Tax season is in full swing and it's time to take another look at the tax implications of selling a small business. As a seller, you are required to pay tax on the gains earned from the sale of your company. But if you haven't laid the appropriate groundwork before you enter the business-for-sale marketplace, the tax code can significantly reduce your net sale proceeds.
Tax Planning Is a Must
Many factors influence decisions about how and when to sell a company. But tax management deserves to be in the mix because the tax liabilities associated with selling a small business can be staggering.
Under the current system, it's possible for sellers to incur a much higher tax burden by simply neglecting to make a few easy decisions before the sale.
In most cases, taxes can be reduced through a multi-year strategy that limits current year tax liability. It's not uncommon for small business sellers to save tens of thousands of dollars by structuring the sale in a way that mitigates their exposure in any given tax year.
Tax Management Tips for Small Business Sellers
You're fooling yourself if you think you can manage tax planning on your own. With a significant portion of sale proceeds on the line, the decision to consult a tax professional before the sale should be a no-brainer.
There are several things to consider as you develop a tax planning strategy with your accountant or lawyer:
1. Understand the consequences of receiving all proceeds at closing.
The decision to accept the entire purchase price at closing presents the lowest payment risk because it eliminates concerns about the buyer's ability to pay the remaining balance in the future.
However, payoff at closing also presents the greatest tax exposure because it forces you to accept all sale proceeds in a single year--an action that will likely push you into higher tax brackets.
Depending on your sale goals, it may make sense to receive all proceeds upfront. But if you insist on receiving the entire sale price now, you have to be willing to accept the fact that you will likely pay a higher tax rate on a portion of the sale.
2. Consider a deferred payment or installment strategy.
One of the most common ways to reduce the tax liability of a business sale is to receive payment over time. By deferring the receipt of proceeds over multiple years, you can control your tax rate by managing the portion of the sale price that falls into higher tax brackets.
Seller-financed loans, earn-out payments and similar scenarios sidestep higher tax brackets by avoiding the single-year tax liability trap. The caveat is that you will need collateral or other measures to protect your interests should the buyer fail to make scheduled payments. Another option is to work with a third-party tax-deferral finance company that can help create the best tax deferral strategy and reduce the risk of buyer default.
3. Negotiate a favorable price allocation.
For IRS purposes, the buyer and seller must agree on the allocation of price among the assets that are being transferred in the sale. Some assets are treated as capital gains and taxed at a lower rate, while others are treated as ordinary income and taxed at a higher rate.
As a seller, your goal is to include as many assets as possible under the capital asset classification. But reaching an agreement with the buyer won't be easy because capital assets are depreciable and tax deductions for capital assets are amortized over a much longer period of time.
Although specific IRS rules govern the allocation of assets, it's in your best interest to negotiate an agreement that maximizes the portion of the purchase price allocated to capital assets.
Many of the strategies for managing the tax burden of a business sale also provide other benefits for sellers. For example, by offering seller financing, you may be able to receive a higher sale price as well as the tax benefits of a deferred payment strategy.
In the end, information is your ally. By understanding the tax implications of the sale now, you can avoid costly surprises later--when it's too late to prevent a major bill from the IRS.