If you Sell a Business How is it Taxed

If you sell a business, how is it taxed? This seems straightforward, but the answer can be somewhat complex. 

The type of business, the assets included in the sale, and even the structure of the sale all play a role. These factors affect the type of tax you’ll pay on the sale and how much you’ll pay. Fortunately, there are several ways to limit your tax liability.

How Business Sales Are Taxed 

The sale of a business usually results in capital gains (profit from the sale of the asset), which means having to pay capital gains tax. However, other factors are involved, such as how long the seller owned the business and any deductions they may have claimed for depreciation. 

If you’re selling your business, here’s what influences the tax you’ll face.

Capital Gains Tax

Capital gains tax (CGT) is the tax paid on profits earned from the sale of assets. CGT only applies when an asset sells for a higher price than it was bought for, and the Internal Revenue Service (IRS) considers those gains taxable.

These assets can be tangible, like physical property and equipment, or intangible, like brands, copyrights, and other intellectual property. However, intellectual properties are usually taxed at the ordinary income tax rate. 

CGT rates are typically lower than the ordinary income tax rates determined according to your specific income bracket.

Depreciation Recapture

Depreciation recapture comes into play if you claim tax deductions for an asset’s depreciation but later sell it for more than its book value. You'll need to pay taxes on the difference between that depreciation (book) value and the sale proceeds.

Ordinary Income Tax

Ordinary income tax may apply to the sale of an asset held for less than a year. In the US, there are several income tax rates. 

At the time of writing, the maximum is 37%. For most people, the GCT rate is a maximum of 15%. However, it can be higher for higher income brackets, so most business sellers prefer to hold on to assets and pay CGT rather than ordinary income tax on the proceeds. 

If You Sell a Business, How Is It Taxed Based on Your Business Structure?

Is your business a limited liability company, a C or S corporation, or a sole proprietorship? The business structure will influence the tax implications of its sale. Below is a breakdown of how different business structures are taxed. 

Limited Liability Company (LLC)

When you sell an LLC, how it's taxed usually depends on how you've set it up with the IRS. Most LLCs are treated as "pass-through" entities, meaning the profits from the sale move directly to you as the owner and are taxed at your personal tax rate. 

In other words, selling your LLC is similar to selling any valuable asset, such as a home or investment property, where you'll typically owe taxes only on the gain (the difference between what you originally invested and what you sell it for). 

S Corporation

S Corporations are also "pass-through" entities, so the sale itself is not taxed directly at the corporate level. Instead, you'll pay taxes on your share of the profits from the sale, typically at capital gains tax rates. Basically, you'll only owe taxes on the difference between what you initially invested in your business and what you sell it for. 

C Corporation

Selling a C Corporation has a slightly different tax situation because these corporations are taxed separately from their owners. When you sell a C Corporation, the sales profits typically get taxed at the corporate level and then again personally when you receive the sale proceeds.

Sole Proprietorship

If you sell a sole proprietorship business, the proceeds of most of the assets will be subject to capital gains tax. However, some assets, such as inventory, are taxed as ordinary income as one person owns and manages the sole proprietorship. 

How to Minimize Tax Liability

There is no way to avoid paying taxes entirely when selling a business. However, there are some ways to minimize tax liability. Sellers can defer capital gains tax through deductions, charitable contributions, and re-investment strategies. Installment sales are another effective tactic.

Installment Sales

Installment sales entail the buyer paying the seller over an extended period in several installments instead of paying a lump sum. You can defer capital gains tax because you will receive a smaller amount each year instead of the entire amount in one year. 

Deductions 

Unlike repairs expensed in the year incurred, capital improvements are capitalized and depreciated over time. Therefore, capital improvements to your business property offer another opportunity for deductions. 

According to the IRS, a capital improvement must improve, restore, or adapt the property to a new or different use. Such improvement costs can be recouped through depreciation expenses.

Charitable Contributions

You can reduce your capital gains tax liability by donating long-term appreciated assets to charity organizations. However, the amount you can deduct is typically limited to a percentage of your adjusted gross income (AGI). This can vary according to the type of asset donated.

1031 Exchange (for Real Estate)

A 1031 exchange is a swap of one real estate investment property for another. It allows capital gains taxes to be deferred when doing so. Both properties must be located in the US.

Baton Streamlines the Entire Business Sale Process

If you sell a business, how is it taxed? It depends mostly on the business’s structure. Selling any type of company can have significant tax consequences. But you can minimize those consequences with smart strategies and Baton.

Baton offers a better way to sell a business and maximize the profits with free business valuations. Knowing your potential proceeds will be in advance equips you to estimate how much profit you could make and how you’ll be taxed on your business sale. 

Do you want your business sale to be less stressful and more efficient? 

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