When selling a business, the purchase price is determined by the separate values of the various assets and liabilities acquired from the transaction. What does this mean? In a nutshell, this means that when you negotiate a sale price for a business, you and the buyer must agree on how much of the purchase price applies to each individual asset and how much applies to intangible assets such as goodwill.
Goodwill is calculated by taking the purchase price of a company and subtracting the difference between the fair market value of the assets and liabilities.
The allocation determines the capital income, or ordinary income tax that you must pay on the sale. Allocation is the process of shifting overhead costs to cost objects. This will also have consequences for the buyer. Capital income tax is capital gains, income from the sale of a capital asset, such as a house. Ordinary income tax is a tax on ordinary income, such as wages, subject to the standard tax rate.
Generally, a good tax scenario for the seller is not a good scenario for the buyer and vice versa. As this is the case, the allocation of price to various components of the sale is frequently an area for negotiation and compromises.
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Financials to have ready when selling your business
As the prospective buyer wants to know the financial health of the business, you’ll need to have the following clean financials ready to present to the buyer.
- At least 3 years of tax returns
- Profit and Loss Statements for at least 3 years
- Balance sheets for at least 3 years
- Cash flow statements for at least 3 years
6 Tax considerations before you exit your small business
When exiting your business, there are different approaches you can take. The different approaches are:
The stock sale or an asset sale
In a stock transaction sale, the buyer purchases stock to acquire an ownership stake in the business. An asset transaction sale involves capital assets. A capital asset is tangible property, such as a building and equipment. Note that you can complete an asset sale for inventory separately from the business sales price.
Establishing the value of business assets
In addition to the purchase price of a business asset, such as a piece of machinery, you can include the other costs associated with its installation. These costs can include the installation, as well as the employee training.
Purchase Price Allocation (PPA)
This allocation method is used by a business owner to calculate fair market value, typically for mergers and acquisitions. If you have a small business, you’ll likely not have to be concerned with mergers and acquisitions.
The buyer(s) allocate the purchase price amount into various assets and liabilities. The seller calculates net assets and uses “goodwill accounting” to add the value of intangible assets. Intangible assets can include business names and logos. A PPA is typically subject to bank reviews.
Type of Entity
The IRS treats the percentage of interest (ownership) that an individual has in a business as capital gain income when the individual sells his or her interest (the portion of ownership).
The tax implications and capital gains rates vary depending on the type of entity. You can read more about Capital Gains in IRS Publication 550.
C Corporation
Shareholders pay capital gains when they sell stock. The shareholders may also pay a corporate tax when the C corporation is sold.
S Corporation
The transaction can be structured as a stock sale or asset sale when an S corporation sells. The corporate structure can remain intact, meaning there are no additional corporate tax implications.
Partnership
The capital gain is due on the individual’s partnership assets. An individual can sell their percentage of the partnership interest to a buyer.
Sole Proprietorship
A sale is treated as if you sold each asset separately if your business is a sole proprietorship. This is because most of the assets trigger capital gains. However, the sale of some assets, such as inventory, produces ordinary income.
IRS Form 8594, Asset Acquisition Statement, shows seven classes of assets to which you must allocate the purchase price. The first class includes cash and checking accounts, to which you allocate the purchase price dollar-for-dollar. The final class (class VII) is for goodwill and going-concern value.
This is the intangible asset that commands part of the purchase price. The more goodwill the business had, the greater the allocation to this class. (Goodwill is an intangible asset when one company acquires another. It includes reputation, brand, intellectual property, and commercial secrets).
Note that negotiation determines the allocation. The reason for this is that while the seller wants to allocate as much as possible to capital gain assets such as goodwill, the buyer wants a good allocation for assets, such as equipment, which can depreciate in taxable value going forward.
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Income Tax Rate
The personal tax rate of the buyer may be higher than the highest long-term capital gains rate, which is currently 15% ($41,675-$459,750) 20% (Over $459,750). The highest personal tax rate is currently 37%.
State Taxation
Keep in mind that you will have state taxes to pay as well. A sale of a business doesn’t stop at the federal level.
Your main concern is your profit from the sale is the taxable amount. The profit is the difference between your tax basis and your proceeds from the sale. Your tax basis is generally your original cost for the business, minus depreciation deductions claimed, minus any casualty losses claimed, and plus any additional paid-in capital and selling expenses.
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As the seller, you will probably want to allocate (shift) most, if not all, of the purchase price to the capital assets that were transferred with the business. You’ll want to do this because proceeds from the sale of a capital asset, including business property or your entire business, are taxed as capital gains, generally at a higher rate.
If your small business is a sole proprietorship, a partnership, or an LLC, each of the assets sold with the business is treated separately. Certain assets are not eligible for capital gain treatment; any gains you receive on that property are treated as ordinary income and are taxed at your normal rate.
Dissolving your business as a sole proprietor
As a sole proprietorship, dissolving your business is much simpler than if you were a corporation. As a sole proprietor, when dissolving your business, do the following:
Federal
- Notify the IRS
You must notify the IRS, state, and local tax authorities that you no longer operate the business. Keep records of final tax forms and close business accounts so interest does not continue to accrue and create additional tax liabilities for the business.
- Cancel licenses
To properly dissolve your sole proprietorship, cancel all licenses and registrations associated with the business. If you registered a business name with the Secretary of State or local corporation’s commission, cancel the assumed or trade name so the office where you registered knows that the business no longer exists.
State
Other than the information relating to EINS, the following information does not apply to sole proprietorships.
If your business is registered with your state, you will need to formally dissolve the business through the state’s process. First, you’ll need to have a resolution of dissolution, and then you’ll need to file a notice of dissolution with your state.
Some states impose an annual franchise fee for businesses. Formally dissolving your business on the state level, you will no longer have to pay this fee.
However, suppose you do not formally dissolve the business on the state level, and the state imposes an annual franchise fee. In that case, you will still be responsible for paying that annual fee until you formally dissolve the business. Dissolving the business is done through the Secretary of State’s office.
Regarding the Resolution of Dissolution: In order to dissolve the business, the business must have a formal agreement by the owners to dissolve. Even if you have a single-member LLC, it is recommended to have this document. This document does not need to be filed with the state. However, there must be evidence that the shareholders, partners, or members have formally approved the dissolution.
The Dissolution document that you file may vary from state. The dissolution notice must be filed with the state’s business or corporate division, which is part of the Secretary of State’s office.
Cancel your EIN and Close Your IRS Business Account (if you used an EIN)
To cancel your EIN and close your IRS business account, you will need to send a letter to the IRS that includes the following information.
- The complete legal name of the business
- The business EIN
- The business address
- The reason you wish to close the account
If you still have the notice that the IRS sent to you when the EIN was assigned, you should enclose a copy of it with your EIN cancellation letter. Then, send both documents to the IRS at:
Internal Revenue Service
Cincinnati, OH 45999
Note that the IRS cannot close your business account until you have filed all necessary returns and paid all taxes owed. Therefore, remember to keep a copy of everything that you send to the IRS.
Keep Your Records
How long you need to keep certain documents depends on what’s recorded in each document.
Property records. Keep records relating to property until the period of limitations expires for the year you dispose of the property. The period of limitations is the period of time in which you can amend your tax return to claim a credit or refund, or the IRS can assess additional tax.
Business owners should keep employment tax records for at least four years.
Final Thoughts
No matter the size of your business, selling (exiting) a business has significant tax implications. Sometimes doing your due diligence is simply not enough, and maximizing your tax savings may not be obvious. Engaging a tax professional or CPA is generally a very good idea as this person can help you best plan a strategy to minimize your tax liability.