How To Avoid Capital Gains Tax on Business Sale
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Summary:
If you sell a business for a profit, whether in stocks or assets, a capital gains tax will be applied to the sale. However, many of these tax consequences can be mitigated substantially depending on the business’s structure and the selling process. Whether your business is structured as a partnership, a sole proprietorship, or a corporation will determine how you can avoid capital gains tax on the sale of the business.
There is no better way to accumulate wealth rapidly than running a successful business with equity that grows exponentially. Many of the top members of the Forbes 100 list have a net worth dictated by the value of the equity in their primary business: Bill Gates’s net worth goes up and down with the value of Microsoft, and Elon Musk’s net worth is substantially tied to the value of Tesla stock.
Tech industrialists aren’t the only business owners whose net worth fluctuates with the value of their business. There are millions of big and small business owners in the United States. And sometimes, a business owner will realize the gains they have made from their business by selling it.
Whether you’re selling a big corporation or a small local coffee shop, it’s worth understanding the process and tax liability of selling a business to smartly realize the gains from the business you’ve poured your heart and soul into. After all, knowing how to lessen your capital gains tax bill will put more money in your pocket in the long run.
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What are capital gains taxes in business?
Capital gains tax is the most important tax you should know about before going through with a business sale. Obviously, unless you’re selling the business due to retirement or an emergency, you’re planning to gain more money from the sale than you paid when you started the business. But since a business is considered an asset, like a stock or bond, a profitable sale of the business will come with a special tax known as capital gains tax.
How much you’ll have to pay in capital gains tax from the sale of your business will depend on its structure. The tax liability is calculated differently for a partnership, a sole proprietorship, or a corporation (C corp or S corp). Furthermore, there are different methods for valuing the assets of a business, and the buyer and seller will have conflicting incentives for reaching that valuation. Finally, depending on the timing and buyout structure of the business sale, you as the business owner can take advantage of certain capital gains tax breaks.
How capital gains taxes work
Capital gains taxes are levied on the realized gains from the sale of an asset. For example, if you buy a stock at $10 and sell it for $20, then you must pay capital gains tax on that $10 of profit. The capital gains tax rate is determined by both your income level and the time when you sell the asset.
Short-term capital gains
A short-term capital gain is a gain realized when you sell an asset within 12 months of acquiring it. Short-term capital gains are taxed at ordinary income tax rates based on your normal income. As of the 2022 tax year, the ordinary income tax rate spans from 10% to 37%.
Long-term capital gains
A long-term capital gain is a gain realized when you buy an asset and sell it after 12 months. Capital gains tax rates for long-term capital gains are substantially lower compared to the taxes on short-term capital gains. Based on the federal income tax rate as of 2022, depending on your income level, the sale of your long-term capital gain will be taxed at 0%, 15%, or 20%.
How business structure affects capital gains tax
The first rule of thumb when determining how much you’ll pay in capital gains tax is to look at how your business is structured and how you are selling it. Let’s take a look at some typical business structures in the United States and how capital gains taxes are calculated for each type of business.
Sole proprietorship
A sole proprietorship is an unincorporated business that has a single owner. Under U.S. tax law, income from sole proprietorships is treated as normal taxable income, as there is no legal distinction between the owner and the entity. For example, if you start a lawn mowing business and set up a company in which you are the only shareholder, you have a sole proprietorship.
Unlike selling shares, the sale of a sole proprietorship is treated as if the business owner owns all the assets and is selling them separately. For this scenario, the IRS provides a special form called Form 8594, or an “Acquisition Statement,” that distinguishes assets into seven different classes. These range from easily countable cash in the bank to future value and “goodwill.”
| Class | Assets | Examples |
|---|---|---|
| Class I | Cash and deposits | Cash in the bank |
| Class II | Actively traded personal property | Stocks, debt |
| Class III | Accounts receivable | Debt instruments |
| Class IV | Inventory or other property | Storage warehouses, machinery |
| Class V | All other assets not included in another class | Rare collectible cards |
| Class VI | Intangible assets, except for concern value and goodwill | Trademarks |
| Class VII | Goodwill and going concern value | Health of the business, future growth prospects |
Cost basis in a sole proprietorship
If you want to avoid as much capital gains tax as possible on your sole proprietorship, you must first determine the cost basis, which is the original value of the company when it was started or acquired. The cost basis is important because it includes factors such as depreciation. For instance, if you purchased a computer for $1,000 and you wrote off $400 in depreciation, then the cost basis is $600. A favorable cost basis can help you avoid capital gains tax on hard assets when you sell a sole proprietorship.
