The most shocking aspect of selling a business is the unexpected tax bill, particularly capital gains on the sale of the business.
It is alarming to learn that despite all the efforts and time put into building the company, the majority of the sale proceeds will go to taxes.
Maybe that’s why you’re here seeking some clarity. You’re probably looking for ways you can keep more of that sale or just defer some of these taxes.
The good news is that you won’t have to do all this yourself. We have the right strategies, such as installment sales, asset sales, and reinvestment options, which will help you hold onto as much of what you have earned. Learn how to avoid capital gains tax when selling a business through practical tips in saving your finances.
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Understanding Capital Gains Tax on the Sale of a Business
Capital gains tax is what you owe on the profit from selling your business or other assets. The profit is the difference between the sale price and what you originally invested, also known as the basis.
In simple words, the basis includes what you paid for the business, along with any improvements or investments you’ve made over time.
You only pay capital gains tax on the portion of the sale that exceeds your basis. If you sell for less than your original investment, you’ll owe no capital gains tax.
| The capital gains tax rate starts at 15% and can go as high as 40% for those in higher income brackets. It’s generally lower than the regular income tax rate. This rate is often also affected as a result of how long you’ve owned the business. If you’ve owned it for over a year, you qualify for the lower long-term capital gains tax rate. But if you’ve owned it for less than a year, the profit may be taxed at your usual income tax rate, which is often higher. |
How the IRS Taxes Business Assets?
When you sell a business, the IRS doesn’t treat it as one big sale. Instead, they look at each asset separately and tax them individually. As a result, this impacts the total you end up owing.
They’ll typically assess assets individually, like:
- Real estate (such as buildings or land owned by the business)
- Equipment or machinery used for business operations
- Property leases
- Raw materials and supplies
- Intellectual property like trademarks, patents, or copyrights
The length of time you’ve held these assets also plays a role in how they are taxed. Some, like inventory and accounts receivable, are taxed as ordinary income rather than capital gains, which could mean a higher tax rate.
If you sell your business for less than the amount you originally invested (your basis), you incur a capital loss instead of a gain. This loss can offset capital gains from other investments or, in some cases, even reduce your taxable income.
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How to Avoid Tax on Sale of Business?
You might not be able to avoid paying capital gains tax entirely, but with some planning, you can reduce how much you owe.
Here are some strategies to look at:
Smart Negotiation
When selling your business, the way the sale price is divided between different assets matters. It’s often better to assign more value to capital assets, like real estate or equipment. Why, you ask? Well, it can lower your overall tax burden. If you take time to map out the allocation, you can easily expect a more favorable outcome.
Installment Sales
Instead of receiving the full sale payment upfront, you could arrange smaller amounts over time. This spreads out the income and the taxes you owe. For many, it becomes easier to deal with. While it won’t get rid of the tax entirely, it reduces the pressure of paying a big lump sum.
Timing Matters
If you’ve owned your business for less than a year, selling it may subject you to a higher tax rate. If possible, wait until you’ve owned it for over a year so that the lower long-term capital gains tax rate applies. This can help you in the long run.
Selling to Employees
If your business is structured as a C-corporation, selling the business to your employees through an Employee Stock Ownership Plan (ESOP) can help reduce taxes. By doing this, you might be able to delay paying taxes by investing the sale money in certain types of plans.
Reinvesting in Opportunity Zones
Another way to delay paying capital gains on sale of business is by reinvesting your gains in an Opportunity Zone. If you reinvest the money within 180 days of the sale, you can defer the tax until 2026. This option won’t eliminate the tax but gives you more time before you have to pay it.
Each of these methods can help reduce the capital gains tax you owe when selling your business. But, it’s always a wiser choice to converse with a tax expert to see which strategy works best for you.
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Final Thoughts!
Normally, sales tax on capital gains is waived when selling a business, but an exit plan prevents anyone from missing even better benefits.
A strategic exit planning advisor guides a business owner to extract as much as possible from the sale of the business by using all the strategic levers to maximize profits and minimize risk.
Another area to explore is goodwill—a type of intangible asset, such as the reputation or brand value of your business. Booking more of the sale price as goodwill in the agreement cuts down the tax bill since it is taxed at a more preferable capital gains rate.
Add to that and don’t forget state taxes. In some states, you have to pay state capital gains tax which varies very much by state. Talking to a tax planning advisor who knows both federal and state laws is a good idea to avoid surprises, especially if you want to learn how to avoid tax on sale of business
Get in touch today to ensure your business sale is handled in the most tax-efficient way possible.
