If you are selling your business, be ready to receive a heavy tax bill. The truth is any careless mistakes can cost you heavily. Before you know it, you end up paying around half the money you receive for the sale as taxes and professional services fees. It takes a little professional advice with the right planning to reduce your tax burden, or at least defer it, when selling your business. You have to pay taxes on the profit from the sale. Although you can control the time at which you pay the tax via the terms of the sale, you will have to pay taxes eventually. BUT there’s ways you can reduce the amount of tax you pay, and do it legally!
How much tax will I pay?
The total amount you are bound to pay in taxes depends on the method of taxation. You will be taxed based on either your ordinary income or the capital gains. All profits from the sale of the business assets are likely to be taxed at capital gains, whereas the money you get under a consulting agreement is considered ordinary income. All individuals who finance the sale of their business by taking back a mortgage or note for part of the purchase price might report at least a bit of the capital gains, on the installment method.
Since this method allows them to defer some of the tax due on the sale by the time they get paid in future, it is popular. This method is used when you obtain at least one payment after the year of the sale of a business. Although the installment method cannot be used if the sale results in a loss, usually that is not the case. In addition to that, payments for most of a business’ assets may not be eligible for the installment sale method. It should be noted that only capital assets qualify for installment treatment. All things on which gains are treated as ordinary income are ineligible for the installment sale method.
This covers payments:
- for accounts receivable
- for inventory;
- for any personal property
- for property that’s been used for or less than a year
For all such items, tax must be paid on any gains in the year of the sale regardless of the fact that you have not received payments for the items. You can also treat the profits on any intangible asset as an installment sale. You, along with the buyer, have to decide the structure of the sale. You have to determine what percentage of the purchase price will be divided among the different tangible and intangible assets, including goodwill. This applies to both small firms and large organizations.
This allocation evaluates the amount of capital or ordinary income tax that is payable on the sale and also has tax consequences for the buyer. Generally, a good tax picture for the seller is equally bad for the buyer or vice versa. Therefore, all allocations to several components of the deal require negotiation and compromise. Generally, sellers prefer allocating some of the amounts of the sale to the capital assets that are transferred as part of the deal. This is because any profit when selling a capital asset, which includes your business and any properties included in the sale, is taxed based on capital gains.
In case your business is registered as a sole proprietorship, LLC, or partnership, each asset you sell will be treated separately says Dr Xerri from CBSgroup. A business organization or corporation can follow the same route. However, there you have the option of reporting a stock sale by structuring the transaction accordingly. Hence, all actions must be applied separately to every asset in the sale. Since a few assets do not qualify for capital gain treatment, any returns you gain on that property are categorized as ordinary income and taxed at the normal rate.
Starting a new business
You can transfer the sale of business proceeds into a new startup business. This is a smart method of lowering the capital gains tax that you have to pay. This can be done because now you can offset some of the startup capital expenditure against the CGT of your old business that you are selling. Both the sale of the old business and the start-up of the new business must be done during the same fiscal year.
Whichever method you choose, doing it legally is the way to go.