The Tax Implications of Selling a Business

Guest Post by Riley Adams

You’ve worked hard to create a business worthy of being viewed favorably by someone else — if you’re lucky, multiple someones! The profit you’ve earned has paid off and now you have considered making a change in your circumstances. Quite often, a common exit path includes selling your small business. However, before proceeding, you will need to consider the tax implications involved.

Like any other transaction which nets you a profit, the sale of a business qualifies as income and you must pay taxes on any gains recognized during the sale. The income received classifies either as a capital gain or ordinary income and applies whether you sold assets of a company or shares of a company’s stock.

The type of company

When selling your business, the tax consequences and liabilities you face depend on the type of sale and transaction structure you set in place with the buyer. Most sellers make the mistake of not consulting with a tax advisor and needlessly hand away tax payments to the government.

When considering how much you might ask for in the sale of your business and how you will classify assets (e.g., Section 1231, 1245, or 1250 property, inventory, or another category), you should conduct some due diligence ahead of time and see if the type of company makes a difference.

Specifically, you should understand the tax consequences involved when selling your business from different corporate organization structures like a limited liability corporation (LLC), sole proprietorship, partnership, C Corp, or S Corp. Knowing the corporate structure will guide your tax strategy when it comes to selling your business.

For example, if you sell the assets held by an LLC and your transaction results in a gain, you will only pay capital gains taxes. In this instance, because the IRS treats LLCs and sole proprietorships as disregarded entities, you only have one taxable event, not a separate event on your personal income tax return and your commercial tax return.

As an option, you can have any gains made from the sale of these capital assets only appear on your personal income tax return, often resulting in a lower tax burden because long-term capital gains are lower than short-term capital gains (also referred to as ordinary income).

When you sell a business (LLC or S Corp), because you’ve likely held it for longer than a year, you usually prefer to have the capital gains treatment because the tax rates are lower and only occur once.

Basket purchase vs. sale of stock

A purchaser has two primary methods for acquiring a company: a basket purchase of the assets or outright purchase of the company stock. In the former, the underlying assets transfer from seller to buyer with the agreed-upon market price allocated to the assets.

In other words, if an asset has a depreciated value of $50 but is sold for $60, this new value must be assigned to the asset at sale, which is then depreciated by the new owner. To formalize this price allocation in the eyes of the IRS, the buyer and seller both file a Form 8594: Asset Acquisition Statement with their tax returns.

In the event of an all-stock sale (stock purchased instead of assets owned by the company), the seller will realize a capital gain just like they would on the sale of capital assets.

The seller must also decide which entity is selling the stock: if the company sells the stock, then double taxation will occur (tax paid at the corporate rate and then the capital gains tax paid on a personal income tax return). If you sell assets through an S corporation or partnership, the individual owners (or shareholders) will each have a responsibility to pay capital gains taxes on their personal returns.

Now, let’s take a closer look at the capital assets involved in a business change of ownership transaction.

Capital assets

Per IRS rules, capital assets categorize into one of three different groupings:

1. Real property — Real estate property of the business, such as land and building structures. Sale of real property has tax levied as a separate capital asset unless the buyer chooses to purchase the entire entity.
2. Depreciable property — Type of property which loses value over time with normal wear and tear. Such examples include equipment, hardware, computers, office furniture, etc. The IRS treats the sale of depreciable property as a gain or loss, based on current value. If you held the property for longer than a year, you will face a long-term capital gain or loss. You will use the current value versus the purchase price to decide the applicable tax rate for this depreciable property.
3. Inventory property — As a going concern, most businesses hold inventory which it sells at a markup in the attempt to earn a profit. This inventory, when converted to sales, represents ordinary income and the IRS considers this as part of your normal business income. However, when the inventory counts as part of the business sale transaction, the IRS considers this as a capital gain (loss) instead.

As mentioned above, in the case of owning and selling an S Corp or LLC, you will strongly prefer a long-term capital gain resulting from your sale. This results in single taxation on your personal income tax return and at lower long-term capital gains rates.

How to sell a business without any tax implications

If you want to have Uncle Sam left out of this transaction altogether, an alternative does exist in the form of a stock exchange. In the event you’d prefer having stock in exchange for your own company’s stock, as opposed to cash or other proceeds, you can avoid paying taxes on this stock-for-stock exchange.

Certain provisions for avoiding taxation exist pertaining to this business reorganization; however, this method can avoid paying any taxes on the sale of your business. The IRS states the seller must receive between 50 percent and 100 percent of the buyer’s stock in order for the transaction to side step paying any taxes.

Tax implications of selling a business

Finding a buyer for your company is part of the natural lifecycle of a business. From founding, startup, scaling and maturation, selling to an interested buyer only amounts to the next phase of your business’s life.

When deciding how to structure the transaction, make sure you plan ahead on how you will classify the various assets of the business as well as how you might be able to avoid paying taxes at all on the sale.

Riley Adams, CPA, is a senior financial analyst working for a Fortune 500 company in New Orleans, Louisiana. He also runs the personal finance blog called "Young and the Invested," a site dedicated to helping young professionals find financial independence and live their best lives.