The tax consequence of selling a business
Selling a business is an exciting experience and there are several things you can do to develop a tax strategy and ensure that the process goes as smoothly as possible. Business owners who are considering selling their company should take into account the taxes they will owe before putting the “For Sale” sign up.
When a sale produces income, owners have to pay taxes on at least part of their gains from the sale. How these capital gains are taxed depends largely on the structure of the business, whether the business is being sold as a set of assets or as an entity, and the type of assets being sold.
The IRS generally views a business as a collection of assets — including real property, equipment, inventory and goodwill. The gain or loss on the sale of different categories of business assets are taxed differently. When they are sold, the assets must be classified for IRS purposes as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers (such as inventory or stock in trade). Under the Internal Revenue Code, sellers and buyers must assign a specific value to each asset or groups of similar assets, and report a gain or a loss from the sale of each asset to the IRS. The sale of capital assets results in a capital gain or loss; the sale of real property or depreciable property used in the business and held longer than one year results in a gain or loss from a Section 1231 transaction; and the sale of inventory results in ordinary income or loss.
The tax consequences of selling your business also depend on the structure of the business. What type of business entity do you have? Because sole proprietorships, partnerships and limited liability companies (LLCs) are considered “pass-through” entities, owners of these companies enjoy a degree of flexibility in negotiating an asset sale.
C corporations can sell both stocks and assets, but, unlike pass-through entities, a C corporation is taxed twice when its assets are sold. The company pays the corporate tax rate on any gains realized from the sale of the assets, and the company’s individual shareholders pay capital gains taxes when they receive distributions from the liquidation of the corporation. But when a C corporation sells its stock, the seller pays only capital gains taxes on the profit from the sale.
Meanwhile, in purchasing a company’s stock, the buyer is acquiring the company as an entity, including any of the business’s existing liabilities. If (instead of purchasing the stock) the buyer acquires the company’s assets, the buyer receives a new tax basis in the assets, and higher depreciation and amortization deductions in the future. So, buyers are more likely to want to acquire the assets of a company rather than the stock, while the seller may prefer to sell the company as an entity. Because a stock sale usually results in a lower overall total tax bill than an asset sale, the seller may wish to consider adjusting the purchase price in order to persuade the buyer to accept a stock transaction rather than an asset sale.
S corporations are taxed in a manner more similar to that of partnerships than of C corporations, and thereby avoid this double taxation. The income or losses of an S corporation flow through to the shareholders, who report those numbers on their personal income tax returns and pay taxes on that income at their individual income tax rates. Therefore, no second taxation occurs when an S corporation sells its assets. To discourage C corporations from changing to the S status shortly before a sale, the IRS rules state that a company must have been an S corporation for a certain amount of time prior to the sale to qualify for all of the tax advantages.
Since selling a business can be a complex undertaking, business owners should meet with legal and tax professionals beforehand to discuss tax strategies for making the company attractive to buyers, while minimizing their own tax liabilities.