The tax on selling a business can be a major source of stress for business owners.
Although it can feel overwhelming, the good news is there are steps that entrepreneurs and business owners can take to reduce the amount of taxes they owe on their sale.
In this post, I’ll walk through 13 tips to help you minimize your tax burden when selling a business.
As a quick disclaimer, this post is purely for informational purposes. Make sure you consult with M&A experts and tax professionals before making any decisions for your specific situation.
How are you taxed when you sell a business?
When you sell a business, the proceeds from the sale will typically be considered capital gains or losses. Capital gains are taxed differently than ordinary income, and the exact rate will depend on your income level and how long you held the business before selling it.
A quick rule of thumb:
If you held the business for more than a year, the gain will be considered a long-term capital gain and taxed at a lower rate.
On the other hand, if you’ve owned the business for less than a year, you’ll pay a higher ordinary income tax rate on your profits.Â
Capital Gains Tax Rate
This is the tax you’ll pay on the difference between the sale price of your business and your “tax basis” in the business (generally, what you paid for it).
The good news is that the capital gains tax rate is typically lower than the ordinary income tax rate. The current tax rate for long-term capital gains (assets held for more than a year) is 20% for those in the highest income bracket, 15% for those in lower brackets, and 0% for those in the lowest bracket.
Mistakes to Avoid: Business Sale Tax Liability
Before we get into the strategies, I want to spend a minute covering a handful of common mistakes I see business owners making when selling.
Avoiding these mistakes will ensure you’re paying the correct amount of taxes and taking full advantage of any tax breaks or deductions that may be available.
- Not keeping accurate records: In order to accurately calculate the gain or profit from the sale of a business, accurate records are crucial. This includes keeping track of all expenses, investments, and improvements made to the business. Not having accurate records can lead to overpaying taxes or not being able to take full advantage of tax breaks or deductions.
- Not understanding the difference between an asset sale and a stock sale: Some business owners assume that they can avoid taxes by structuring the sale as an asset sale instead of a stock sale. However, the IRS closely scrutinizes these types of transactions and may reclassify them as stock sales for tax purposes. It’s also possible for an asset sale to result in higher taxes for the seller in some cases. The big takeaway: there is no one-size-fits-all answer and the decision go with a stock or asset sale should not be taken lightly.
- Not understanding the difference between short-term and long-term capital gains: The tax rate on the sale of a business depends on the individual’s income tax bracket and can vary greatly. Depending on the business owner’s tax situation, it may be possible to qualify for lower tax rates on long-term capital gains. It’s important to understand the difference between short-term and long-term capital gains and plan accordingly.
- Anything that appears too good to be true: The IRS is very good at cracking down on any attempts to sidestep taxes. If a proposed tax strategy seems too good to be true, it almost definitely is. Make sure you understand the rules and regulations before making any decisions about how you structure your sale or take deductions.
13 Ways to Reduce Taxes on Business Sale
To minimize the taxes you will pay when selling your business, there are a few strategies I’d recommend looking into.
Many potential savings opportunities are deferrals in some capacity, meaning that you’ll be pushing off the tax costs until a later date. It’s important to evaluate all options carefully and weigh the pros and cons of each.
1. Maximize Retirement Contributions
One of the most effective ways for to drive tax savings is to maximize contributions to retirement plans. Since you are self-employed, you have more flexibility with retirement plan contributions compared to W2 employees.
When you invest in a retirement plan such as a SEP-IRA or 401(k), you can deduct those contributions from your business income, reducing the amount of taxes you owe.
Here’s a breakdown of retirement plan contribution limits (as of 2022):
2. Tax Loss Harvesting
Tax loss harvesting is a strategy where you sell investments that have declined in value, creating capital losses to offset any realized gains from the sale of your business.
If you’re sitting on a position that’s currently underwater, whether it be stocks or crypto, there’s a simple strategy you can use to turn that loss into a tax benefit.
The key is to sell that losing position in the same tax year, and use the loss to offset any capital gains and net investment income tax you may have.
3. Buy Qualified Small Business Stock (QSBS)
Qualified Small Business Stock (QSBS) allows you to purchase stock in qualified small businesses without having to pay capital gains tax on the sale of that stock.
This can be an incredibly useful tax planning when looking to increase your investment portfolio while reducing your tax burden.
As Michael Girdley explains on his blog, here’s how the strategy works:
1) Buy stock in a US federal C-corporation
2) Sell it after five years
3) You pay 0% capital gains taxes on the greater of $10 million or 10x your investment. If you haven’t held QSBS for 5 years, you can roll the proceeds into another QSBS investment until you hit the 5 year hold requirement (see Section 1045 if you’d like to learn more).
Keep in mind you need to plan pretty far in advance and meet certain requirements to qualify for QSBS, so make sure you do your research.
4. Start a New Business
One way to reduce the taxes you pay when selling your business is to start a new business. I’d only recommend going down this path if you truly are planning to start a new business and not just doing it for the tax benefit.
Any losses resulting from the new business will offset any gains from the sale of your old business, reducing your overall tax liability.