Another factor to consider when selling a sole proprietorship is the matter of intangibles, such as goodwill and the value of the business based on growth and incoming receivables. The IRS does not define how to calculate this value; instead, this value is negotiated during the sale of the business. For instance, if you have a coffee shop that has been growing its customer base by 10% a year but is now projected to grow by 20% a year due to redevelopment in the area, the value of this growth will be negotiated between the buyer and the seller. Once this value has been settled, the IRS can attach a taxable gain to levy capital gains tax on it.
Debts in a sole proprietorship
Just as a sole proprietorship’s taxes are indistinguishable from a normal individual’s, so are its debts. This means that if you sell the business, the debts don’t transfer unless negotiated as such directly with the buyer. This is important to keep in mind because you could otherwise end up on the hook for a substantial amount of debt without an income-generating business to help you pay it back.
Pro Tip
Before buying a capital asset, it’s important to compare its fair market value to its cost basis. If the asset’s fair market value is substantially greater than what you claim on your tax forms, it could raise questions from the IRS. When filing your taxes, make sure to get help from a tax advisor to avoid any costly mistakes down the line.
Partnerships
A partnership is a business owned and operated by two or more people. Although the most famous examples are law firms and accounting firms (where the goal is often to “make partner”), partnership structures exist in all sorts of businesses. For instance, if you run a coffee shop with your cousin and you have a 50/50 equity split, this is considered a partnership.
Although a partnership is run by more than one person, its tax treatment is similar to that of a sole proprietorship. According to the IRS,
“A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” profits or losses to its partners. Each partner reports their share of the partnership’s income or loss on their personal tax return.”
If the seller wants to sell their partnership interest or their shares in the partnership, this sale is treated as a normal capital gain asset. However, if the entire partnership is sold, including the underlying assets, then the taxes on the assets are calculated on a cost basis, the same as a sole proprietorship. This means that taking advantage of factors like depreciation can greatly save you capital gains taxes on the sale of an entire partnership.
Corporations
Owners of growing businesses who have to deal with multiple business operations and daily overheads often find it makes sense to form a corporation. If you buy stock in a publicly-traded company, you are buying C-corp stock. These gains are calculated based on the difference between your stock basis and the stock sale price. The stock basis is either the original purchase price of the stock or, in the case of an early shareholder, the value of the capital investment that was put into the company.
There are several different ownership structures for a corporation, but for the purpose of capital gains taxes, let’s focus on the two most prevalent: C corps and S corps.
C corporations
According to the Small Business Administration, a corporation, sometimes called a C corp, is a legal entity that’s separate from its owners. Corporations can make a profit, be taxed, and be held legally liable.
A corporation differs substantially from a sole proprietor or partnership in that it pays income tax on its profits at the corporate income tax rate. The dividends are then paid to the shareholders and taxed again. This can create the problem of “double taxation”: once on the corporation’s profits and again on the profits being passed to shareholders in the form of dividends.
Qualified small business stock (QSBS) on C corps
If you are selling stock in a C corp, then you are taxed on the gain of your asset, calculated as the difference between the purchase price or cost basis and the sale price. However, there is a method to avoid capital gains tax on a C-corp stock sale. According to IRS Section 1202, if you are selling a qualified small business stock (QSBS), then any sale under $10,000,000 is exempt from capital gains tax.
There are three conditions a company must meet in order to qualify for QSBS:
- The company must be incorporated as a U.S. C corporation.
- The company must have had gross assets of $50 million or less at all times before and immediately after the equity was issued.
- The company must not be on the list of excluded business types.
The QSBS program was set up to ensure that new businesses would be able to avoid taxes on their stock, thus allowing them more capital to grow. Once a stock has been defined as QSBS, the stockholders need to hold the stock for at least five years, after which they can sell the stock and mitigate or avoid capital gains tax.
