Tax Considerations

Income Tax Considerations When Selling a Business

Selling a small business has many moving parts. The Internal Revenue Service may restrict some choices, and knowing this will assist in the best structure possible for the sale structure of your business. Of course, some of these decisions will be negotiated by the Buyer since some of their interests may be contrary to yours. All that being said, the way you structure the sale can make a major difference in how much of the sales price goes to pay taxes and how much of that sales price stays with you. This includes the sale structure, the arrangement in which the current business exists, and whether the sale is for all cash or payment is made to you over time. You must speak with an accountant, CPA, Attorney, or an Estate Planner who can guide you specifically through the complex nature of your financial situation.

The TAX SIDE of selling a small business has many moving parts. That is why it is important to know all the Tax ramifications of the sale so one knows exactly what the Net proceeds are to you.

How Business Sales are Taxed

To the IRS, the selling of a business is generally not viewed as the sale of a single asset. Most assets within the Business are treated as though they are being sold separately. This approach affects how the sale proceeds will be taxed. Some of the sales proceeds will be taxed as a long-term capital gain, others at a short-term capital gain, some at ordinary income levels, and certain assets will not be taxed at all.

Generally, the sale of assets held longer than 12 months is considered a long-term capital gain, taxed at the maximum Federal rate of 20% and taxed at the appropriate rate in California, which is up to nearly 13%.

If the sales proceeds of certain assets are classified as ‘Ordinary Income, the Federal Rate could be as high as 37% plus the nearly 13% rate in California.

In General, the sales of Assets are taxed as follows:

Inventory: The sale of a business's inventory can be classified for tax calculations as either Ordinary Income or not taxed at all. For example, if you sell the inventory for the exact amount that you paid for the inventory, you have no tax. If you sell the inventory for more than you paid for it, the amount realized from the sale above your actual cost of the inventory is taxed as Ordinary Income, not Long-Term Capital Gain Income. You then subtract the amount paid by the new buyer from the gross sales price, and that result is what the business actually sold for.
Equipment and/or Vehicles: Business equipment and vehicles are generally considered capital assets, the costs of which are recovered through depreciation deductions. If the assets have been fully depreciated and are sold for less than you paid for them, you may still owe taxes on their sale. While Business Equipment and / or Vehicle costs are recovered through the chosen depreciation deductions over their useful lives. In practice, these costs are recovered more quickly by using one of the following legal deduction strategies.

Accelerated Depreciation Assuming the useful life of the equipment/vehicle(s) purchased is 5 years, (MACRS) the applicable percentage of accelerated depreciation would be 33.33% year 1, 26.67% year 2, 20% year 3, 13.33% year 4, and 6767% year 5.

Section 179 Expensing Internal Revenue Code Sec. 179 currently allows a business owner to deduct, rather than depreciate, the full cost up to $1,160,000 in equipment and/or vehicle purchase costs as well as other qualifying asset costs. The deduction is then lowered dollar for dollar to the extent that the total investment in Sec. 179 assets for the year does not exceed $2.89 million.

Bonus Depreciation For assets purchased after 2007 and before 2023, legally created, Bonus Depreciation allows one to deduct up to 100% of the cost of the Equipment/Vehicles as well as other qualifying assets. That being said, Bonus Depreciation is currently being phased out and is scheduled for elimination after 2026. It allowed one to deduct up to 80% of the equipment/vehicle costs purchased in 2023, 20% in 2024, 2025, and 2026. As stated above, it will be phased out at the end of 2026.

Selling a Depreciated Asset When you sell or trade in a used asset, you may trigger a taxable gain and/or “recapture” of previous depreciated deductions of an asset. “Recapture” is generally taxable at ordinary income tax rates, but in some cases, the sale of the asset may be taxable at both ordinary income tax rates, with the excess treated as a long term capital gain, typically taxed at 15% up to a certain amount of gain and 20% on any gain amount above the amount taxed at 15%.

