Thursday, August 7, 2014

Tax Implications When You Sell a Business

What will be the tax implications when you sell a business?

Pass Through Entities:

The tax on the sale of a business will typically depend on your ownership structure and the terms of the deal.  Sole proprietors, partners, and members or shareholders of an S Corporation will be taxed according to their personal tax situation.  So a seller that has one of these structures will want to consider the overall tax consequences of the sale on their personal tax return.  The ordinary income recognized on the sale of a business can move the seller into other income tax brackets so the tax impact could be greater than just the tax on the sale, it could also increase other taxes as well.

The sellers may be taxed on the profit of the sale at ordinary income tax rates or favorable capital gains tax rates or a combination of the two depending on the types of assets sold.  So the asset allocation of the sales price is very important. From the seller's perspective it is advantageous to have as much of the sales price allocated to capital assets as possible.  The gain or loss on the sale of capital assets will typically be subject to favorable capital gains tax rates. 

Capital Assets:
Capital assets can include real property or depreciable personal property used in your trade or business and held for more than 1 year.  Capital assets do not include property held mainly for sale to customers.  Additionally, the profit from the sale of a copyright, a literary, musical, or artistic composition or similar property may be  considered ordinary income rather than capital gains.

Capital Gain or Loss:
The gain or loss on the sale of capital assets is the difference between the amount you realize from a sale or exchange of property and your adjusted basis and costs associated with the sale.  Your adjusted basis is your original cost or other basis plus certain additions (that have not been expensed and deducted already), such as the cost of capitalized improvements, and less certain deductions, such as depreciation.  Typically your cost includes amounts that were capitalized rather than expensed.

Tax Rates for Capital Gains for 2014:
The Short Term Capital Gains are taxes at the same rate as the individual's ordinary income tax rate.  For example assets held for less than one year could be subject to short term capital gains treatment. 

Long Term Capital Gains Rate:
Long Term Capital Gains Tax Rates are determined by the individuals personal income tax bracket.  Below are the 2014 Long Term Capital Gains Tax Rates as they correspond to personal income tax rates.

Personal Income
Long Term
Tax BracketCapital Gains Rate
10% - 15%0%

Ordinary Income Taxes:
Some assets, such as personal property, inventory and receivables, do not qualify as capital assets and the profit on the sale of these assets and the amount allocated to a non-compete agreement are subject to ordinary income tax rates.  Taxes on ordinary income can range from 10% to 39.6%.  Then there are also additional taxes from the Alternative Minimum Tax, The Net Investment Income Tax, and the Additional Medicare Tax, and of course state and local taxes to consider.  Finally, in some cases there may be a recapture of depreciation previous taken on assets which will be taxed at ordinary income tax rates.

 C Corporations:

For businesses structured as C Corporations the tax picture is not favorable.  There are no capital gains rates for C Corporations.  The tax rate paid by C Corporations on the profit from the sale of assets is the same as their ordinary income tax rates which are as follows for 2014:

15% on first $50,000
25% on next $25,000
34% on next $25,000
39% on next $235,000
34% on excess up to $10 mil.

After the tax is paid by the C Corporation, the individual shareholders will also pay taxes on the distribution of the proceeds.  In the event the C Corporation is liquidated this return of proceeds to the shareholders would be taxed at favorable Long-Term Capital Gains Tax Rates if the shareholder owned his shares for more than a year.

Financing the sale over multiple years:
Receiving payments on the sale of assets over a period of time can have very beneficial tax implications for the seller.  The seller will usually bear the tax burden on capital assets when he receives the payments. The seller financed sale of assets are treated as  installment sales and the seller pays tax on the profit portion of the proceeds he receives in a given year.  The seller will also have taxable interest received as part of the payments.

For assets not qualifying as capital assets the seller must pay the tax on them in the year of the sale regardless of when they receive payment.

Performance based financing:

This type of earn out clause is very complicated and subject to special tax rules.  The IRS uses the term "Contingent Payment Sales" for this type of transaction.  In some situations the seller may  recognize the gain or loss currently regardless of when the payment takes place.  It can also be handled as an installment agreement recognizing the gain or income as the payments are received.  He may also be able to recognize the gain after the basis in the property sold is recovered.  The terms of the agreement can affect the profit percentage used to determine the taxable portion of the payments received in a given year.  Although this can be very complicated it can favor the seller by helping him to spread out his recognized income reported over several year.

Typically the earn outs are taxed at the same rates based on the asset allocation agreement.  In other words if the earn out payments are applied to capital assets the profit portion of the payments can be subject to favorable capital gains rates based on the asset allocation agreement.

This can also be a very powerful way to structure a deal when the two parties do not agree on the value of the business. 

Additional tips:

As you can see from this brief overview of general tax issues, there are so many variables that can affect a seller's tax situation and there are many more that were not discussed in this article.  IRS publication 544 on "Sales and Other Dispositions of Assets" contains 42 pages on this complex subject.  While this article can give a seller a general idea about the tax consequences of his sale, to understand the true tax implications of a sale there are many more factors that should be discussed with a CPA who has experience with these type of transactions. 

I used the terms "typically" and "usually" because the application of the tax law is applied based on the specific facts and circumstances of the parties involved in the transaction.  The sale of a business is such an important transaction in the seller's life and they should get help from someone experienced in negotiating such deals, good legal counsel and tax advice from an experienced CPA.  The sellers should retain an experienced CPA to do tax projections for them for the various scenarios being considered and provide suggestions to help minimize the tax consequences.   

Other Posts Related to Buying and Selling a Business:

If you are considering purchasing a business there other things you will want to consider.  For more on this subject see my post: 

If you own a business or are considering purchasing a Business you will want to have an exit strategy.  Check out my post on this subject:

I have consulted with many sellers of assets such as we have considered in this article.  If you want my assistance with the sale of your business feel free to contact me using my information below.

While my main business is preparing tax returns, I also work with clients to setup accounting systems to start, manage and develop their business(es) and develop and implement a financial plan. Contact me using my information below to schedule a free introductory consultation up to a half hour. 

Jeff Haywood, CPA

The CPA Superhero

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My posts contain general information that does not fit every situation, they are not all inclusive, and as always for your tax situation everything "depends on facts and circumstances."  In addition, the information/IRS requirements are always subject to change.  So call me to talk about your specific facts and circumstances and what you want to accomplish.