There’s a lot to consider Check this when selling a business and tax planning is at the top of the list. When you sell a business or business assets at a profit, the IRS expects to receive a cut in the form of capital gains tax. That could potentially result in a larger-than-expected tax bill. If you’re in the initial stages of planning your exit, it’s important to know how to avoid capital gains tax on a business sale.
For more help managing capital gains taxes or any other financial issues, consider working with a financial advisor.
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How Is the Sale of a Business Taxed?
The sale of a business or business assets is generally subject to capital gains tax. Capital gains tax is a tax that’s assessed when you sell an asset for more than its basis, or what you paid for it. The IRS levies two types of capital gains tax: short-term and long-term.
The short-term capital gains tax rate applies to assets held for less than one year. Short-term capital gains are taxed as ordinary income. So whatever tax bracket your business normally falls into would apply when calculating short-term capital gains tax.
Long-term capital gains receive more favorable tax treatment. The long-term capital gains tax rate applies to assets held for longer than one year. The current long-term capital gains tax rates are 0%, 15% and 20%, depending on income.
When applying capital gains tax rules to the sale of a business, the IRS typically looks at the individual assets of the business. That’s assuming that your business is structured as a sole proprietorship, partnership or limited liability company (LLC). So instead of seeing your business as a single asset or entity, the IRS looks at all the assets the business owns, including:
Real estate
Equipment or machinery
Property leases
Raw materials and supplies
Intellectual property, such as trademarks, patents and copyrights
Again, the capital gains tax rate you’ll pay on the sale of those assets depends on how long you’ve held them. It’s also important to note that certain assets, such as inventory or accounts receivable, are taxed as ordinary income rather than capital gains.
How Allocation of Sale Price Affects Taxation
how to avoid capital gains tax on business sale
When you’re working out a purchase agreement with a buyer, part of the negotiations involves choosing a sale price that applies to each tangible and intangible asset of the business. What you’ll pay in taxes for the sale of a business can hinge largely on how you allocate the sale price of individual business assets.
Here’s why that matters. The purchase price you set for each asset can determine your capital gain (or capital loss) on the asset. It also establishes the buyer’s basis for each asset that’s purchased. While that’s less important for your tax situation, it’s important to note that the buyer may also be angling for the most favorable tax treatment when negotiating prices.
In terms of how to avoid capital gains tax on business sale, you’re walking a fine line because you likely want to maximize profits while minimizing tax. Under Section 1060, the IRS offers some guidelines on how to value assets when allocating the purchase price to manage taxation. Generally, you’d allocate the purchase price to assets in this order:
Cash and deposits held in checking or savings accounts
Actively traded personal property, which can include certificates of deposit (CDs) and publicly traded stock shares
Receivables
Inventory and stock in trade
Furniture, fixtures, buildings, land and other assets that don’t fit into any other asset class
Intangible assets, other than goodwill and going concern
Goodwill and going concern value
Again, keep in mind that the buyer will be looking to allocate more of the purchase price toward assets that will depreciate quickly as that can yield more tax benefits on their side.
How to Avoid Capital Gains Tax on a Business Sale
Can you completely avoid capital gains tax when selling a business? Not necessarily. But it’s possible to reduce the amount you may owe in capital gains tax with some strategic planning. Talking to your financial advisor or a tax professional is a good place to start. They can help you to determine if any of the following tax reduction tactics might work in your situation.
Negotiate Wisely
As mentioned, you and the buyer will have competing interests with regard to the allocation of the purchase price. Per the IRS rules, you’re better off allocating more of the price to capital assets rather than depreciating assets. So rather than rushing the negotiation process, it may be better to take your time in order to get the most favorable allocation.
Consider an Installment Sale
An installment sale allows you to sell your business in phases or installments. Rather than receiving payment in full all at once, you could set up a schedule of annual payments with the buyer. That strategy doesn’t eliminate capital gains tax entirely, but it can allow you to spread out your tax liability.
Watch the Timing
If you’re selling a newer business, timing is critical as it can determine whether you pay the short-term or long-term capital gains tax rate. Holding on to the business and its assets for at least one year before selling can help you take advantage of the more favorable long-term capital gains tax rate.
Sell to Employees
If you own a C-corporation, you may be able to minimize capital gains tax by selling the business to your employees. You’d need to set up an employee stock ownership plan (ESOP) to do so. The advantage of doing so is that you don’t have to go looking for a buyer and the cash you receive from the sale can be rolled into an investment plan in order to defer capital gains tax.
Explore Opportunity Zone Reinvestment
Business owners can defer capital gains tax through Dec. 31, 2026, by reinvesting capital gains from the sale of a business into an Opportunity Zone. To qualify for this tax break, any capital gains must be reinvested within 180 days of the sale. While this doesn’t make the capital gains tax disappear, it does allow you to defer payment.
Consider a Charitable Remainder Trust
A charitable remainder trust (CRT) provides tax benefits while allowing the seller to receive income from the proceeds of a business sale. By transferring the business into a CRT before selling, capital gains tax can be avoided at the time of sale. The trust then sells the business, reinvests the proceeds, and provides the seller with regular income payments for a set period or for life. When the trust term ends, the remaining assets go to a designated charity. This method can offer both tax efficiency and philanthropic benefits.
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