For many entrepreneurs and business owners, their business represents a significant portion of their total net worth and retirement nest egg. That means when it comes time to sell their business, it may be one of the largest transactions of their lifetime.
The stakes are high, and it is essential to know some of the common pitfalls and tax considerations when approaching the sale of your business. For some, a failure to plan ahead can result in a tax bill of almost half the entire sale price. Fortunately, proper planning may help business owners significantly reduce their tax liability and keep as much money in their pockets after the sale.
Here are 4 critical tax considerations when selling your business:
First, the Allocation of the Sales Price Will Determine the Tax Outcomes
When you sell your business, you and the buyer can negotiate how much of the sales price will be allocated to each specific asset of the business. For example, intangible assets, such as goodwill—which represents the company’s brand name, customer base, and relationships—can be assigned a certain dollar amount based on the buyer’s and the seller’s agreement, subject to certain IRS rules.
This is critical when negotiating the sale of your business because gains from different assets are taxed at different rates. The specific allocation you agree on will determine how much of the sale is treated at favorable capital gain rates and how much is treated at potentially higher ordinary income rates.
It is often to your advantage as a seller to have as much of the sale as possible allocated towards capital assets and receive favorable long-term capital gains treatment of the gains recognized. That said, certain assets are not eligible for capital gains treatment and will be taxed at ordinary income rates.
Depreciation Recapture Is Taxed as Ordinary Income
One crucial aspect to consider is that the gain on depreciable personal property—any property other than real estate—is treated as ordinary income up to the amount that the gain equals the depreciation you have already claimed on those specific assets.
This often comes into play for businesses with a lot of equipment that’s been depreciated and is included in the sale of the business. This can lead to a portion of the gain on the equipment counting as ordinary income, for any amounts that were depreciated and are now being “recaptured” and any remaining gain amounts being taxed at more favorable capital gains rates.
You Must Follow IRS Allocation Rules
As you can imagine, the IRS has some specific rules for allocating the purchase price of your business to specific tangible and intangible assets.
As a rule of thumb, all tangible assets need to be valued at their fair market value, in a specific order, with the value of goodwill coming last. That means that goodwill gets the residual value, or whatever is leftover, after accounting for the fair market value of the other business assets.
That said, there are still many things that can be up to negotiation. Often a third-party appraiser determines the fair market value of certain assets. So as long as your allocation is reasonable, and the buyer agrees to it, you may have some wiggle room in assigning the purchase price to various assets.
Consider an Installment Sale
Lastly, you may be able to limit your tax liability by spreading out your taxable gain over multiple years using an installment sale. There are specific rules to navigate when using an installment sale, but the general idea is that you finance the sale of your business by receiving part of the purchase price now and holding a note or mortgage for the rest of the sale price. Then, the buyer will pay you out each year following the terms of the note until the entire loan is paid back.
This can be to a seller’s advantage because it avoids realizing all of the taxable gains in one year, which could potentially result in maintaining a lower marginal tax bracket over time, reducing your tax liability.
In the end, business owners preparing for a sale have many tax planning tools at their disposal, but the rules can be complex. Often, it is prudent to hire a financial professional to help navigate the intricacies of tax minimization and help you avoid common pitfalls during one of the single most significant transactions of your lifetime.
At Truenorth Wealth, We’re Here to Help
If you’re currently looking for a fiduciary CFP® professional to help navigate the sale of your business, complete with a custom tax strategy to minimize your tax liability, then TrueNorth Wealth is here to help.
TrueNorth Wealth is one of the top Wealth Management firms in Utah and top financial planners in Idaho, with offices in Salt Lake City, Logan, St. George, and Boise. At TrueNorth Wealth, our sole focus is to help our clients meet long-term financial goals while also maximizing the enjoyment they receive from their assets. We do this by pairing clients with a dedicated CFP® professional backed by an incredible team.
For the professionals at TrueNorth, it’s about so much more than money. It’s about serving communities across Utah and helping families achieve true financial freedom and economic flexibility in their lives. To learn more or schedule a no-cost consultation, visit our website at TrueNorth Wealth or call (801) 316-1875.