We all know what it is like to build a business from scratch with years of consistent hard work. But for some reason, you have to sell it and hand the ownership to someone else. There are many things that you have to worry about when selling a business. You have to agree on some terms with your buyer while also negotiating the price involved, excluding the fact that you also have to look for a buyer. You also have to add the tax to this list. How much tax would you pay and how much can you defer?
Selling a business might be a little complicated so it's best to work employ a qualified tax advisor or CPA. However, you do not want to be totally naive or ignorant of the whole process. There are a number of things that you can learn by yourself. And you can use these things to get the best deal to make a successful sale financially. The knowledge of capital gain tax and how to reduce it are one of such things.
What is Capital Gain Tax?
Capital gain tax usually occurs when a business owner sells its asset (business) for a higher price than they purchased it (which is the basis of its tax). An asset can include a business, land, share on the stock, etc.
For instance, if you buy a stock for $8000 and three years later you're selling that stock for $12000, the increase of $4000 on the stock is what's called capital gain and the IRS taxes this gain.
How Capital Gains are Taxed?
Short Term Capital Gains
If you owned the business that you are selling for a short period of less than one year, the capital gain tax that you will be paying will be higher. The reason for this is that the rate for taxing short term capital gain is the same as the ordinary income. As of 2017, the tax rate was around 10% - 39.6%, although many people tend to pay 25%.
Long Term Capital Gains
This is different from the short term gain because the tax rate you are charged with is quite lower, and in most cases does not go past 20%. To qualify for long term capital gains, you have to have owned the business for a period of more than a year. The rate is usually lower than ordinary income. This means that the tax rate when you sell the business will be less than the rate on the salary. The most that taxpayers have to pay for long term capital gain is 15%.
According to the IRS, if your income tax bracket is between 10% and 12%, you do not have to pay any taxes on the capital gain as the net tax rate for your capital gain is 0%. However, if your income tax bracket is around 37%, you will be required to pay around 20% capital gain tax. But if you fall somewhere in between both brackets, your capital gain tax rate is likely to be around 15%.
With capital gain tax, you are likely to have a tax bill that is lower compared to paying tax on ordinary income.
When Is Capital Gain Tax Paid?
You have to pay capital gain tax when you sell a capital asset from your business. The IRS does not view your business as one big asset. It is viewed as a collection of different small assets that can all be sold individually.
You should know that taxing and taxes are not usually straightforward and things can get complicated very quickly if you do not pay close attention. For instance, not all of your business assets are going to be taxed at the same rate as capital gains. There are some of your assets that will be taxed at the same rate as the ordinary income. And in many cases, this means a higher tax rate. When you sell your inventory, for instance, the tax rate is the ordinary income rate and not the capital gain tax rate.
There are different guidelines by the IRS on the valuation of each business asset. You need the service of a professional tax adviser to appropriately deal with issues like this.
Allocating purchase prices
The way you allocate purchase price for different assets in your business goes a long way in determining the amount of money that you will be paying in taxes. This allocation is what determines if you will be making any profits or losses on the individual asset. It also determines the basis of the buyer in different assets.
There are guidelines from the IRS on the way purchase prices should be allocated on business assets. The value of the asset should be at the fair market value in a particular order. The order is as follows:
- Class 1: All deposits and cash (including savings account deposits and checking).
- Class 2: Personal property that is actively traded which includes US securities, certificates of deposits, publicly-traded stock, and certificates of deposits.
- Class 3: Receivable accounts and other things that can be marked to market annually at least.
- Class 4: Properties and inventories that are put up for sale ordinarily in the course of business.
- Class 5: Other assets that are not considered a part of another class such as land, building, furniture, equipment, and vehicles.
- Class 6: Intangible assets such as trademarks and licenses, excepting going concerned and goodwill.
- Class 7: Going concerned and goodwill value.
Treatment for partnerships and corporations
The treatment is different when you are selling a business that is built as a corporation or when you are parting with your shares in a partnership business. The difference is explained below.
If the business is a partnership business and you are selling your own shares, there is no need for you to allocate purchase price for the assets in the partnership. All your shares in the partnership business are considered a capital asset. So your capital tax gains payment will be on the total money that you receive from the adjusted bases which are considered the partnership cost.
For example, if you are selling your own share in a partnership business that has an adjusted basis of $15,000. Then you end up selling your share of the partnership business for $40,000. Your capital gain is a sum of $25,000. If you have been a part of the business for more than a year, then your tax rate will be based on the long term capital gains.
In a Corporation
If the business that you are selling is built as a corporation that means that you have your stock in the company you built. When you are selling this corporation, you have a choice of either selling the individual assets or to deal with it as stock selling. The latter option is the one that is commonly preferred by many business owners looking to sell their corporations. If you owned this business for more than 12 months, then the profit from the sale of the period can be treated as a capital gain. So your tax rate will be the long term capital gain.
Is It Possible To Totally Avoid Or Reduce Capital Gains Tax?
If you have decided to sell your business, it is only normal that you try to reduce your tax bill. But this is a task that you have to leave to the professionals to deal with. It will definitely cost you some money to bring in experts to handle different situations when selling your business. But failure to bring them in to help you out will cost you a lot more. These experts also help you to make the best decisions in strategic periods or situations. Consulting a tax advisor or CPA that deals with the tax rules in your state is important as it can work differently from federal tax payments.
Video: How to Avoid Capital Gains Tax when Selling a Business | Nomad Capitalist
Some of the strategies that you might consider in this case are:
Installment sales help to reduce the amount of capital gain tax that you would pay if the profit from selling your business will be pushing you into a tax bracket that’s higher than you already are in. if you are choosing installment sales, you will be getting one of the payment a whole year after you’ve sold the business. It means that you have an agreement with the buyer to be paid in multiple installments annually, instead of a one-time payment.
For example, if you are selling your business on installment sales that split over a period of four years. The tax that you will be paying will be years after you have received each payment. This spreads your tax bill over that period of installment payment.
However, there are some business assets that are not eligible to be sold in installment sales and have to be sold off at once. An example of such an asset is inventory. So, if you are considering installment sales, check with the IRS guidelines and also talk to a tax expert.
Purchase Price Allocation
The tax rate on capital gains is not as high as the ordinary income tax rate. Unless you are selling your shares in partnership business or your business is a corporation, you have to allocate a purchase price or value for each of your business assets. The amount that you allocate to each asset can impact your tax payment. The method of purchase price allocation is known as a residual method.
If the purchase price has a lot of items that can be taxed at the rate of the long term capital gain, then you would not be paying as much as if mostly contains items taxed at the ordinary income tax rate.
While the residual method is mostly straightforward, there are still some things you have to discuss with your buyer. For instance, it might profit you to categorize some assets as capital gain but it is not in the buyer’s best interest. These are things that you have to work out through negotiations. Both buyer and seller have to work on the residual method as it determines the business basis for the buyer and the amount of purchase price that is assigned to intangible assets or goodwill. You should work with professionals in fixing the prizes before you finalize the sale.
You have to take your time to understand the impacts of tax when you are trying to sell your business. This will guide many of the decisions that you take so you do not take the wrong choice. It is always a good idea to work with professionals to deal with different situations and determine the best strategy to help you reduce tax amounts.
More on the topic: Capital Gains Tax Considerations When Selling a Business
Leon Collier is a freelance writer at a essay writing service from the UK. He loves to write about everything: pop-culture, travel, self-development, and marketing. He enjoys reading and playing tabletop games on Saturday with his friends. Follow him on twitter @LeonCollier12.