When you sell your business, you will almost always have to pay a capital gains tax. Do not confuse this tax with the corporate income tax which is based on the profits of the business itself. Capital gains tax is a tax on the company’s capital assets that you sell and make money on. The most common types of capital assets include real estate, intellectual property, stocks, bonds, accounts receivable, and equipment property. On the other hand, all personal property and raw materials will not count as capital assets.
It is possible for the business entity to own capital assets for investment purposes rather than for the day-to-day operations of the organization. For example, let’s say your limited liability company purchases shares of another company and then sells them. In this case, the company would be subjected to a corporate capital gains tax. But if you sell a capital asset linked to the operation of the company, such as shares of its stock or equipment, then you pay the capital gains tax on your personal income tax return.
No matter what type of company you own, chances are you will be paying capital gains tax during the sale of the business. However, it is important to understand the differences between the sale of these types of companies. Then you will be able to calculate how much capital gains tax that you’re likely going to pay after you sell your business.
Sole Proprietorship
If you are selling a sole proprietorship, then you are only selling its capital assets. A sole proprietorship means that the owner is the only entity of the business. There is no separate entity for the company which you can sell and transfer to someone else. All you can do is sell the capital assets which have been acquired while you were running the sole proprietorship. Some states allow you to create a fictitious name for the business which you can manage it under. But you will still be paying all your taxes for the business on your personal income tax return.
How to Sell a Sole Proprietorship
A sole proprietorship will typically have equipment and/or intellectual property to sell during the sale of the business. Since these are all capital assets, you can easily calculate the capital gains tax you owe by simply multiplying the capital gains tax rate by the amount of profit you made from the sale of these assets.
Selling Your Business: Going FSBO vs Hiring a Broker
Limited Liability Company
There are multiple ways in which a limited liability company can be taxed. If it is a single-member LLC, then your company becomes a disregarded entity. That means you can pay the company’s taxes on your personal income tax return and not get taxed twice. But if the company is a multi-member LLC, then they will get taxed as a partnership instead. In this case, each member will pay taxes on the profits they made from the company. The only time an LLC would get taxed twice is if the owners chose to classify it as a corporation for tax purposes.
As far as capital gains taxes are concerned, each owner would pay a capital gains tax on the amount they made from the sale of the company’s capital assets. If you’re a single member, then you’ll pay the whole amount. Regardless of your classification, you won’t have to pay the corporate capital gains tax when you sell your business.
Corporation
Shareholders are the owners of a corporation. The value of the corporation is determined by the value of its shares. The buyer would basically be purchasing enough shares of the company to have power and control over it. The difference between the purchase price of the shares and the value of the shares will determine if it was a capital gain or a capital loss. If it’s a capital loss, then you obviously wouldn’t pay any capital gains tax because you lost money on the deal. But if you made a capital gains from the sale of the shares, then you would pay a capital gains tax on the profits you made from it.
Remember that shareholders must pay the capital gains tax on their personal income tax return by filing a Schedule D form. The sale wouldn’t be considered a corporate capital gains because the actual business entity doesn’t own the shares. It was the individual shareholders who owned the shares, which means they must pay the capital gains tax on their individual tax return. But as you’re waiting for the sale to take place, the corporation will be taxed separately for the appreciation of the capital assets until they are sold.
The sale of a C-corporation is usually a timely and well-planned process. It could take months or even years for the sale to take place. Meanwhile, the corporation is still faced with double taxation on its appreciated capital assets and profits. If you have a C-corporation that you are selling, consider changing it to an S-corporation as you wait for the sale to take place. Then your business won’t have to pay corporate taxes on the asset appreciation.
If you want to defer the capital gains taxes altogether, then you can let the buyer pay you with stock instead of money. In return, you will transfer your company’s stock over to them after you’ve reorganized the company. If you follow the rules of the Internal Revenue Service carefully in this transaction, then you won’t have to pay any taxes on the stock you’ve received from the buyer. The only time you’ll pay capital gains taxes on the stock is after you sell it in the future.
The IRS will require you to hold their stock for 2 years before you can sell it. Otherwise, you won’t be able to defer the capital gains taxes any longer. Remember that your buyer will have complete control over your company after you transfer your stock to them. The stock they give you is likely not going to give you power over another company, so make sure you’re getting valuable stock in exchange for your company’s stock.