Looking to invest in a C corp that has an awesome growth trajectory but is probably below its intrinsic value? Here are some investment advisors that can help.
S corporations
Unlike a C corporation, an S corporation avoids the problem of double taxation — that is, taxes at both the company level and the individual level. In an S corp, the business chooses to pass the income, losses, deductions, and credit through to the shareholders before it is taxed. Then each shareholder is taxed on an individual level, similar to a partnership or sole proprietorship. The only taxes an S corp is responsible for at the corporate level are the taxes on its employees’ wages.
If a portion of stock in an S corp is sold for a gain, then the seller must pay taxes on the difference between the selling price and the stock basis, the same as a normal capital gain. If the business is sold in one piece, then because that money “passes through” to its shareholders, the capital gains are taxed at the individual level. Like a sole proprietorship or partnership, the only way to avoid capital gains tax on the sale of an S corp is to take advantage of the depreciation of assets and negotiate favorable terms with the buyer.
Additional strategies to avoid capital gains tax
Besides knowing the rules of each type of business structure, there are additional strategies you can use to avoid capital gains tax on the sale of your business.
Sell your business at the right time
As mentioned above, capital gains are taxed differently depending on the timing of the sale. If you sell an asset within 12 months of acquiring it, then that qualifies as a short-term capital gain, and you will have to pay a lot more taxes on it.
If it isn’t imperative that you sell the business right away, then it’s much smarter to wait until after you’ve owned the business for over a year. With this simple timing trick, you can save yourself a substantial amount of money on capital gains tax.
Sell the business in installments
A buyer of a company is more than likely willing to negotiate with the seller to make sure their incentives are aligned. Structuring a deal in which the buyer pays in installments, known as an installment sale, is a smart way to alleviate your tax burden. If you space the payments of your business sale over five years as opposed to receiving it all in one lump sum, you can spread out the tax liability as well.
Give company stock to your employees
Philanthropic capitalism has become increasingly popular over the years. And what better way to give back than to give company stock to your employees? The employee stock ownership program, or ESOP, lets employers sell or transfer stock to their employees for a nominal rate. The IRS gives special tax treatment to employee stock, so you may be able to significantly mitigate capital gains tax by taking advantage of this program.
Put your gains in a charitable trust
In case you are feeling especially charitable, the IRS allows you to effectively give away the profits from your business sale through the setup of a charitable remainder trust. The program lets donors place cash or property in a trust. Any equity or cash derived from a stock or asset sale that is placed in this type of trust qualifies for major tax advantages from the IRS.
Allocate your assets properly
As mentioned previously, the IRS has seven different classifications for assets when it comes to selling a business, particularly a sole proprietorship or a partnership. How you allocate the assets from your business will have a significant impact on both the sale price and the taxes levied on the sale.
When dealing with such a complex transaction, it’s best to talk to a qualified CPA, as they can advise you on the best way to file your taxes that will legally get you the maximum tax breaks.
FAQ
How does capital gains tax work when selling a business?
Like with any capital asset, capital gains are taxed based on the sale of the business. However, the amount of taxes depends on the structure of the company, when it’s sold, and if it qualifies for tax exclusions.
How can I avoid capital gains tax legally?
There are several methods you can use to avoid capital gains tax legally. For example, the timing and structure of the sale can help you avoid paying capital gains tax that’s tethered to ordinary income taxes.
How do businesses lower capital gains tax?
Businesses can lower capital gains taxes through strategies like allocating capital assets into classes that might receive a more favorable tax treatment.
How much is capital gains tax on the sale of a business?
Capital gains tax on a business sale can vary depending on the structure of your business and when you sell it. You can be taxed for short-term capital gains at ordinary income tax rates (up to 37%) or for long-term capital gains at more favorable rates (up to 20%).
Key Takeaways
- Like with any capital asset, capital gains from the sale of a business are subject to capital gains tax.
- Capital gains tax is calculated differently based on whether the business is a sole proprietorship, a partnership, or a corporation.
- The timing of a business sale determines whether the capital gains are taxed at short-term capital gains tax rates (ordinary income) or long-term capital gains tax rates (more tax advantageous).
- The tax bill on capital gains can also be lessened through other methods, such as giving stock to your employees or putting the gains into a charitable remainder trust.
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