A business sale can get quite complicated depending on the type of business structure. When selling a business, this usually involves the disposal of various assets. As such, selling your business may result in capital gains tax. Capital gains tax on a business sale can be minimized, deferred, or avoided. What is the best way to avoid paying extra sales on the sale of your business? How to avoid capital gains tax on a business sale is what we are discussing today. So, let’s get to it!
What are Capital Gains?
When you sell a business’ capital asset for an amount that is more than its basis, you realize capital gains on the sale. In its most simple form, the basis of a capital asset is usually what it cost to purchase or produce the asset, including certain costs incurred to acquire the asset such as sales and excise tax, freight, installation and testing, applicable legal and accounting fees, etc. Capital gains are considered short-term if the asset is held for a year or less or, long-term if the asset is held for more than a year.
In most cases, the adjusted basis or fair market value (FMV) of an asset is used to determine the capital gains on the asset sale. An adjusted basis is when the cost of an asset is adjusted to account for items such as any improvements or additions to increase the value or life of the asset, depreciation, non-taxable corporate distributions, etc.
For example, the basis of a business asset can be increased by certain capital improvements and further reduced by depreciation to arrive at an amount that will be used to calculate the capital gains tax when the asset is sold.
A simple basic illustration is this: Suppose you have purchased a business asset for $50,000, incurred expenses of $5,000 for capital improvement, and depreciated the asset by $10,000 to date. The adjusted basis for the asset will be:
Cost of asset: $50,000
Plus: Capital Improvement: $5,000
Less: Accumulated Depreciation: ($10,000)
Adjusted Basis: $45,000
If the business asset is sold for $50,000, then capital gains will be calculated as:
Sale Price: $50,000
Less Adjusted Basis: ($45,000)
Capital Gains: $5,000
Understanding Capital Gains Tax
A capital gains tax is a levy on capital gains that arise from the sale of an asset. The capital gains tax charged on an asset sale will vary based on how long the asset has been owned, and if the capital gains realized are classified as short-term or long-term.
When you sell a business asset, it can result in either a capital gain or a loss if held for more than a year, or otherwise as an ordinary income or loss. Generally, the tax rate charged on a capital gain is lower than the tax rate charged on an ordinary income.
Some capital gains tax can be avoided if your taxable income is below $80,000, however, for most people, the tax rate on capital gains is usually about 15% or more under certain exceptions.
Capital Gains Tax on Business Sale
The capital gains tax on a business sale depends largely on the business structure and the assets owned by the business. Business entities in the United States are usually set up as sole proprietorships, partnerships, corporations, S corporations, or limited liability companies (LLC).
Generally, when a business is sold, the sale is considered to be based on the different assets held by the business. A lump-sum payment received for selling your business is considered to be applied to each asset owned by the business. The different business assets have to be identified and separated to determine the basis and sale price for each asset. The business assets can either be long-term capital assets such as equipment or machinery, real estate property such as buildings or land, or assets intended for sale to customers such as inventory.
Here’s how a business sale may be treated based on your business structure.
Sale of a Sole Proprietorship: If your business is a sole proprietorship, then the sale of your business assets is taxed as your personal assets. If the sale proceeds are more than the adjusted basis of the assets then this results in capital gains and you may be subject to a capital gains tax.
Sale of a Partnership: As a partner in a business partnership, a business sale will be treated as the sale of your interest in the business which is considered a capital asset. Ordinary income can also be realized from the sale of inventory or unrealized receivables owned by the business; this is because they are usually held for less than a year and therefore classified as short-term capital gains.
Sale of a Corporation: If your business is a corporation, your ownership interest in the business is usually represented as stock certificates, which when sold, can result in capital gains. The liquidation sale or distribution of business property can also lead to capital gains that will be subject to capital gains tax.
Sale of a Limited Liability Company (LLC): A limited liability business is either classified as a partnership, corporation or entity that is disregarded as separate from its owner for income tax purposes. If you sell your LLC business, then the capital gains tax will be treated based on the classified structure.
How to Avoid Capital Gains Tax on a Business Sale
You may be able to defer or avoid capital gains tax on a business sale through the following ways:
When you sell an asset due to a business sale, you can opt to spread the payment over a couple of years and receive it in installment payments instead of a lump-sum payment in the tax year of sale. A business sale is considered an installment sale when part of the consideration (purchase price) is received in the following year of the business sale.
When you choose an installment sale method, then you realize a capital gain when you receive payment thus deferring capital gains tax on the remaining part of the sale. It is important to note that the installment sales method does not apply to capital losses or short-term capital gains from the sale of inventory. You can report an installment sale using Form 6252 PDF, Installment Sale Income.
Using the installment sales method is beneficial if you want to keep your income level within a specific tax bracket, this way, you can defer the capital gains to a further period when your income may be lower and you fall within a lower tax bracket.
Investing in Qualified Opportunity Zones or Funds:
In 2017, The Tax Cuts and Job Act (TCJA) introduced the Qualified Opportunity Zones investment opportunity that encouraged investors to buy property in distressed economies. When you sell your business, any capital gains can be invested in qualified opportunity zones to defer or avoid taxes. Starting in December 2017, you may be able to temporarily defer taxes of capital gains from your business sale by investing in Qualified Opportunity Funds.
You may also be eligible to permanently avoid capital gains tax if your reinvestment in the Qualified Opportunity Fund is held for 10 years or more. It is important to note that when the new investment property is eventually sold, tax charges on the capital gain will apply. A tax deferral through the QOFs is applicable until December 31, 2026.
If your business sale results in the sale of a real estate property, you can take advantage of the 1031 like-kind exchange which was introduced by the Internal Revenue Agency (IRS) in 2007. If the proceeds from the sale of real property are used to purchase a new property that is considered as like-kind in nature to the sold property, then you may qualify for capital gains tax deferral. Some certain rules and requirements must be followed to ensure that your capital gains from a business sale qualify for tax deferral through the 1031 like-kind exchange.
For example, the new reinvestment property needs to be identified within 45 days of selling your existing property and the sale exchange should be completed within 180 days of the business property sale. Also, for you to be eligible for a capital gain deferral, the transaction should be facilitated by a third party, mostly known as a qualified intermediary.
Carried-Over Capital Losses:
If you have a capital asset gain from a business sale, you may be able to reduce this gain with an eligible short or long-term capital loss. The capital gains tax will be applied on your net capital gain which is excess of your net long-term capital gain over your net short-term capital loss for the year. Your long-term capital gains can be reduced by long-term capital losses that have been carried over from previous years. This is why it is important to keep good business records and practice proper documentation.
There are required steps involved when you sell a business, part of which involves reporting any capital gains that arise from the sale. To minimize the tax you pay on the gains from a business sale, you need to ensure that eligible expenses and losses are accurately captured to reduce your capital gains on the sale. Also, it is recommended to use the services of tax experts who can help you explore the different available options for you to minimize the capital gains tax on your business sale.