Tax Strategies for Selling a Business
Many business owners’ exit strategies involve selling their businesses. And while that can be a lucrative and business-preserving method for exiting, owners must keep their tax liabilities in mind when structuring a sale.
Before selling a business, it’s crucial to understand how the sale will affect your tax bill. By taking advantage of a number of strategies to minimize your tax liability, you can keep more of the profits from the sale of your business to fund your retirement or your next business venture. Understand the basics of these tax strategies before you commit to selling your business.
Basically, installment sales, which use seller-financed notes, allow buyers to finance the purchase of a business over multiple years, and allow a seller to pay taxes on the sale over multiple years. While you transfer full ownership at the time of the sale, the buyer makes payments to the seller over time, including interest.
As the seller, you receive capital gains income as well as interest income until the payment period is complete. Your long-term capital gains will be taxed at the tax rate in effect in the year the payments are received, and it is possible to structure the installments to keep your taxable income below a certain income tax bracket.
Note that an election for installment sales treatment is not permitted for gains on ordinary income property, such as sale of inventory. Ordinary gains must be recognized in the year of sale, regardless of when you receive payment.
Post-sale employment contracts
Sometimes, a business buyer will want the seller to stay on board in some capacity after the sale is completed. If you plan to continue providing services to the business after the sale, it may benefit one or both parties for you to sign a post-employment contract or non-compete agreement.
With a large, one-time business purchase (e.g., $2 million), the buyer does not get to deduct the full purchase price right away. But with a post-sale employment contract, they could break the purchase price into smaller “wage” payments over a few years. That way, the seller gets the money as income, and the buyer gets a faster deduction.
As the seller, you may want to get the smaller payments in the form of wages over a longer-term period to avoid a big tax bill in one year. With a post-sale employment contract, you’ll be guaranteed to earn wages from the business for a certain number of years, with a portion of your taxes paid by the employer.
Allocation of purchase price to a non-compete agreement could recharacterize a portion of the gain from ordinary to capital which may provide lower, preferential tax rates.
Personal goodwill vs. corporate goodwill
When the owner has personal skills (such as technical skills) that are integral to the business, he or she can segment the purchase price of the business into parts. For instance, you may be able to charge a certain amount for the personal goodwill and another amount for the corporate goodwill.
By breaking up the payments in this way, you may be able to lower your tax bill on the sale of your business. However, there are certain hoops to jump through (e.g. valuation of personal goodwill) to obtain these tax savings.
Deal-specific tax strategies
Various types of business deals offer opportunities for different tax strategies that are specific to the sale structure. For example, if your business plans to pay out large severance packages to executives, you may face potential tax penalties. Make sure your advisor understands the strategies you need to undertake in order to avoid those penalties.
Again, it’s very important to work with tax advisors and business advisors who understand the ramifications of various sale structures and are able to advise you knowledgeably about how to make the right choices and use the right strategies to minimize your tax liability. As a result, your exit strategy can leave you ready to retire successfully rather than worried about paying taxes on your business sale.