Tax Considerations When Selling Your Business
- When a buyer approaches, business owners must look beyond the sales price to consider the tax implications of selling the company’s assets or stock.
- While sellers generally prefer a stock sale over an asset sale, each approach has advantages in certain situations. Understanding the specific opportunities and risks may make a big difference in the amount you take away from the transaction.
- Working with a team of transaction specialists is essential. These ideas could help start the conversation.
For owners who have poured everything into growing their business, a sale may offer a sizable reward and the opportunity to create a post-sale family legacy and pursue life’s next adventures.
A major tax consideration when you sell your business is whether you should sell the assets of the business or your stock in the company.
There are advantages and disadvantages in both options. Generally, buyers want to purchase assets, and sellers want to sell their stock. Because of this dichotomy, not only do we advise you to engage and consult with your attorneys and CPAs, but you should understand what the pros and cons are to each.
Let’s review some basic tax considerations in an asset or stock sale. Starting to think about this early, even years before you anticipate selling, can help you take necessary steps to best position your company for a successful sale.
Understanding the Basics
Of the two basic ways of selling a business — asset sale or stock sale — sellers and buyers have strong and opposing reasons for preferring one over the other. From a tax perspective, sellers may prefer a stock sale because the gain on the sale will likely be taxed as long-term capital gains at a top current federal tax rate of 20% (plus a 3.8% net investment income tax), as opposed to ordinary income with a top federal tax rate of 37%.
Buyers, in contrast, may prefer an asset sale (i.e., an itemized purchase of the company’s assets — equipment, inventory, customer lists, etc.). By doing so, the buyer may immediately begin depreciating those assets, generating tax deductions. There is no depreciation with a purchase of stock, and the cost is only recuperated with the sale or liquidation of the company. The buyer in an asset purchase may also pick and choose the portions of the business that they want. With a stock purchase, the buyer is buying all assets and liabilities of the company, currently existing and those that may arise in the future.
For sellers, the downside of an asset sale — in addition to the complexities of valuing and negotiating the sale of individual assets — is that a portion of the proceeds will often be taxed at the higher ordinary income tax rates. Because an asset sale will likely result in a higher tax obligation for the seller, buyers may be willing to offer a higher price as an incentive.
Stock Sale Planning
If you are selling your company’s stock, the gain will generally be taxed at preferential capital gains tax rates. Additional considerations may impact your overall tax picture. For example:
Qualified small business stock (QSBS). To stimulate the growth of small businesses and the U.S. economy, lawmakers have enacted various tax incentives for taxpayers who start and invest in small businesses. Individuals (i.e., noncorporate shareholders) holding QSBS may be eligible to exclude up to 100% of their gain from the sale of stock. The QSBS rules are subject to a number of restrictions.
In general, to qualify as QSBS, the stock must be issued by a domestic C corporation with no more than $50 million of gross assets at any time between August 10, 1993 (or when the qualified small business started), and the time the stock was issued or acquired by the taxpayer on original issuance, and the stock must be held for at least five years.
Tax-free reorganization. The Internal Revenue Code outlines several scenarios for tax-free business reorganizations, including a stock-for-stock exchange, known as a “B” exchange. If an owner selling a business receives stock of the acquiring company with an equivalent cost basis, he or she may defer capital gains taxes. This has potential advantages for buyers as well, especially those who don’t wish to deplete their cash reserves in order to make the purchase.
Employee stock ownership plan (ESOP). Since 1974, founders have been able to transfer ownership of their businesses to their employees through ESOPs. While ESOPs remain relatively rare (fewer than 6,000 corporations have ESOPs out of millions of privately held S and C corporations in the United States1), they offer significant advantages for certain companies and situations. The owner may transfer shares to employees and reinvest the proceeds in diversified securities, deferring capital gains taxes. Meanwhile, the employees have the opportunity to carry on the company’s legacy.
Pre-transaction charitable gifts of stock. A gift of stock to a qualified charitable organization in advance of a stock sale may be advantageous for the charity and for you personally. For example, if you contribute stock valued at $100,000 (in advance of the sale of your company), you may be able to deduct that full amount on your personal tax returns and avoid paying tax on the built-in gain on the stock.
If you wait until after the sale, you would be donating money already subject to federal and state capital gains taxes stemming from the sale. In real terms, your donation (and deduction) might be reduced to around $70,000.
Advance planning is essential. Donations made too close to the time of the sale could be deemed post-sale for tax purposes.
Case Study: Reaping Entrepreneurial Rewards Through a Stock Sale
Entrepreneurs Sally and Thomas combined their engineering knowledge and passion for sustainability to form a company manufacturing parts and accessories for solar-powered scooters. As the company grew, they were able to reinvest after-tax profits into the business, making no dividend distributions. As a C corporation, the company paid a federal tax rate of 21% at the corporate level. Had they started an LLC instead, that income would be subject to a top federal tax rate of 37% as a flow-through item to their individual tax returns.
