When it comes time for a business owner to transition or sell their business, taxes tend to be one of the most important planning points. After all, a solid tax planning strategy remains one of the most essential components of building personal wealth and preserving multigenerational longevity.
Regardless of how much you secure for the sale of your business in negotiations, the tax implications of the sale should always remain at the forefront of your mind. Of course, the goal will be to minimize the tax impact of the sale on your overall financial framework to keep more of the profits in your own pocket and not that of Uncle Sam’s.
Of course, there are a number of ways to navigate tax mitigation strategies as a transitioning business owner and the best combination of techniques for you will depend on your personal circumstances. However, below we have outlined a few of the more common strategies we use to help business owners overcome this planning challenge.
How Taxes are Determined on the Sale of a Business
Business sales are taxed based on capital gain. The seller’s taxable gain is determined by the following formula:
The “amount realized” over the “adjusted tax basis” of the assets sold = the “taxable gain.”
- If the adjusted tax basis exceeds the amount realized, the seller has a “tax loss.”
- The amount realized is the amount paid by the buyer, including any debt assumed by the buyer.
- The adjusted tax basis of each asset sold is generally the amount originally paid for the asset, plus amounts expended to improve the asset (not yet deducted), minus depreciation or amortization deductions previously allowable with respect to the asset.
- Transactional costs and expenses paid by the seller can reduce the taxable gain and/or raise the taxable loss.
Whether or not the asset is taxed as ordinary income or as long-term or short-term capital gains will be dependent on the business structure and how long the business has been in operation.
Because the sale of a business is considered the sale of an asset—appreciated or not—there are reinvestment, deferral, and planning techniques that can be utilized to mitigate the overall tax burden of the sale.
Reinvesting Gain in an Opportunity Zone
Owners who realize capital gains on the sale of their business have a way in which to defer tax on that gain if they act within 180 days of the sale. This once-in-a-lifetime tax benefit only exists thanks to the emergence of the Opportunity Zone created by the Investing in Opportunity Act (a part of the Tax Cuts and Jobs Act). Essentially, if you reinvest capital gains in real estate or other businesses located in an Opportunity Zone, you’ll defer (and potentially reduce) the tax on your reinvested gain. Then, if you hold the investment long enough, you’ll eliminate the tax on your new investment’s future appreciation.
You do this by investing in a Qualified Opportunity Fund, which is an investment vehicle established to invest in Qualified Opportunity Zone Property — i.e., eligible businesses and property that are located in a qualified Opportunity Zone. An owner who sells his or her business doesn’t have to put all the proceeds into a QOZ, but the tax deferral is limited accordingly. There are quite a few stipulations to keep in mind—including requirements placed on investors—so you’ll want to fully explore this option before jumping in.
Rollovers and Exclusions
- "Tax-Free" Rollover From the Sale of a Business to an Employee Stock Ownership Plan (ESOP)
A business owner can sell company stock to an employee stock ownership plan (ESOP) and defer federal (and often state) tax on the transaction by rolling over the proceeds into qualified replacement property (QRP), such as the stocks or bonds of domestic operating companies. From a legacy planning standpoint, these are especially beneficial. If the ESOP is held through the owner’s lifetime, the deferred taxes are extinguished at death and the children will receive a stepped-up tax basis on these assets.
- Capital Gains Exclusion
Small business owners can exclude at least 50% of the gain recognized on the sale or exchange of qualified small business stock (QSBS) that is held for five years or longer. This gain is limited to the greater of $10 million or 10 times their basis in the stock.
- Rollover Taxable Gain into Another QSBS
One technique that is especially beneficial for serial entrepreneurs is rolling over the taxable gain of Qualified Small Business Stock (QSBS) into another QSBS within 60 days of the sale. This allows the seller to defer the recognition of capital gains due until the newly acquired business is sold or transitioned over. This technique can be combined with a Section 1202 exclusion so that some of the proceeds of a qualified sale can be retained as cash, and the remainder can be reinvested in another business.
State Income Tax
There are a number of tax deductions available to owners of operating businesses, but one strategy in particular has been gaining popularity with our clients who own businesses in high state income tax states:
- Setting Up an Incomplete Non-Grantor Trust (INGT)
This type of jurisdictional planning allows business owners to use the INGT structure to shift tax exposure from a high-tax state such as California or New Jersey to a state with no income tax like Florida, Delaware, or Nevada. If created far enough in advance of the sale of the business, usually at least two years, an additional benefit is the elimination of state capital gains taxes on the sale.
Years of Experience on Our End Translates into Thoughtful Planning on Yours
Thoughtful tax, trust, and business succession planning strategies provide the greatest opportunity to maximize wealth for business owners. Without a working knowledge of the tax laws and “tools of the tax planning trade” that will benefit you most, you stand to forfeit much of your profit to taxes.
If you are a business owner considering the sale of a business or are starting your succession planning in advance, the RiversEdge Entrepreneur’s Planning Group can help. Schedule a call to meet with one of our advisors today. We serve clients locally in the Wilmington, DE area and virtually across the country.