Capital gains tax weighs heavily on an owner’s mind when considering exit strategies. Selling a business can already be a complex process, and factoring in capital gains tax on top of the other requirements of a sale (including feasibility scenarios, due diligence, valuation of the business and legal fees, to name a few) can be overwhelming for departing owners.
“Careful and strategic planning can help owners reduce the brunt of capital gains taxes.”
When selling a business, owners are often prepared to pay taxes on the transaction. Without considering the dramatic impact the capital gains tax has on the sale, owners may risk paying much more than expected. To address this issue, owners must be fully informed on how the capital gains tax can affect the sale of a business, as well as the preparation and implementation of tax strategies.
Defining Capital Gains Tax
Capital gains tax applies when an owned asset is sold for a price higher than it was originally purchased. The difference between the basis of the item and what it was sold for is referred to as the capital gain, or the amount for which tax will be paid. For businesses, the IRS considers the business to be a collection of capital assets that will include stocks, bonds, real property, equipment, inventory and goodwill value.
The length of the company’s ownership of the asset also plays a part in levying the tax. Short-term capital gains are assets that sold within a year of procurement and carry a larger tax rate than long-term capital gains, which meant the assets would have been owned for more than a year.
For most taxpayers, the long-term capital gains tax rate is 15 percent. According to IRS tax code, however, taxable capital gains from selling a qualified small business can be taxed at a rate of up to 28 percent. It also holds that short-term capital gains can be subject to taxation as ordinary income at graduated tax rates.
Planning for the capital gains tax will help owners mitigate taxes due after selling a business.
Strategies to save on capital gains tax
The capital gains tax certainly looms large on owners as they conduct a business sale, but there are several tactics they can take to potentially reduce capital gains taxation:
- Allocation in the purchase price: While the tax code is stringent, there is room for owners to maneuver in the allocation of the purchase price of the sale agreement. Because long-term capital gains are taxed at a rate less than regular income, many sellers advocate or negotiate with the buyer to declare certain assets as taxable under capital gains to reduce the amount of taxes owed. In allocating these prices, the IRS requires that each be given a fair market value.
- Installment sales: Selling their company through installment plans can help owners defer or reduce capital gains on which they’d pay taxes. Such a plan would first require the seller to finance the sale in part to make the installment payments possible. Such plans dictate the seller receives at least one payment after the year of the sale, and allows the taxpayer to defer some taxes until they are paid in full over the course of the installment. However, installment plan purchases can only be applied to capital gains, and exclude arrangements for the purchase of inventory or personal property, for example.
- Using an ESOP: Another way to defer tax payments lies in pursuing a sale using an Employee Stock Ownership Plan (ESOP). This plan first requires the business is classified as a C-corporation. Selling to an ESOP allows a seller to roll over proceeds by reinvesting cash from the sale into Qualified Replacement Property. If a taxpayer owns those securities forever, they may be able to defer all or a portion of the capital gains tax.
Capital gains taxation is a major concern when selling a business, and owners must be educated on the ways in which the tax and the assets they’re selling will impact the selling price and any post-transaction tax liabilities. However, careful and strategic planning can help owners evade the brunt of capital gains taxes and profit more from the sale of their own business.