Understanding Taxes When Selling A Business

Imagine this: After years of hard work, John and Kate finally sell their business for a life-changing amount of $5 million. The deal is closed, the funds hit their account, and they start planning their next move—whether it’s a new venture, a well-earned break, or retirement.

But not so fast—then come the tax bills, and a significant chunk of their hard-earned business sale goes to the government. 

If taxed as income, the government takes 37% of the $10 million, significantly reducing their take-home amount. What seemed like a massive payout suddenly ended up smaller than expected, impacting John and Kate's next plans.

As a business owner, moments like these shouldn’t come as a surprise. Instead, you need to understand your tax obligations upfront, plan strategically, and take steps to maximize your take-home profit. 

This becomes far more doable with Baton Market's cutting-edge mergers and acquisitions (M&A) platform, which simplifies business-sale processes and helps sellers navigate financial complexities.

Still, let’s review a practical guide to understanding and managing taxes on selling a business.

Types of Taxes When Selling a Business

As part of your business financial planning, you must understand the various types of taxes and IRS rules on owner financing, including the following.

Capital Gains Tax

Capital gains tax (CGT) is charged on profits made from the sale of a business or other capital assets. Depending on your income, rates can be 0%, 15%, or 20% of the profit. 

There are two types of CGT:

• Short-term: This is levied on the profits of a business held for a year or less.

• Long-term: This is imposed on the profits of a business held for more than a year.

CGT calculations depend on your gains' size, federal tax bracket, and holding term. For instance, single filers with a taxable income of $47,025 - $518,900 pay tax at a rate of 15%, while those in the $0 - $47,025 bracket pay no tax.

Ordinary Income Tax (for Certain Business Assets)

Certain assets are taxed as capital gains or ordinary income based on their nature in a business sale. For instance, inventory and accounts receivable are taxed as ordinary income because they would have been taxed as regular income if sold during normal business operations.

As a result, ordinary income items have a higher tax liability than capital gains assets, with tax rates reaching up to 37%. The best way to determine what's affected is by identifying all earnings the business would have received during normal operations, like those from stock and unpaid invoices.

Depreciation Recapture Tax

If you had previously claimed depreciation on equipment and vehicles, you’d pay tax on the gains realized from selling those assets. This tax, known as depreciation recapture tax, is considered an ordinary income tax, attracting a higher tax burden.

For instance, say you bought a used machine for business at $12,000 and sold it 2 years later at $9,000. During the time of ownership, you claimed $8,000 in depreciation. 

The basis at the sale was $4,000 ($12,000 - $8,000 = $4,000). In this case, your gain is $5,000 ($9,000 - $4,000 = $5,000), which would be taxed as ordinary income.

State and Local Taxes

When selling a business, several state and local taxes must be considered, and the laws vary by jurisdiction. 

Examples include:

• State income tax: If part of the sale is taxed as ordinary income, it may be subject to state income tax at your personal tax rate. States like Colorado (4.4%) have a flat rate, while others have progressive rates based on income.

• State capital gains tax: States like Texas, Nevada, and Florida don’t impose this tax, but New York levies it at up to 10.9% and California at up to 13.3%, among the highest in the country.

• Withholding tax: Some states charge a withholding tax on certain assets if the owner doesn’t reside in the state. For example, California withholds 3.3% of the purchase price for non-residents.

Due diligence is critical to uncover more tax exposures in your state, including sales, transfer, and local business taxes. Some authoritative resources you can use include the Small Business Administration (SBA), the Internal Revenue Service (IRS), and SCORE.

Self-Employment Tax (for Sole Proprietorships and Partnerships)

Unlike corporate structures where owners may avoid self-employment (SE) tax, sole proprietors and partners could owe 15.3% SE tax on certain parts of the sale. This rate has two parts: 12.4% for Social Security and 2.9% for Medicare.

All assets taxed as ordinary income, like accounts receivable, depreciation recapture, and inventory, are subject to SE tax. You can reduce your SE tax liability by allocating more value to goodwill and intangible assets or restructuring to an S or C corp before the sale.

How Business Structure Affects Taxes

Your business structure also impacts how the proceeds from a business sale are taxed. Here is what you need to know.

Sole Proprietorships and Partnerships

Sole proprietorships and partnerships are pass-through entities, meaning profits and losses pass through to the owner or individual partners, who must report them on their personal tax returns. The business itself isn’t taxed.

In these structures, profits are taxed like any other income, and certain assets like inventory and accounts receivable are subject to a 15.3% SE tax. These structures can only sell business assets, not stock, impacting their tax liability.

C Corporations

C corporations are not pass-through entities; they pay corporate tax at a flat rate of 21%. Profits distributed to shareholders are also taxed, which is why this structure has a double taxation risk.

When selling a C corporation, a stock sale is preferred over an asset sale. In this case, the business only pays capital gains tax, avoiding corporate taxation. In the event of an asset sale, the corporation is taxed at 21%, and shareholders pay taxes again on dividends.