After five successful years, a private equity company offered to purchase the company’s assets for $20 million. An asset sale would have resulted in tax at the corporate level and a reduced cash payout for the entrepreneurs. Their stock, however, qualified as qualified small business stock (QSBS), which would offer significant benefits in a stock sale.
Working with their transaction team, Sally and Thomas negotiated a stock sale, accepting a slightly lower price. Thanks to the QSBS rules, the sellers could exclude the full amount of gain and incur no federal tax liability on the sale — giving them that much more to put toward pursuing their next entrepreneurial dream.
Asset Sale Planning
An asset sale will likely result in a combination of gain taxed at both ordinary and capital gains rates, depending on the nature of the individual assets. Generally speaking, sales of assets such as equipment, buildings, vehicles and furniture will be taxed at ordinary income tax rates, while intangible assets such as goodwill or intellectual property will be taxed at capital gains rates. Here are some tax considerations with an asset sale:
Purchase price allocation. One of the most complex and delicate parts of an asset sale is negotiating the price of the individual assets — a process known as price allocation. As previously mentioned, buyers want assets that can be immediately depreciated after purchase. Sellers prefer to allocate more to intangible assets, where any gain is taxed at the preferential capital gains tax rates.
A 1031 exchange. If the asset sale is for real property, the seller may be able to defer taxes on the gain using a 1031 like-kind exchange. As the name implies, if you use the proceeds to exchange that property for a like-kind asset, you can defer taxes on the property you sold. But note that there are a number of restrictions — for example, in order to qualify, you need to identify the replacement property within 45 days of the sale and complete your purchase of the replacement property within 180 days.
Case Study: Preparing for a Tax-Efficient Asset Sale
The co-owners of a contracting LLC received an offer from a prospective buyer interested in a prime piece of commercial real estate in the firm’s possession. The offer was extremely attractive, especially considering that the owners paid comparatively little for the property when they started out 20 years earlier. A sale of this property would likely result in a high tax bill.
Fortunately, the owners, aware that the property was rising in value, had planned in advance. Their tax specialist helped ensure the property met the qualifications for a 1031 exchange. When the offer came, they had already identified a like-kind property to invest in. By completing the exchange within the required 180 days, no gain was recognized on the transaction, and taxes were deferred until the replacement property was sold.
Post-transaction charitable gifts. The proceeds from an asset sale will likely result in significant income. If you are charitably inclined, charitable contributions made during the same tax year may offset this additional income.
Gauging the effect of net investment income tax (NIIT). As mentioned previously, asset sales generally result in gains taxed at both ordinary and capital gains tax rates. Gains characterized as capital may be subject to the federal 3.8% net investment income tax (NIIT). Before the sale, review how the NIIT could affect your tax picture.
Other Tax Considerations
Some tax considerations apply regardless of whether you ultimately transfer your business through a stock or asset sale.
Installment sale. To lessen the impact of capital gain or income tax obligations in a single year, you may want to negotiate a sale where proceeds are received over more than one tax year (i.e., an installment sale). Under an installment sale, the buyer takes immediate ownership, but payments are made over more than one year. Interest may accrue with delayed payments.
Your non-business finances. Before selling your company, a careful review of your other finances and overall tax picture can be essential to make your business transaction as tax efficient as possible. Capital loss carry forwards may offset capital gains from the sales transaction. Or if your transaction is a stock sale and you have under performing assets elsewhere in your investment portfolio, harvesting those losses could help offset extraordinary gains in the year or years when the transaction is completed.
If your transaction is an asset sale, losses from a separate business venture unrelated to your company could offset ordinary income from the asset sale.
State tax planning and residency considerations. State tax laws vary widely and should be factored into any sale. In addition to varying income and capital gains rates, states have different rules on specific programs. For example, California does not recognize the QSBS rules. In some cases, with advance planning, it may be advisable to switch the location of a business to a different state prior to its sale.
Finding Guidance for Your Situation
Whether you ultimately have an asset or stock sale, there are no simple, off-the-shelf ways to sell your business. In many ways, a rewarding sale is as complex as the innumerable decisions you put into making the business a success. As such, specific ideas contained in this article may or may not apply to your situation, but could help you start productive conversations.
We recommend planning years ahead of a potential sale. Experienced tax professionals and attorneys can help you negotiate effectively, avoid missed opportunities, and realize the reward your years of hard work warrant. Reach out to your Bessemer Trust team for help in understanding how taxes related to your transaction may affect your overall financial and tax situation.
- “Employee Ownership by the Numbers,” National Center for Employee Ownership. Most recent available figures.
This material is for your general information. It does not take into account the particular investment objectives, financial situation, or needs of individual clients. This material is based upon information obtained from various sources that Bessemer Trust believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Bessemer Trust does not provide legal or tax advice. Please consult with your legal and tax professionals accordingly.