Selling a Small Business Tax Implications
Selling a small business tax implications is better explained as a sale of a collection of tangible and intangible assets.3 min read
Selling a small business tax implications is better explained as a sale of a collection of tangible and intangible assets. Tangibles include real estate holdings, inventory, and machinery. Intangibles include a trade name, goodwill, or accounts receivable.
When selling a small business, tax implications should be reviewed to avoid the net sale proceeds being negatively affected by the tax code. It is common for small business sellers to structure the sale of the business in a way that will create a significant amount of financial savings.
Tax professionals should be consulted prior to the sale to make sure all steps are properly and legally taken. There are numerous factors to consider when selling a company and the top of the list is tax implications and the financial liabilities that follow.
Tax Management Tips
The overall tax amount can be reduced by creating a strategy over a multi-year period. Some tips include the following:
- When deciding to sell, it may seem like the obvious choice to accept payment in full to avoid the risk of the buyer defaulting on future payments. However, receiving the full amount increases your tax exposure by receiving a large sum within one tax year. This will likely put you into a higher tax bracket. For some, the full amount upfront may be the best option. Review and analyze the tax implications before making a final decision.
- If you choose to defer payments, such as seller-financed loans or earn-out payments, that will be received over a multiple year period, you are taking control of your tax rate and avoid higher tax brackets.
- With deferred payments, collateral or additional measures should be in place to protect your interests against a buyer who is unable to make payments.
- When negotiating the sale, the buyer and seller must agree to a price for the assets that will be transferred as part of the sale.
- Some assets are valued as capital gains which are taxed at a lower rate, while other assets are deemed ordinary income and taxed at a higher rate. The seller should aim to include assets under the capital asset classification.
- Due to depreciation, it may be difficult to convince a buyer to agree to these terms. IRS rules determine the allocation of assets, so it is important to negotiate the purchase price to include as many capital assets as possible.
- Small business owners who sell should be able to see the negatives and positives of the sale, leadership transition, income, and goals for the long-term legacy.
Small Businesses Types and Taxes
Sole proprietorships, partnerships, and S corporations are considered "pass-through" entities. Based on the type of small business, certain implications will be in place regarding how assets are handled. Sole proprietorships, partnerships, and LLC's assets sold with the company are handled separately.
LLC's are not recognized by the IRS and are therefore determined to be either a partnership or sole proprietorship based on how many members are involved. The LLC may also choose to be taxed as an S corporation. By choosing S corporation, it allows for LLC's, partnerships, and entities to avoid double taxation on the sale income.
Corporations and the shareholders may see double taxation on an asset sale at both a corporate and individual shareholder return level. However, the corporation may be able to leverage operating losses or business credit layovers to reduce overall tax exposure.
Pros and Cons of Selling a Small Business
Selling a small business creates both pros and cons to the seller. While creating a huge financial windfall, you also create larger tax implications. The final amount you receive and the structure of the sale will depend on the type of corporation of the small business. This means that, at the time the business was formed, the sale of the business should have been considered.
While costs will be incurred, it is highly recommended that professional tax and legal advisors be consulted when a letter of intent is supplied by the buyer. Professionals will be able to help navigate the negotiation process where the tax outlook for the buyer isn't the best for the seller and vice versa.
If you need help with selling a small business and resulting tax implications, you can post your job on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.