Tax on Sale of Business: Everything You Need to Know
The tax on sale of business can be costly, perhaps even to the tune of half the company's value.3 min read
2. Purchase Price Allocation
3. Installment Method
The tax on sale of business can be costly, perhaps even to the tune of half the company's value. Any profit your company makes will be taxed. No matter how well you negotiate the deal, the IRS will claim its share. With careful planning, however, you can save yourself money.
Assets or Stock
Typically, in a business sale, you either sell your company's assets or its stock. In a stock sale, the two parties agree on a price and trade stock for cash. Asset sales are more complicated since the parties have to agree on how the cost is allocated among all the assets. The tax assessment for each differs.
In terms of tax payment, the IRS usually gets less from a stock sale. This makes stock sales a more attractive option for sellers.
- Most states do not impose sales or use transfer taxes on stock sales, though some might levy a stamp tax.
- Stocks are subject to capital gains tax, but this decreases the longer the seller has held the stock. It's likely the seller has owned stock longer than assets.
- With a C corporation, both the company and the shareholders are taxed. This “double taxation” is one reason why many prefer a stock sale. With asset sales, the company is taxed on gains from the sale of assets. The shareholders then have to pay capital gains taxed upon liquidation. Stock sales are also liable to capital gains tax. However, this is usually at the long-term rate.
- It is possible to make a tax-free stock sale, provided the transaction is an exchange of stocks, and the seller receives between 50 to 100 percent of the buyer's stock. Any cash exchange will be taxed.
However, most buyers prefer asset sales.
- Buyers can get a step-up in the basis of the assets purchased. That is, appreciated assets can be revalued which can lead to better tax deductions in the future.
- When a buyer purchases a company's stock, the buyer also inherits any liabilities from the seller. This is not the case with an asset sale, where the buyer purchases the company's assets but the seller maintains liability for past business.
- Tax-free asset transfers are possible, but only if the seller receives 100 percent of the buyer's stock in exchange. As with a tax-free stock sale, any cash exchange will be taxed.
Both buyer and seller need to be aware of their state tax laws. Some states impose sales tax on the sale of asset, and some tax stock sales. Depending on where you live, you might also have to pay transfer taxes on assets and real estate.
Purchase Price Allocation
IRS rules require that with an asset sale, the purchase price of the business must be allocated among all assets. This price allocation must be the same for both buyer and seller, and should, therefore, be written into the sales contract.
It is here that perhaps the needs of the buyer and seller are most in conflict. The buyer wants to reduce the business's tax bill as much as possible in the first few years. This means allocating money to items that can be deducted immediately, or to quickly-depreciating assets. The seller, however, wants to designate more of the money to assets that are treated as lower-rate capital gains.
It is important therefore that the parties negotiate this aspect of the sale carefully and thoroughly.
One way of lowering the immediate tax burden is by arranging with the buyer to purchase capital gains assets over a period of time. This is known as an installment method. Since the seller receives payment in a number of installments as opposed to a single sum, the tax payment on each installment is usually less than on the whole.
Some rules apply to this method:
- It only applies to capital gains income, so the following cannot be considered:
- Accounts receivable
- Property in use for less than a year
- Any other gains which are considered ordinary income
- There must be a payment made one year after the sale.
- The sale must not have resulted in a loss.
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