Capital Gains Tax Rate
Now that you understand which assets get taxed as a capital gain, next you need to understand what the capital gains tax rate is. There are actually two types of capital gains taxes; the short-term and the long-term. The short-term capital gains tax applies to any capital assets which you have owned for less than one year. The long-term capital gains tax applies to any capital assets which you have owned for over one year.
Typically, the short-term rate will be much higher than the long-term rate. In fact, the short-term rate will be the same as your personal income tax rate. The government does it this way in case you are purchasing capital assets and then quickly reselling them for a profit. Since the sale of capital assets is not supposed to be the company’s main source of income, the government wants to ensure that you’re not cheating the system by reselling assets as a side business. So, they tax short-term asset resales as personal income.
The short-term capital gains tax rate can be anywhere from 10% to 39.6%. Those who make under $9,325 are the ones who pay 10% and those who make over $418,400 will pay 39.6%. For example, let’s say you owned a sole proprietorship for less than a year and you end up selling a newly established trademark and a few pieces of equipment. If your profit was $100,000, then you would pay a 28% capital gains tax rate. This is the same rate as it would be for your personal income. The tax amount in this example would come out to $28,000.
The long-term capital gains tax rate will be 0%, 15%, or 20%. If your income is less than $37,950, then you don’t have to pay any long-term capital gains tax. If your income is between $37,951 and $418,400, then you only pay 15% tax. If your income is over $418,400, then you pay 20% tax. Therefore, if you’ve had your business for over one year and then you sell the assets, the amount of income you make during the year of the sale will determine what your long-term capital gains tax rate is. But this will be a different tax rate than your personal income tax rate because it’s long-term and not short-term.
Capital Gains vs. Capital Loss
When you sell the assets of your business, you will hopefully have more gains than losses. If you subtract the capital losses from the capital gains that you made from the sale, this becomes your net capital gain. But if you find that you have more capital losses than capital gains, the Internal Revenue Service allows you to deduct up to $3,000 of those losses per year on your tax return. If you sold your business for a loss bigger than $3,000, you could spread those deductions out over the years to make up for it. The only problem is that if you have future capital losses, you won’t be able to claim those losses if you’re still claiming $3,000 from the previous losses.
Tax Considerations When Selling a Business
Reduce Your Tax Burden
When you sell your business, there is a way to reduce your tax burden by allocating the purchase price toward its more valuable tangible assets. In other words, if the value of your company is based heavily on its tangible assets instead of its intangible assets, then your state’s sales tax will be applied to most of the sales price instead of the capital gains tax. As you probably know, the buyer is the one responsible for paying the sales tax. This means you can get away with reducing your liability on the capital gains taxes.
Of course, the only problem with this is getting the buyer to agree to it. The buyer will be looking to pay fewer sales taxes in the purchase agreement. You don’t want to scare the buyer away by making them pay too much, but you also don’t want to pay a lot of capital gains tax either. So, what do you do? One arrangement you can make is to have your buyer depreciate their biggest expenses over a period of time. That way, they don’t have to pay all the taxes at once. They can just spread it out and pay while they’re operating the business. Meanwhile, you can still allocate the sales price on the tangible assets.
If your business is less than a year old and you want to sell it already, then you can reduce your tax burden by simply waiting until it is over a year old. This will make your capital assets become long-term assets instead of short-term. As you previously learned, long-term assets are taxed a much smaller tax rate than short-term assets. However, the only problem with this is if you have a lot of expenses to pay while you’re keeping your business open. It really depends on the circumstances and which assets you have available to sell.
If you have a sole proprietorship, limited liability company, or partnership without any real estate, you could close your physical establishment and just keep the tangible capital assets in storage until they are a year old. Then you can sell them and pay the long-term capital gains tax rate on the profits. If you have a corporation, then it likely has equity value in addition to its asset value. You can’t very well eliminate the physical establishment of the corporation and store the assets without hurting the equity value of the company. The only thing you can do in this case is to try to allocate the sales price toward the tangible assets.
Installment Sale
If you’re selling your business with a seller financing option, you can spread your capital gains tax burden throughout the duration of the financing term. This only applies to the sale of certain capital assets that are considered capital gains income and not ordinary income. Intangible assets would fall into the category of capital gains income. The financed sale of these assets can allow you to spread out the taxes until the full price is paid. You just can’t do this with short-term tangible assets like inventory or any property owned for under one year.
Disclaimer
This is not a tax advice. All decisions regarding the tax implications with a business sale should be made in consultation with a qualified Tax Advisor.
