Selling a Business: Capital Gains Tax

Vikingmergers

Are you a small business owner considering selling a business? There are a few key items involved with capital gains tax that you’ll want to understand as you embark on this decision.

What are Capital Gains?

A profit gained from selling a capital asset is referred to as capital gains. This could be an investment like a stock or an asset like a business. There can be both capital gains and losses and when you sell a business: the difference between the original cost and its sale price is the capital gain (or loss). There are also ways to reduce your capital gains, such as the depreciation of equipment or the cost of capital improvements. 

For example, imagine that you acquired a business for $300,000 and added an improvement for $100,000. If you then sold the business for $450,000, you would have a capital gain of $50,000. On the other hand, if you sold the business for $350,000, you would instead have a capital loss of $50,000.

What is Ordinary Income?

While capital gains arise from selling an asset, ordinary income includes items like business profits, wages, and interest income. Ordinary income is subject to standard tax rates.  

Capital Gains Tax vs. Ordinary Income Tax

When a business is sold, it means capital assets are being sold, and taxes will be due on those capital gains. Within capital gains tax, we have two buckets: short-term and long-term capital gains. 

Short-Term Capital Gains

Short-term capital gains tax applies to any businesses held for less than one year. A net short-term capital gain is usually taxed as ordinary income, based on your tax rate (up to 37%).  

Long-Term Capital Gains

Long-term capital gains tax applies to businesses that are held for more than one year. A net long-term capital gain is usually taxed no higher than 15% for most taxpayers, but there are some exceptions. To be strategic about which tax rate you ultimately pay, it makes the most sense to hold a business for more than one year to avoid incurring a much higher tax rate.

In the words of the IRS, “If you have a net capital gain, a lower tax rate may apply to the gain than the tax rate that applies to your ordinary income. The term ‘net capital gain’ means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss for the year. The term ‘net long-term capital gain’ means long-term capital gains reduced by long-term capital losses including any unused long-term capital loss carried over from previous years.”

Asset Allocation

Per the IRS, “The sale of a trade or business for a lump sum is considered a sale of each individual asset rather than of a single asset.” Additionally, “A business usually has many assets. When sold, these assets must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade.”

What does this ultimately mean for you as a small business owner? It is not as simple as valuing the business as one lump sum and calculating taxation based on that single figure. It is more nuanced than that, which means it is important to consult with a CPA and professional business advisor when considering the capital gains tax implications of selling a business. 

Other Tax Tips When Selling a Small Business

As stated above, you will want to hire a professional advisor. Whenever possible, this person should be engaged a year or two before you plan to sell the business so they can direct you on structure changes today that will benefit you in the long term. 

You can also consider selling your business to your employees. Whether through an Employee Stock Ownership Plan (ESOP) or long-term installment sale, it is a way to incentivize your employees, ensure they keep their jobs, and provide long-term job security into the future. 

In that same vein, you could consider selling the business to your family. In this instance, you will definitely want professional advisors to help you navigate the family business succession plan

You might also structure your deal as an installment sale. This could be an earn-out, where you, as a Seller, get paid as a consultant and stay on board with the business for 2-3 years while earning a salary. (This could also be structured as a cash plus seller financing where a Buyer agrees to pay a lump sum portion of the sale price and signs a promissory note for the installment purchase.) 

With so many details to consider, make every effort to surround yourself with the best possible team to mitigate any unnecessary expenses, taxes, or headaches. With decades of experience buying and selling businesses, our Viking team of advisors is also here to help. If you are thinking about your future exit, reach out to us today for a no-obligation, complimentary consultation.

  1. https://www.irs.gov/taxtopics/tc409
  2. https://www.irs.gov/businesses/small-businesses-self-employed/sale-of-a-business
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