Depreciation Recapture Example (sale of Equipment, Vehicles) XYZ Company buys a piece if Equipment for $15,000. This represents the original cost basis of the asset. In the year the asset was purchased, IRS Section 179 accelerated depreciation was taken for the full amount of the purchase price, $15,000, was taken, so the adjusted cost basis of that asset is now $0.00. That asset is sold by the XYZ company for a price of $5,000. Since the asset has an adjusted cost basis of $0.00, there is a net taxable long-term Gain of $10,000. This amount will be taxable on a long-term capital gain basis, Federal 15%, and state up to nearly 13%. Under IRS code 1245, there would have to be depreciation recapture of $10,000 that would then be taxed at the ordinary income tax rate for both Federal and State Income.

Goodwill Business Goodwill is typically calculated as a residual number. Take the Purchase price of the Business (typically calculated as a multiple of net actual net income (EBIDA) and subtract the price of replacing the asset at the appropriate year (tangible property, and intellectual property). The amount then allocated to Goodwill can be amortized by the new owner over 15 years. For the Seller, the sale of Goodwill is typically Federally taxed as a long-term capital gain (15% - 20%) as opposed to ordinary Federal Income Tax rates. Goodwill typically includes the reputation of the business, existing customer relationships, and brand recognition.

Importance of Allocating as much as allowable to Goodwill It is typically recommended that owners (sellers) try to allocate as much of the sales price to assets that are NOT subject to IRS Section 1245 Depreciation Recapture. Thus, avoiding the purchase price of the assets to be taxed at ordinary Federal and State tax levels. It is typically beneficial to assign a greater amount of the purchase price to “Goodwill since the sales proceeds so assigned will be taxed at the Federal long-term capital gain applicable rate (15% - 20%)

Owners ongoing participation in Business If a deal is structured to give the Seller an ongoing salary, or ongoing consulting fee that allows the new owner to deduct the amounts paid, the income received by the Seller is taxed as recognized by the IRS as Ordinary Income, since the Seller is being compensated for future services rather than being compensated for a transfer of assts.
Non-Complete Agreements: All recipients, including the Seller, who sign and receive compensation for agreeing not to compete with the new owners, must pay taxes on the amount received at the Federal and State ordinary income tax levels.
Real Property Sometimes, when a Business is sold, the Real property in which the business operates is also sold. The real Property may be owned by the business entity itself, or may be owned directly by the owner personally, or could be owned by a separate entity. When the property is sold (assuming it was owned for over 1 year, there may be a capital gain. (Sales Price less costs of sale minus the accounting Basis it the Property (Typically its cost and the cost of all improvements made thus far). The calculated long-term capital gain is taxed at 15% up to a certain amount and 20% on the balance of the gain. This equates to the amount of long term capital gain tax due upon sale. To calculate the total tax due you must also determine any appreciation recapture as outlined immediately below.

Depreciation Recapture Real Property In all sales of Real Property, the depreciation must be recaptured. Under IRS Code 1250, generally, the Depreciation that must be recaptured is taxed at a maximum Federal Rate of 25%, and in California, up to almost 13%. That being said, IRS Section 1250 also says there is NO depreciation recapture if the Real Property Asset was depreciated using the “Straight Line” (not accelerated) depreciation schedule. For the sale of Real Property like commercial buildings, warehouses, rental properties, etc.

Structuring the sale to maximize capital gains treatment requires careful negotiation of how payments for various assets are categorized. Some Sellers negotiate to minimize their tax obligation by allocating more of the sales price to goodwill and any real property that may be being sold, rather than the ordinary income components. It is important to keep in mind that the IRS closely examines each sale transaction to prevent misclassifications, particularly when there is a mismatch between the buyer and seller IRS required reports on the sale.
Every Seller and Buyer is highly encouraged to retain and follow the advice of both Legal and Accounting Professionals to best advise them of all the tax consequences of both the sale and the structure of that sale of their business.