Baby boomers own 2.3 million businesses, according to Project Equity. This nonprofit organization predicts that 6 out of 10 owners plan to sell their businesses within the next decade. If you’re among this number or a younger-generation owner thinking of selling a business, keep these seven tax considerations in mind.
1. Negotiate everything for the sale of a sole proprietorship
If your business is a sole proprietorship, a sale is treated as if you sold each asset separately. Most of the assets trigger capital gains, which are taxed at favorable tax rates. But the sale of some assets, such as inventory, produce ordinary income. It’s up to the parties to negotiate the terms of the sale, which includes allocating the purchase price to the assets of the business.
IRS Form 8594, Asset Acquisition Statement, shows seven classes of assets to which you must allocate the purchase price. The first class includes cash and checking accounts, to which you allocate the purchase price dollar-for-dollar. The final class (class VII) is for goodwill and going-concern value. This is the intangible asset that commands part of the purchase price. The more goodwill the business had, the greater the allocation to this class.
Keep in mind that allocation is a negotiation. The reason: while the seller wants to allocate as much as possible to capital gain assets such as goodwill, the buyer wants a good allocation for assets, such as equipment and realty, that can be depreciated going forward.
2. Sell a partnership interest
The sale of an interest in a partnership is treated as a capital asset transaction; it results in capital gain or loss. But the part of any gain or loss from unrealized receivables or inventory items will be treated as ordinary gain or loss. Capital gain deferral is possible through an Opportunity Zone investment (explained in #7 below).
3. Decide on a corporate sale of stock or assets
If you own a corporation, there’s a choice in how to structure the sale: sell stock or characterize the transaction as a sale of assets. Generally, sellers like to simply sell the stock to limit tax reporting to capital gain on the transaction. But buyers prefer an asset sale because this creates higher basis for the depreciable assets they’re acquiring. Again, negotiations between the parties can resolve the structure of the sale. For example, a seller may be willing to take a little less to complete a stock sale, reflecting the higher tax bill that would have resulting from an asset sale.
4. Make an S election
The characterization of the sale as a stock or asset sale applies equally to C and S corporations. But there’s tax savings to be reaped by being an S corporation. Gain on the sale of a C corporation requires the owner to report an additional 3.8% Medicare tax on this net investment income. In contrast, if the business is an S corporation and the owner is actively involved in the business and not merely a silent investor, then the gain is not subject to this tax. A C corporation planning on a sale can make an S election where advisable, assuming the corporation meets the requirements for being an S corporation.
5. Use an installment sale
One of the ways to minimize the tax bite on profits from the sale of a business is to structure the deal as an installment sale. If at least one payment is received after the year of the sale, you automatically have an installment sale. But there are some points to keep in mind. You can’t apply installment sale reporting for the sale of inventory or receivables. And there’s always a risk in an installment sale arrangement that the buyer will default. Details on installment sales in the instructions to Form 6252.
6. Sell to employees
If your business is a C corporation and you plan ahead, you can sell your business to your staff through an employee stock ownership plans (ESOP). The ESOP is owned by employees (find more information about ESOPs from the IRS). From an owner’s perspective you have captive buyers and don’t have to search around. You set a reasonable price for the sale and receive cash from the ESOP. You can then roll over the proceeds into a diversified portfolio to defer tax on the gain.
You can also use ESOPs for S corporations, but the deferral option for an owner doesn’t apply. Revoking an S election in anticipation of a sale is something to consider.
7. Reinvest gain in an Opportunity Zone
Owners who realize capital gains on the sale of their business have a way in which to defer tax on that gain if they act within 180 days of the sale. They can reinvest their proceeds in an Opportunity Zone (you go into a Qualified Opportunity Zone (QOZ) Fund for this purpose). Deferral is limited because gain must be recognized on December 31, 2026, or earlier if the interest in the fund is disposed before this date. Holding onto the investment beyond this date can result in tax-free gains on future appreciation. An owner who sells his or her business doesn’t have to put all the proceeds into a QOZ, but tax deferral is limited accordingly. Find details about Opportunity Zones from the IRS.
Many business owners find it difficult to walk away from their businesses. They love the action and don’t have personal plans for their time in retirement. They can consider negotiating a consulting agreement with the buyer. This gives the departing owner ongoing income and continuing tax breaks (such as claiming the qualified business income deduction if eligible).
A sale of a business is a highly complex matter from a legal and tax perspective. Don’t proceed without expert advice.