Tax Considerations When Selling a Business

For owners who have poured everything into growing their business, a sale may offer a sizable reward and the opportunity to create a post-sale family legacy and pursue life’s next adventures.

A major tax consideration when you sell your business is whether you should sell the assets of the business or your stock in the company.

There are advantages and disadvantages in both options. Generally, buyers want to purchase assets, and sellers want to sell their stock. Because of this dichotomy, not only do we advise you to engage and consult with your attorneys and CPAs, but you should understand what the pros and cons are to each.

Let’s review some basic tax considerations in an asset or stock sale. Starting to think about this early, even years before you anticipate selling, can help you take necessary steps to best position your company for a successful sale.

Understanding the Basics

Of the two basic ways of selling a business — asset sale or stock sale — sellers and buyers have strong and opposing reasons for preferring one over the other. From a tax perspective, sellers may prefer a stock sale because the gain on the sale will likely be taxed as long-term capital gains at a top current federal tax rate of 20% (plus a 3.8% net investment income tax), as opposed to ordinary income with a top federal tax rate of 37%.

Buyers, in contrast, may prefer an asset sale (i.e., an itemized purchase of the company’s assets — equipment, inventory, customer lists, etc.). By doing so, the buyer may immediately begin depreciating those assets, generating tax deductions. There is no depreciation with a purchase of stock, and the cost is only recuperated with the sale or liquidation of the company. The buyer in an asset purchase may also pick and choose the portions of the business that they want. With a stock purchase, the buyer is buying all assets and liabilities of the company, currently existing and those that may arise in the future.

For sellers, the downside of an asset sale — in addition to the complexities of valuing and negotiating the sale of individual assets — is that a portion of the proceeds will often be taxed at the higher ordinary income tax rates. Because an asset sale will likely result in a higher tax obligation for the seller, buyers may be willing to offer a higher price as an incentive.

Stock Sale Planning

If you are selling your company’s stock, the gain will generally be taxed at preferential capital gains tax rates. Additional considerations may impact your overall tax picture. For example:

Qualified small business stock (QSBS). To stimulate the growth of small businesses and the U.S. economy, lawmakers have enacted various tax incentives for taxpayers who start and invest in small businesses. Individuals (i.e., noncorporate shareholders) holding QSBS may be eligible to exclude up to 100% of their gain from the sale of stock. The QSBS rules are subject to a number of restrictions.

In general, to qualify as QSBS, the stock must be issued by a domestic C corporation with no more than $50 million of gross assets at any time between August 10, 1993 (or when the qualified small business started), and the time the stock was issued or acquired by the taxpayer on original issuance, and the stock must be held for at least five years.

Tax-free reorganization. The Internal Revenue Code outlines several scenarios for tax-free business reorganizations, including a stock-for-stock exchange, known as a “B” exchange. If an owner selling a business receives stock of the acquiring company with an equivalent cost basis, he or she may defer capital gains taxes. This has potential advantages for buyers as well, especially those who don’t wish to deplete their cash reserves in order to make the purchase.

Employee stock ownership plan (ESOP). Since 1974, founders have been able to transfer ownership of their businesses to their employees through ESOPs. While ESOPs remain relatively rare (fewer than 6,000 corporations have ESOPs out of millions of privately held S and C corporations in the United States¹), they offer significant advantages for certain companies and situations. The owner may transfer shares to employees and reinvest the proceeds in diversified securities, deferring capital gains taxes. Meanwhile, the employees have the opportunity to carry on the company’s legacy.

Pre-transaction charitable gifts of stock. A gift of stock to a qualified charitable organization in advance of a stock sale may be advantageous for the charity and for you personally. For example, if you contribute stock valued at $100,000 (in advance of the sale of your company), you may be able to deduct that full amount on your personal tax returns and avoid paying tax on the built-in gain on the stock.

If you wait until after the sale, you would be donating money already subject to federal and state capital gains taxes stemming from the sale. In real terms, your donation (and deduction) might be reduced to around $70,000.

Advance planning is essential. Donations made too close to the time of the sale could be deemed post-sale for tax purposes.

Asset Sale Planning

An asset sale will likely result in a combination of gain taxed at both ordinary and capital gains rates, depending on the nature of the individual assets. Generally speaking, sales of assets such as equipment, buildings, vehicles and furniture will be taxed at ordinary income tax rates, while intangible assets such as goodwill or intellectual property will be taxed at capital gains rates. Here are some tax considerations with an asset sale:

Purchase price allocation. One of the most complex and delicate parts of an asset sale is negotiating the price of the individual assets — a process known as price allocation. As previously mentioned, buyers want assets that can be immediately depreciated after purchase. Sellers prefer to allocate more to intangible assets, where any gain is taxed at the preferential capital gains tax rates.

A 1031 exchange. If the asset sale is for real property, the seller may be able to defer taxes on the gain using a 1031 like-kind exchange. As the name implies, if you use the proceeds to exchange that property for a like-kind asset, you can defer taxes on the property you sold. But note that there are a number of restrictions — for example, in order to qualify, you need to identify the replacement property within 45 days of the sale and complete your purchase of the replacement property within 180 days.

Post-transaction charitable gifts. The proceeds from an asset sale will likely result in significant income. If you are charitably inclined, charitable contributions made during the same tax year may offset this additional income.

Gauging the effect of net investment income tax (NIIT). As mentioned previously, asset sales generally result in gains taxed at both ordinary and capital gains tax rates. Gains characterized as capital may be subject to the federal 3.8% net investment income tax (NIIT). Before the sale, review how the NIIT could affect your tax picture.

Other Tax Considerations

Some tax considerations apply regardless of whether you ultimately transfer your business through a stock or asset sale.

Installment sale. To lessen the impact of capital gain or income tax obligations in a single year, you may want to negotiate a sale where proceeds are received over more than one tax year (i.e., an installment sale). Under an installment sale, the buyer takes immediate ownership, but payments are made over more than one year. Interest may accrue with delayed payments.

Your non-business finances. Before selling your company, a careful review of your other finances and overall tax picture can be essential to make your business transaction as tax efficient as possible. Capital loss carry forwards may offset capital gains from the sales transaction. Or if your transaction is a stock sale and you have under performing assets elsewhere in your investment portfolio, harvesting those losses could help offset extraordinary gains in the year or years when the transaction is completed.

If your transaction is an asset sale, losses from a separate business venture unrelated to your company could offset ordinary income from the asset sale.

State tax planning and residency considerations. State tax laws vary widely and should be factored into any sale. In addition to varying income and capital gains rates, states have different rules on specific programs. For example, California does not recognize the QSBS rules. In some cases, with advance planning, it may be advisable to switch the location of a business to a different state prior to its sale.

Finding Guidance for Your Situation

Whether you ultimately have an asset or stock sale, there are no simple, off-the-shelf ways to sell your business. In many ways, a rewarding sale is as complex as the innumerable decisions you put into making the business a success. As such, specific ideas contained in this article may or may not apply to your situation, but could help you start productive conversations.

We recommend planning years ahead of a potential sale. Experienced tax professionals and attorneys can help you negotiate effectively, avoid missed opportunities, and realize the reward your years of hard work warrant. Reach out to your Bessemer Trust team for help in understanding how taxes related to your transaction may affect your overall financial and tax situation.