S Corporations and Limited Liability Company (LLC)

S corps and LLCs don’t pay corporate taxes, as LLCs can be taxed like partnerships or sole proprietorships, while S corps are pass-through entities. But they still pay capital gains tax on goodwill and real estate.

In S corporations, a stock sale is more favorable as the sale is taxed as capital gain income, while LLC owners may avoid SE tax on part of the sale if it is taxed as an S corporation.

Asset Sale vs. Stock Sale: The Deal Structure That Saves You Money

There are two common deal structures in M&A transactions: Stock or asset sale. Your choice depends on specific motivations and circumstances.

Here are the differences: 

• Asset sale: In this sale, a business or owner sells specific assets to the buyer instead of ownership via company shares. Asset sales generally result in gains, which are subject to ordinary income tax up to 37% and capital gains tax up to 20%. Sellers pay more taxes on this sale, but buyers prefer it as it has fewer liabilities and better tax treatment due to asset depreciation.

• Stock sale: This sale involves selling the entire entity to the buyer, meaning the buyer acquires all assets, liabilities, and contracts. Sellers prefer this option as they pay only long-term capital gains tax, which can be 0%, 15%, or 20% of the profit. It’s more tax-efficient with no SE tax or depreciation recapture. However, buyers inherit liabilities and face higher due diligence costs.

Your pick between these structures depends on your business size, tax implications, and buyer preference. For instance, opt for a stock sale to minimize taxes. If the buyer demands an asset sale, negotiate favorable tax allocations, such as allocating more value to goodwill and intangibles.

Tax Strategies to Reduce Your Tax Burden

Selling a business is a major financial transaction with multiple seller financing tax implications. How you structure the sale impacts your tax liability. Follow these best practices to maximize your after-tax earnings.

Structure the Deal for Tax Efficiency

Structure the sales for capital gains tax treatment—in this case, opt for a stock sale instead of an asset sale. Capital gains tax rates (0%, 15%, or 20%) are lower than ordinary income tax rates (up to 37%).

If an asset sale is unavoidable, allocate more value to goodwill and intangible assets instead of inventory and accounts receivable.

Consider an Installment Sale

Opt for an installment sale to spread the payments over multiple years, reducing the tax impact in one year. Receiving a lump sum attracts a large tax bill as it falls in a higher tax bracket. An installment sale lets you stay in a lower tax bracket, reducing your immediate tax liability.

Maximize Tax Deductions

You can deduct certain expenses when selling your business to reduce your taxable income and tax bill. 

Some examples include:

• Selling expenses like broker, legal, accounting, and valuation fees

• Depreciation recapture offset

• Unused net operating losses (NOLs)

• State and local taxes

• Business loan payoff interest

• Lease termination costs

• Employee severance and benefits payouts

• Retirement contributions

Consult a business tax professional to take advantage of these deductions and boost your after-tax revenues.

Use Tax-Deferred Strategies (If Applicable)

If your business is a C corp that qualifies under Section 1202, take advantage of the Qualified Small Business Stock (QSBS) Exemption to eliminate up to 100% of capital gains taxes. In this case, your business must have been a C corp for at least 5 years and meet all IRS requirements.

Also, under Internal Revenue Code (IRC) Section 1031, you can defer capital gains taxes on a business sale by reinvesting the proceeds into another like-kind business or property. While the 1031 exchange has many complex moving parts, it offers flexibility by ensuring more capital for your investment, and it’s common for a capital asset transaction like buying a building.

The Baton Market Advantage: More Than Just Finding a Buyer

Selling a business has several tax implications, impacting your take-home value. Enlisting traditional brokers and listing sites can also significantly reduce the amount due to opaque fees, high rates, costly valuations, and lengthy timelines.

Instead, you can simplify the selling process with Baton Market, a technology-driven, expert-supported platform for M&As. 

Baton offers:

• A free business valuation: Get an accurate, data-backed estimate of your business's worth for a fair market value, allowing you to avoid overpricing or underpricing.

• Expert guidance on sale structuring: Ensure tax-efficient deal structures to boost your after-tax amount.

• Transparent selling process: Clear pricing and regular updates keep sellers informed.

• Pre-vetted buyer network: Serious buyers for faster, smoother transactions and successful closings.

Baton Market offers access to financial professionals and acquisition advisors to help you throughout the sale and lower your tax liability. You also get our clear-cut selling a business checklist to simplify the process and avoid frustrations. Plus, you can close 50% faster than the industry average at a fraction of the cost of traditional brokers.

Sell Smarter, Keep More

Your business results from years of hard work—you deserve to keep more earnings after selling it. But this all depends on how you structure your business and the sale. That’s why early planning and professional tax consultations are essential to identifying the most effective ways to minimize taxes on selling a business.

Baton Market streamlines the selling process, helping you maximize your earnings. You’ll have access to finance professionals and advisors for expert guidance on tax. Plus, our network of high-quality buyers makes it easier to negotiate options like an installment sale, which can lower your tax burden.

Get a free valuation with Baton Market to start the sales process and engage expert business advisors.