t-shirt printer for $2,000. Over the years, you invest $500 into the printer for upgrades and improvements. 

In this scenario, your capital base would be $2,500. When you sell the business, you are able to sell the printer for $3,000. Your capital gains would be $500, or $3,000 minus $2,500. 

Due to the favorable capital gains tax rate, it would be advantageous from a tax perspective to sell as much of your business as a capital asset as possible. But while there is some room to allocate assets in your favor, you must still abide by IRS rules. 

“Aside from asset allocation matters, timing can play a significant role in the overall tax burden you incur from the sale of your business.”

Lump-sum payments vs installment plans

Aside from asset allocation matters, timing can play a significant role in the overall tax burden you incur from the sale of your business. When it comes to time considerations, there are several factors to think about. 

Let’s say you sell your business and receive payment in one lump sum. In this scenario, the full purchase value determines your tax rate. Depending on the value of your business, this is likely to push you into a higher tax bracket. 

You have the option, however, to structure the sale so that you receive installment payouts over the course of several years. Of course, there may be other reasons why you would not want to wait to receive your money, but by spacing out the payments you may be able to pay a lower tax rate. 

For example, let’s say you sell your business for a $540,000 purchase price and file your personal income taxes as a single earner. If you receive one lump-sum payment of $540,000, you would pay the second-highest tax rate of 35 percent.

Scenario #2

However, let’s say that instead, you structure the deal to receive three payments spread out over the course of three years. For the sake of simplicity, let’s say each payment would be $180,000, adding up to the total purchase price. In this scenario, you would pay a top tax rate of 24 percent. 

As you can see, just by delaying receipt of the balance of your money for several years you save 11 percent on your taxes. This translates into a $59,400 gain in profit—money that you get to keep. Of course, this weighs against the time cost of foregoing the balance for two years. In addition, you may also need the full sum more immediately, whether to buy a house, support a family, or start a new business.

“Since your taxable income takes into account your profits and losses, it can be beneficial to sell during a year of significant costs or losses.”

Timing considerations for business taxes

Aside from installment payments, it can be helpful to take into account the timing of your business sale. Since your taxable income takes into account your profits and losses, it can be beneficial to sell during a year of significant costs or losses. This will serve to reduce your overall taxable income, thus lowering your tax liability. 

Of course, this is not always possible. In addition, selling during a down year may serve to lower the final sales price of your business. This must be weighed against the potential tax liability upside to determine if this is a good path for your exit. 

Share versus Asset Sale of a Business

When it comes to business transactions there are two different ways of transferring ownership. These are referred to as an asset sale or a share sale. A share sale is often also called a stock sale. Each conceptualizes the transfer in a different manner. Likewise, each type of sale has important implications for your tax mitigation strategy. 

Asset sale

So far, we have been primarily discussing tax strategies in the context of asset sales. In fact, the vast majority of small- and medium-sized business sales are asset sales. With an asset sale, you assign each asset or liability of the business its own value. Then, you sell all agreed-upon assets and liabilities to the buyer.

As you can imagine, the asset allocation agreement is crucial for the reasons we discussed before. While many assets may be able to be classified as capital assets, you will still likely have significant noncapital assets as part of the sale. As such, you will likely pay capital gains taxes for certain portions of your business and income taxes for other portions of your business during an asset sale. 

“With a share sale, or stock sale, the buyer purchases the underlying stock of the business.”

Share sale

With a share sale, or stock sale, the buyer purchases the underlying stock of the business. By doing so, you can bypass the need to price and sell every individual asset separately. As the seller, your proceeds from the sale are taxed at the capital gains rate instead of the normal income rate. 

Whether you structure the sale as an asset sale or a share sale will have important implications for your tax liability. 

Taxes for Selling Unincorporated Businesses

When it comes to tax considerations, it is crucial to understand the difference between taxes for selling unincorporated businesses and taxes for selling incorporated businesses. 

Asset sale

If your business is structured as a sole proprietorship, partnership, or LLC, you must sell your business as an asset sale. Unincorporated businesses do not have the option of doing a stock sale. 

This means the terms of your asset allocation agreement will have very significant ramifications when it comes to your overall tax liability. In addition, if you sell outside of your home country, you will also need to engage in international tax planning when considering your exit options. 

“If your business is structured as a sole proprietorship, partnership, or LLC, you must sell your business as an asset sale.”

Taxes for Selling Incorporated Businesses

If you are selling an incorporated business, you will have more options available to you when choosing how to structure the deal. This will have important implications for your tax burden after you sell.

Asset sale or stock sale

As the owner of an incorporated business, you have the ability to sell as an asset sale or as a stock sale. Of course, the final terms will depend on the deal you reach with the buyer. Many entrepreneurs elect to have a stock sale if they have the choice. 

When selling a C corporation under an asset sale, the seller is taxed twice: once during the sale of assets and the second time on the sale of the stock. If you simply sell the stock, though, then you will only incur capital gains taxes on the profit from the sale. This will likely lead to a significantly lower tax rate. 

If you are selling an incorporated business, speaking with an experienced tax professional should be high on your seller’s checklist. 

“As the owner of an incorporated business, you have the ability to sell as an asset sale or as a stock sale.”

Conclusion

The world of business taxes is complex and nuanced. What may be right for other sellers may not necessarily be the right option for you.

In order to legally minimize your taxes it is important to work with a qualified tax professional to determine the best course of action for your needs. Additionally, don’t wait until the last minute to consider the tax implications of selling. In general, it is advisable to start your exit planning 12–24 months before you plan to sell. 

With the right approach, you can work to minimize your tax liability. This allows you to take home a greater share of the profits of your business sale and helps set you up for future success. 

“In general, it is advisable to start your exit planning 12–24 months before you plan to sell.”

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