5. Equity Rollover
An equity rollover allows business owners to retain a portion of their equity in the acquired business, rather than selling it all to the buyer in a traditional acquisition. This can be an attractive option for business owners who want to participate in the future growth of the business, while also receiving cash or other assets that they can use to reinvest in other opportunities.
This strategy works by structuring the transaction as an equity rollover rather than a sale of assets. This means that the buyer purchases the equity in the business, rather than the assets. By doing this, the seller can defer paying taxes on the portion of the equity that is rolled over until they ultimately dispose of it.
6. Opportunity Zone Investments
Opportunity Zone investing is extremely tax advantaged and very few people know about it.
Although your money is illiquid for a significant period of time (typically 10 years), there are significant benefits including cost segregation depreciation, deferral of gains, and a 10-year basis step up.
Barrett Linburg has a terrific Twitter breakdown on the topic if you’re interested in learning more.
7. Sell to an ESOP
An Employee Stock Ownership Plan (ESOP) is a trust that holds the stock of a company and can be a tax-efficient way to sell a business.
Section 1042 of the Internal Revenue Code allows you to defer paying taxes on the sale of a business if you roll over the proceeds into a Qualified Replacement Property (QRP) within 60 days of the sale.
8. Sell assets separately
If possible, consider selling assets of the business separately, such as real estate, capital assets, or intangible assets. This can allow you to take advantage of depreciation recapture rules and potentially pay a lower tax rate on those business assets.
9. Consider using a installment sale structure
You could consider offering seller note to the new buyer, which is referred to as an “installment sale.
Under this structure, the seller receives the purchase price for the business over time, rather than all at once. This allows you to spread the recognition of the gain over several years, which can significantly reduce the amount of tax you owe in any given year.
10. Invest in real estate
One option is to buy commercial or residential properties, and conduct a cost segregation study on them. This allows for accelerated depreciation, generating losses in the current tax year. For example,
Another strategy is investing passively in a real estate fund. Depending on the type of real estate and investment strategy, this can also provide accelerated losses. But it’s important to note that the investment needs to be made in the first year to qualify for the tax benefits.
11. Charitable giving
Consider charitable giving strategy, such as charitable remainder trusts, charitable lead trusts or charitable gift annuities. These strategies can help you to reduce the taxable gain on the sale of your business, while also providing tax benefits and supporting charitable causes.
12. Maximize your basis
Your basis in the business is the amount of money you have invested in the business over time. The higher your basis, the lower your capital gains will be.
Going back to my comment around record-keeping earlier – it’s critical to keep detailed records of all investments made into the business over time, so that you can maximize your basis at the time of sale.
13. Consider a like-kind exchange
Take advantage of the like-kind exchange rules under Section 1031 of the US Tax Code. This allows you to defer paying taxes on the sale of the business if the proceeds are used to purchase another similar business or investment property.
This can defer the recognition of the gain until the new business is sold, potentially reducing your tax obligation.
14. Defer the sale
Last but not least, the obvious option to reduce your taxes is to not sell, which of course prevents you from having to pay capital gains tax all together.
As an alternate option to selling, you might want to consider taking out loans against your business, which is covered in my post on small business tax strategies.
Frequently Asked Questions
How are business sales taxed?
The proceeds from the sale of a business are generally considered capital gains or losses. Capital gains are taxed at a lower rate than ordinary income, but the exact rate will depend on your income level and how long you held the business before selling it.
If you held the business for more than a year, the gain will be considered a long-term capital gain and taxed at a lower rate.
Can I defer paying taxes on the sale of my business?
Yes, there are several strategies you can use to defer paying taxes on the sale of your business, such as deferring the sale, selling to an Employee Stock Ownership Plan (ESOP), taking advantage of Section 1042 of the Internal Revenue Code, or structuring the transaction as a tax-free exchange.
Are there any special tax rules for small businesses?
Yes, there are several tax breaks and deductions available for small businesses – I cover 15 strategies in my post on tax planning strategies.
Can I avoid taxes altogether if I sell my business to a family member?
No, you cannot avoid taxes altogether if you sell your business to a family member. If the sale is at fair market value and the terms are comparable to those of an arm’s-length transaction, the tax implications will be the same as if you sold the business to a third party.
Can I reduce taxes by selling my business piecemeal?
Yes, selling assets separately can allow you to take advantage of depreciation recapture rules and potentially pay a lower tax rate on those assets.
It’s important to consult a tax professional to understand the tax implications of selling assets separately.
Wrap Up
Selling a business is a huge accomplishment, but it can also come with a hefty tax bill.
As we covered, while taxes are a necessary part of selling a business, there are quite a few strategies that can be used to reduce the overall tax bill. I hope you walk away from this with a few ideas which can help reduce your tax hit.
As I mentioned earlier, these strategies might not be suitable for everyone and it’s important to consult with an expert when exit planning to understand which make sense for your specific situation.
If you’re interested, I’ve written a detailed post with more strategies on how small business owners can reduce their taxes.
Good luck!
