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Structuring Your Business Sale To Avoid An Unexpected Tax Hit
Selling your business brings a lot of change. This is not a consideration that should be approached lightly. You will almost certainly pay taxes on the sale of your business. The amount that you pay will depend on whether the money you make from the sale of your business is taxed as ordinary income or capital gains. The sale of your business should be planned to create the best possible outcome for you. Decisions you make in your business before the sale can mean the difference between the profits going to you, or the IRS.
How is your business structured?
A business can be structured as a Partnership, a Sole Proprietorship, Limited Liability Company (LLC), S Corporation, or C Corporation. Some entities are considered “pass through” entities and will provide the most flexibility in negotiating a sale of your business. For a C Corporation asset sale, there is a possibility that the seller will be taxed twice: the corporation will pay tax on any gains realized when the assets are sold, and then the shareholders will pay capital gains tax when the corporation is liquidated.
There are many other considerations related to the structure of the selling businesses.
Selling Assets or Stock?
When an entity is involved in the sale, you can sell the stock, or sell the assets. With a C Corporation asset sale, the seller will be taxed twice – the corporation will pay tax on any gains realized when the assets are sold, and then the shareholders will pay capital gains tax when the corporation is liquidated; this is generally what buyers prefer.
The other option is to sell the stock. You will pay capital gains tax on the profit from the sale, and generally it will be at the long-term capital gains rate. To determine which option would be best for you and your business, you should consult with a professional to analyze the pros and cons from the different ways of going about the transfer to permit the least amount of money going to the IRS as possible.
Employee Stock Ownership Plan (ESOP)
An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. If you own a C Corporation, by setting up an ESOP, you can roll over the proceeds from the sale of your business on a tax-deferred basis. You receive cash on the sale and reinvest it in a diversified portfolio. This is called a 1042 rollover after the Internal Revenue Code section that allows the move. With this plan, you potentially can avoid paying capital gains taxes altogether, should you hold onto the securities until you die. This is because this is a deferral method. You pay capital gains taxes on the distributions.
This can be a good way to allow you to defer some of the tax due on the sale of the business until you get paid over the course of future years. Getting paid over the course of time would require you to finance the sale of your business by taking back a mortgage or note for part of the purchase price.
This can be used when you receive at least one payment for your business after the year of the sale. With spreading out your tax bill, only “capital gain income” can qualify for installment sale status. This generally works out to be gains on assets that have appreciated in value beyond their original purchase price such as real property, and even goodwill. Gains on items such as your inventory, accounts receivable, and property that’s been used for one year or less will be treated as ordinary income, and therefore not eligible for installment sale status. You then would need to pay tax on any gains in the year of the sale, even if you haven’t yet received payment for the items.
Specific equations are then used to calculate your profit percentages that will need to be reported as taxable gain for that year. This method can be very effective to help reduce tax liability, but the help of a professional is needed to ensure that these figures are being computed properly.
We Are Here to Help
Whether you know you want to sell your business, or are just entertaining the possibilities, now is the time to consult with a professional to make sure you are set up for the smoothest transfer with the least amount of taxes possible. This article contained a few ideas for helping reduce tax liabilities upon the sale of your business, but for a comprehensive breakdown, come in and speak with a Mesa attorney today to have your business needs evaluated, and any questions answered.
Written By Brad Denton
40 N. Central Avenue, Suite 1400-1532
Phoenix, AZ 85004
GDP Business Blog
Mesa, AZ 85213