Most business owners are focused on the value or selling price of their business, but something often overlooked is the tax consequences of selling their business and what the net proceeds will be. Many business owners wrongly assume they will be paying the maximum tax rate and there is nothing they can do about it.
It does little good to get a great selling price only to lose 50% of it to taxes, but with advance planning and a good tax advisor, you can minimize your taxes and defer as much as 90% of the taxes. Your particular taxes and savings will depend on a number of factors, so it is impossible to provide a one-size-fits-all answer as to what you will save, each business and transaction is unique. But a tax strategy will dramatically reduce your taxes and there are several tax strategies available that provide a means to defer and reduce the taxes on the sale of your business.
Here’s an overview of tax strategies used for both business sales and real estate sold with a business.
- QSBS (Qualified Small Business Stock) Exclusion
The QSBS is perhaps the most generous tax strategy for small to mid-size businesses, but it only works in very specific circumstances. The QSBS up to a $10 million capital gains exclusion or 10X the adjusted bases of the shares (whichever is greater), but the company must be a C corp along with some restriction of the formation date. California has disallowed QSBS for state income taxes. Consult your tax advisor to see if your company will qualify for QSBS and if located in California if you can use QSBS for your federal taxes. The QSBS requires very specific implementation and you should seek both legal and tax advice on this.
see Morgan Stanley’s blog on QSBS - Stock vs Asset Sale
Most business sales are done in the form of an asset sale, which is beneficial to the to the buyer in a number of ways, but unfortunately puts the seller in the highest tax bracket with some of the proceeds taxed at ordinary income rates (the highest tax rate). If the transaction is structured as a Stock Sale then most of the proceeds are taxed at the capital gains tax rate, thus dramatically reducing the seller’s tax liability.
Due to successor liability risks and the loss of depreciation for the buyer, it is often difficult to persuade a buyer to structure the transaction as a stock sale instead of an asset sale. However, there are several instances where a stock sale is a benefit to the buyer and even a requirement. These instances include the sale of a corporation with a contractor’s license, medical licensing, and corporations with government or long-term contracts that need to be preserved. The stock sale preserves contracts tied to the corporate entity and provides a seamless transition with respect to contracts and licensing. Note that many licenses tied to the corporation such as contractor licenses, healthcare & medical licenses, and professional practices licenses require an individual qualifier for the corporate license.
Stock sales are more common in these instances, but you should have a professional business broker, experienced in this type of transaction, and a transaction attorney working with you and advising you. - Price Allocation on Asset Sale
A Price Allocation is required by the IRS on all Asset Sales. The Price Allocation carves up the purchase price into specific tax categories. These tax categories determine ongoing tax rates for both buyer and seller. For the seller, Goodwill and other categories will be treated at the lowest tax rate of Capital Gains, and the equipment value may be treated largely as ordinary income depending on your balance sheet at closing.
When preparing the Price Allocation for the sale of your business be sure to review this with your tax advisor and discuss the tax implication of the proposed price allocation. Price Allocation is a negotiable term in your purchase agreement and you can approach the buyer for a more favorable Price Allocation. - Sales Trust
In a sales trust, you will simultaneously sell your business to a trust through an installment sale in exchange for a secured installment note. The trust then sells that business to the end buyer. The proceeds are then put into the trust where they will be invested. You can choose how much and when to receive payments from the trust. You pay tax on the payments as received from the trust. - Charitable LLC
A charitable LLC allows you to donate an asset to a charitable LLC, The Charitable LLC then gives a portion of its shares to charity. You get a charitable contribution deduction for the value of the asset that you contributed. Future income is split between the charity and your portion of ownership of the LLC. You remain in full control of the LLC and its assets. This will also yield ongoing income reduction and tax savings in future years. - Opportunity Zone
An opportunity zone is an “economically distressed community”. The opportunity zone credit allows you to invest proceeds from the sale of an asset (business included) into an opportunity zone to defer and potentially eliminate a large amount of taxes. - Conservation Easement
A conservation easement allows someone to give up the rights to undeveloped land. In turn, the IRS will give a charitable contribution credit for the amount that the land may have been worth had it been fully developed.
These are some of the more common strategies available when it comes to selling your business or large asset. There are many more to explore that are unique to certain situations. Most of these strategies include immediate tax savings as well as deferred savings in the future. The time value of money and inflation is another factor to consider when determining your exit strategy.
Beware the IRS Dirty Dozen
The IRS publishes an annual Dirty Dozen list of problematic tax schemes. Using a tax strategy on the list is almost certainly a red flag for an audit. Your tax and financial advisor should be familiar with this list and can guide you to the appropriate and safe tax strategy for the sale of your business.
- ERTC (Employee Retention Credit) claims
The ERTC is a legitimate tax credit from the IRS that has been the subject of a great deal of abuse and fraud from internet advertising and telemarketing companies “selling” the ERTC to business owners. Claiming the ERTC does not necessarily lead to an audit, but it is important to ensure your ERTC claim follows the IRS rules. Consult with your CPA regarding compliance. - Charitable Remainder Annuity Trust (CRAT)
The CRAT has recently come under scrutiny by the IRS, but this scrutiny does not affect other tax strategies using trusts such as the CRT (Charitable Remainder Trust). When implementing a tax strategy using a trust it is key to ensure the trust and purchase agreement are prepared in accordance with IRS requirements. Your tax and legal advisor can advise you on selecting the proper trust and implementing it correctly. - Monetized Installment Sale
The monetized Installment sale was popular for a number of years, and recently has come under IRS scrutiny and added to the IRS Dirty Dozen list of problematic tax strategies. This is a tax strategy to avoid. - Syndicated Conservation Easements
- Offshore Accounts and Crypto Currency
- List of IRS Dirty Dozen list from prior years https://www.irs.gov/newsroom/dirty-dozen
As with all advanced tax strategies, there is always some level of risk. The IRS is constantly changing rules and regulations. There is no guarantee any strategy used will not come under IRS scrutiny in the future or be written out of law in the future. Tax strategies require in-depth legal and accounting knowledge of the IRS code, be sure you are working with an advisor who is familiar with these strategies and up to date on all of the IRS changes.
Contact us for a free consultation with our tax and financial advisors specializing in tax planning for business owners selling their businesses and/or real estate.
