Key takeaways
Taxes can impact both the transaction and the proceeds from the sale.
Understand how federal and state taxes will apply, as well as other potential taxes, such as estate tax.
The structure of your business, the classification of the sale and the terms of the sale will all affect how the sale is taxed.
The ultimate payoff for most successful business owners is the ability to pass it on to their children or sell their business and achieve their financial objectives. In many cases, the timing of this is closely related to a planned retirement date.
The decision to step away from your business can be an emotional time and is an important transitional period if you’ve dedicated much of your life to it. You might be inclined to focus most on determining an acceptable sale price. A far more important issue is how much you’ll ultimately get to keep from the sale. The biggest variable is how taxes will impact the transaction.
Without proper planning, there’s a risk of mishandling the transaction that can be detrimental when it comes to taxes. Here are six questions that can help you determine the tax impact of your sale.
1. How will federal and state taxes apply?
The sale of a business usually triggers a long-term capital gain for the seller and federal capital gains taxes will apply. As an example, if you started your business 20 years ago with an investment of $100,000 and sell it today for $10 million, your long-term capital gain is $9.9 million (the selling price minus your original cost basis). A federal capital gains tax of 20% would apply, reducing the net proceeds from the sale to just over $8 million.
State income tax is also a consideration. For example, residents of California could be liable for a tax of 13.3% on the capital gain. Using the example of the sale above with a capital gain of $9.9 million, the net proceeds to the seller after federal and state taxes would be $6.6 million. Some states don’t have a state income tax and conducting your sales transaction while residing in those states has obvious advantages for the seller.
2. What is the structure of the business?
The structure of the business has notable tax implications. The most common business structures are:
- Limited Liability Companies (LLCs)
- Partnerships
- S Corporations
- C Corporations
The first three listed above are considered pass-through entities, in which individual business owners pay taxes on the company’s profits and any profits generated from the sale of the business. Taxes are not assessed at the company level. By contrast, tax implications with C Corporations can be more complex (see below). The structure of your business will influence the type of sale that’s more beneficial for the business owners.
3. Is it a sale of assets or stock?
The sale of a business can be classified in one of two ways. The first is as the sale of company stock to an acquirer. The second is to sell the assets of the company.
“Buyers usually want to purchase assets because that offers them significant tax advantages,” says John Heffernan, managing director of Business Owner Advisory Services from U.S. Bank Wealth Management. In a pass-through structure (LLC, partnership, S Corporations), the seller generally won’t incur any additional taxes by characterizing the sale as one of assets rather than the company’s stock.
If you operate your business through a C Corporation, things get more complicated. In this case, it may be preferable to sell the stock of the company rather than its assets to avoid double taxation (at the corporate and shareholder level). For example, if assets are sold for $10 million (with a cost basis of $100,000), the company would realize a $9.9 million capital gain. This would result in federal and (if applicable) state income tax that could reduce the net proceeds of the sale to approximately $7 million at the company level. The proceeds are then distributed to shareholders, who would pay a dividend tax of at least 15% plus any state income taxes on the distribution. For the shareholders, this can bring the total tax impact of the sale to something in the vicinity of 50% of the profit from the sale.
By contrast, if only the stock is sold, that’s a payment directly to the shareholders with no transaction involving the company directly. Shareholders then would pay applicable federal capital gains taxes and state income taxes on the appreciated value of the shares they sold. “If you own a C Corporation,” says Heffernan, “it’s important to try to negotiate a stock sale if possible because it will make a significant difference in your net return from the sale.”
4. What do the buyers want?
Buyers will typically seek to purchase a company’s assets for the tax benefits they can accrue. “When they purchase assets, tax laws generally allow the buyer to deduct the purchase price,” says Heffernan.
Consider a business that chooses to sell its assets for $20 million, with $5 million attributed to the value of equipment and the remainder to goodwill. The buyer can claim an immediate $5 million tax depreciation deduction and amortize the goodwill over 15 years on a straight-line basis ($1 million tax deduction each year for 15 years).
With this approach, buyers get a 100% tax deduction of their purchase (over a period of years), which reduces future taxes payable on future taxable profits. To sellers of pass-through entities (LLCs, partnerships, S Corporations), the sale of assets (as opposed to selling the stock of the company) will generally not have an adverse bearing on their tax liability from the sale. However, for owners of a C Corporation, a stock sale is critical to avoid the double taxation scenario outlined in #3 above.
In certain circ*mstances, it can be more efficient to structure the transaction as a stock sale. In cases where the business has material contracts that require third-party consents on the sale of assets, a stock sale may be preferred to avoid the need to secure such consents before closing the sale.
5. What are the terms of the sale?
When selling your business, you can expect to be offered terms that may contain one or more of the following forms of consideration:
- Cash at closing. This is the preferred form of consideration from a seller’s perspective, yet not as common as you might expect. Capital gains tax will be due in the year in which the transaction closes. This form of payment has the greatest value for the seller.
- Seller’s note. Some purchasers may not have sufficient cash to cover the entire purchase price, so they ask the seller to carry a note – essentially the buyer’s IOU to pay off the balance over a period of years generally at a low interest rate. This is referred to as deferred consideration.
- Earn out. The buyer pays a portion of the purchase price in cash and the remainder (the earn out) over a period of years, assuming the business meets agreed upon performance milestones. An earn out is frequently used to bridge a gap between the buyer’s and seller’s view of value. Sellers should be cautious accepting earn outs as the seller has relinquished control and generally has little influence over the performance of the business after the sale closes.
- Equity rollover. An example is when a buyer purchases 80% of the company stock and the seller retains 20%. The buyer may entice the seller to hang on to that much stock to capitalize on a potential boost in value in the future when the company is subsequently sold. In that event, the seller would benefit from the appreciated value of the retained stock.
“In any transaction that’s not all cash, the seller takes on added risk,” notes Heffernan. “Sellers should discount the expected value of any form of consideration other than cash.” On the other hand, if payment of a portion of the purchase price is delayed, the seller may have time to modify potential tax considerations after the sale closes. In this scenario, a potential strategy would be moving to a state with no income tax to minimize taxes payable on the receipt of future payments.
6. What other types of taxes might apply?
Proceeds from the sale of a business can be significant, and if a business owner dies, that could leave a sizable estate subject to tax. “I remind business owners that as they prepare to sell their business, they should make sure they have an up-to-date estate plan in place,” notes Heffernan. “Estate taxes can ultimately prove to be as much of an issue as income and capital gains taxes.”
It’s notable that 13 states impose their own estate tax. And substantial changes have been proposed to estate tax laws that could significantly reduce the current unified gift and estate tax exemption of $12.06 million per person that exists today. Even without changes, this more generous exemption amount is scheduled to expire at the end of 2025, which will cut the amount roughly in half.
Seek professional direction
When you begin planning to sell your business, you may find it’s as complex a task as anything you’ve encountered in the years of operating your business. A team of professionals, including financial professionals, tax advisors and business and estate attorneys, can make a big difference in setting the stage for a successful process.
If you’re considering transitioning your business, learn how Business Owner Advisory Services from U.S.Bank can help you evaluate your options and choose the one that’s right for you.
