A business sale can become 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. You can minimize, defer, or avoid capital gains tax on a business sale.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, individuals use the adjusted basis or fair market value (FMV) of an asset to determine the capital gains on the sale of the asset.
An adjusted basis occurs when you modify the cost of an asset to incorporate items such as improvements or additions that enhance the asset’s value or extend its lifespan, 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 on an asset sale will vary based on the duration of ownership of the asset and whether the realized capital gains 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.
People in the United States typically establish business entities as sole proprietorships, partnerships, corporations, S corporations, or limited liability companies (LLC).
Business assets encompass long-term capital items (equipment, machinery), real estate (buildings, land), and customer-sale intended assets (inventory). 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.
Sole Proprietorship: Sale taxed as personal assets; excess proceeds mean capital gains, subject to capital gains tax.
Partnership: Sale of interest treated as capital asset; inventory/unrealized receivables may yield short-term capital gains.
Corporation: Stock sale or property liquidation results in capital gains, subject to capital gains tax.
LLC: Tax treatment based on LLC classification.
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.
An installment sale occurs when the seller receives part of the consideration (purchase price) in the year following 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, you can invest any capital gains 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.
Invest in a Qualified Opportunity Fund to potentially permanently avoid capital gains tax after holding for 10+ years. Keep in mind eventual tax on property sale. Tax deferral via QOFs until Dec 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
The Internal Revenue Agency (IRS) introduced it in 2007. You may qualify for capital gains tax deferral if you use the proceeds from the sale of real property to purchase a new property that the IRS considers like-kind to the sold property. To ensure that your capital gains from a business sale qualify for tax deferral through the 1031 like-kind exchange, you must follow certain rules and requirements.
To defer capital gains, choose a replacement property within 45 days of selling and complete the exchange within 180 days. Use a qualified intermediary for eligibility.
Carried-Over Capital Losses:
Offset capital asset gains with eligible capital losses, reducing capital gains tax. Calculate net gain by subtracting long-term losses. Prior-year losses can also offset long-term gains. Maintain meticulous records.
Selling a business involves several necessary steps, including reporting any capital gains resulting from the sale. To minimize the tax liability on the gains from a business sale, you must accurately account for eligible expenses and losses, thus reducing the capital gains on the sale. It is advisable to seek the services of tax experts who can assist you in exploring various available options to minimize the capital gains tax on your business sale.