Tax Considerations When Selling Your Small Business

selling small business

Nearly half of all Americans—47.5 percent—are employed by small businesses. This means that approximately 60 million employees in the United States work at a small business. According to the Small Business Administration’s Office, small businesses make up 99.9 percent of all U.S. businesses, hence the terminology “small business is the backbone of America”.

When it comes to opening a small business, things are pretty straightforward and relatively simple. However, selling a small to medium-sized business is a complex venture, and many business owners are not aware of myriad tax consequences. Among the many steps involved, we consider your financials, an accurate business valuation, and a tax planning strategy as top priority. Let’s look at some of these in detail.

Accurate Financial Statements

Often overlooked, accurate preparation of your business financials before listing your business for sale cannot be overstated. Every buyer deserves to know what they are buying and nothing provides a more reliable picture than accurate financials. Moreover, every buyer will scrutinize every aspect of your business and they often judge things based on availability of things like financial statements, current, and prior years’ balance sheets, profit and loss statements, tax returns, equipment lists, product inventories, and property appraisals and lease agreements may lead to loss of the sale.

Business Valuation

Most business owners have an idea of what their business is worth, or so they think.  In other words, in many cases, they form an opinion based on hearsay, industry publications, or other rudimentary method. Knowing the value of a business is not as simple as applying a generic ratio or multiple of earnings. Obtaining a third-party business valuation provides business owners with a set a price that is realistic for potential buyers. Additionally, the valuation is vital to achieving maximum value and potentially mitigating unnecessary taxes.

Tax Consequences of Selling

As a business owner you have likely heard that taxes can take a huge bite out of the sale of your company.  Many owners think of business as a single entity which is ultimately sold as a lump sum. The IRS however, views a business as a collection of assets. Profit from the sale of these assets (i.e., your business) may be subject to short and long-term capital gains tax, depreciation recapture of Section 1245 and Section 1250 real property, and federal and state income taxes.

For IRS purposes each asset sold must be classified as capital assets, depreciable property used in the business, real property used in the business, goodwill, or property held for sale to customers, such as inventory or stock in trade. Assets are considered tangible (real estate, machinery, and inventory) or intangible (goodwill or trade name).

The gain (or loss) on each asset sold is figured separately. For instance, the sale of capital assets results in capital gain or loss whereas the sale of inventory results in ordinary income or loss, with each taxed accordingly.

Depreciable Property. Section 1231 gains and losses are the taxable gains and losses from Section 1231 transactions such as sales or exchanges of real property or depreciable personal property held longer than one year. Their treatment as ordinary or capital depends on whether you have a net gain or a net loss from all your Section 1231 transactions.

When you dispose of depreciable property (Section 1245 property or Section 1250 property) at a gain, you may have to recognize all or part of the gain as ordinary income under the depreciation recapture rules. Any remaining gain is a Section 1231 gain.

Business Structure

Your business structure (i.e., business entity) also affects the way your business is taxed when it is sold. Sole proprietorships, partnerships, and LLCs (Limited Liability Companies) are considered “pass-through” entities and each asset is sold separately. As such there is more flexibility when structuring a sale to benefit both the buyer and seller in terms of tax consequences.

C-corporations and S-corporations have different entity structures, and sale of assets and stock are subject to more complex regulations. For example, when assets of a C-corporation are sold, the seller is taxed twice. The corporation pays tax on any gains realized when the assets are sold, and shareholders pay capital gains tax when the corporation is dissolved. However, when a C-corporation sells stock the seller only pays capital gains tax on the profit from the sale, which is generally at the long-term capital gains tax rate. S-corporations are taxed similarly to partnerships in that there is no double taxation when assets are sold. Income (or loss) flows through shareholders, who report it on their individual tax returns.

Help is Just a Phone Call Away

When it comes to selling your business, preparation is key. Underestimating the complexity of a business sale usually ends in disappointment and unintended outcomes. Remember, these transactions involve complicated federal and state tax rules and regulations. If you own a business and want to know more about how to structure a successful sale, contact us today to schedule a visit.