Year in and year out, as a business owner, you pay taxes on what’s called “ordinary income”. When you sell your business, the tax on the increased value of your business is called capital gains tax. This article discusses the definition, calculation, and ways to minimize or eliminate capital gains taxes on the sale of a business.
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What Are Capital Gains Taxes?
When you earn a salary, commissions, or business income, you get taxes on the income as it is received. These forms of income are earned regularly and pay taxes on a pay-as-you-go basis. When you own an asset that appreciates in value, however, like a house, an antique car, stock in a company, or a business, it grows over time. But you don’t pay the tax as it appreciates, instead, you only pay the capital gains tax, when you sell the house or asset.
Tax law has long recognized a principle of paying tax on what you have the ability to pay. Thus, you pay the tax when you actually realize the gain, i.e. you pay capital gains tax only when you sell the business. That’s the good news.
Calculating Capital Gains Tax
Then there is the bad news, and it’s twofold. First, calculating capital gains tax can be very complicated. You are well served to work through your trusted tax advisor and/or a service like the TurboTax tax calculator to help you work through this maze of rules on calculating your capital gain. The other piece of bad news is that since you only pay it once on any given asset, it can tend to be a very high amount of tax that comes due all at one time. For that reason, we will spend some time later in this article discussing ways to defer or eliminate this tax.
Selling Assets that Have Capital Gains in the Sale of a Business
The vast majority of businesses are sold as “asset sales” rather than “stock sales”. This means the buyer is actually purchasing a bundle of assets the seller’s business has owned, rather than the entire business as an entity. While the buyer may even buy the name and continue to operate essentially the same business under the same name, he did not buy it as an entity, he bought certain assets within the entity.
For example, let’s say the seller is selling out of the coffee shop he owns – let’s call it Beano’s Java House. The day after the buyer takes over, he wants and tries to make look and feel like the Beano’s Java House all the customers walked into yesterday, but in reality, he did not buy the entity itself, instead, he bought the coffee roaster, payment portal, food racks, inventory, etc. – and he bought something very, very special. That special ingredient in the purchase of every business is called “goodwill”.
Goodwill is considered the ongoing value of the reputation of the business. It is often the biggest asset in the entire deal. It’s the reason the buyer wants the same name, same location, same tables inside the shop, even the same baristas working for him. To the buyer, goodwill is the most important part of the deal, but to get that, there are lots of other assets he needs to buy too.
Here’s why that’s so important. The IRS treats each one of these assets differently. Some, like inventory, generally are not eligible to get capital gains treatment. On the opposite end, goodwill definitely is. In the middle, furniture, equipment, etc. are often taxed uniquely because they are subject to depreciation expense while the seller owns the business. The process of selling business assets is complicated because each type of business asset is handled differently. Maybe you can begin to see why calculating capital gains tax on the sale of a business is so complicated.
Minimizing Capital Gains Tax and What to Do Before You Sell Your Business
Here are a few tips to minimize capital gains, and get all the information you need for your tax return:
Start with Your Asset Allocation Schedule
When you use a skilled, professional attorney like the lawyers on the team at Landmark Legal Services, they will be sure you have a sound, Asset Purchase Agreement documenting exactly what you agree to when you sell your business. That agreement will include many exhibits, and one of the most important among them is the Asset Allocation Schedule. This schedule is the roadmap to all the numbers and figures you need to report your capital gains on the sale of the business.
Rely on a Professional Business Valuation
Another thing you should have done, actually in advance of the sale is to have a valuation on your business. The closer the date of the valuation is to the date you receive a letter of intent to purchase the business, the more accurate it will be. We recommend working through a group like the Buyer Seller Match or the Intermediary Link in order to ensure you get the most accurate valuation you can before selling the business.
Minimizing the capital gains tax you pay when selling your business
There are many strategies you can employ to minimize the impact of capital gains taxes when you sell your business. These largely involve installment sales, charitable trusts, other irrevocable trusts and the best allocation of assets to limit your exposure to capital gains. Capital gains in the sale of a business can present difficult issues both in how you limit your exposure to them, and in how you calculate what you owe. Regardless, the skilled professionals at Landmark Advisors are available to help. Please contact as and schedule a time we can talk through your situation.
See these IRS publications for more details:
- IRS Publication 544 for tax implications on the sale of business assets
- IRS Publication 541 Partnerships for capital gains on partnership shares
- IRS Publication 550 Investment Income and Expenses for capital gains for corporate shareholders