When you think about selling your business, how much of the sales proceeds do you expect to keep? Many owners respond with a common answer: the net proceeds (sales price minus liabilities), forgetting that silent partner Uncle Sam will also expect his cut. Changes in tax laws from the implementation of Obamacare and from the fiscal cliff outcome have made his slice even larger.
The U.S. has one of the highest capital gains tax rates among developed countries, according to a study by Robert Carroll and Gerald Prante of Ernst & Young LLP. The top long-term capital gains tax rate, when combining both state and federal taxes for a corporation owned by an individual, currently stands at 56.7 percent. That means if you were to sell your corporation today for $3 million, you could walk away with as little as $1.3 million, leaving $1.7 million to the government. The difference between $3 million and $1.3 million could just be your ability to retire vs. having to continue working.
Over the next several years, this already high tax rate is likely to increase. At the federal level, there's tremendous political pressure to increase long-term capital gains taxes—some congressional leaders believe it should at least be equalized with earned income tax rates if not made higher. Influential Senator Max Baucus, who announced his retirement earlier this year, has made securing an increase in capital gains taxes one of his key priorities before his retirement in 2014. If Congress is able to reach an agreement that the president is willing to sign, we could see significantly higher long-term capital gains taxes starting as early as 2015.
But rather than leave most of the fruits of your labor to Uncle Sam when you sell your business, consider these options:
Think about selling sooner rather than later. It’s never a good idea to make decisions solely for tax reasons, but it’s a bad idea to ignore them too. If you're already contemplating selling your business and you don’t expect it to accrue significant value over the next few years, you may want to consider selling before rates increase. Even a 5 percent increase in the long-term capital gains tax rate would mean $150,000 in additional taxes on a $3 million sale.
Evaluate an asset sale vs. a stock sale. These two options can have very different results from a tax perspective. In an asset sale, the buyer purchases the individual assets in the company and assigns a value to each one. The total sum of these asset prices is the total purchase price. The IRS has very specific rules as to how the purchase price should be allocated across individual assets. The seller is left with the proceeds and an empty corporate shell that basically owns nothing. Buyers tend to prefer this method because it allows them to avoid potential litigation and liabilities that may be the responsibility of the company. In addition, the buyer also has the right to depreciate the assets based on the actual purchase price, which means that the buyer’s future tax bill will be lower. As the seller, this type of asset sale means you may be subject to a hefty tax bill.
The alternative is a stock sale, where the buyer pays you for the shares in the company. In this type of sale, they take ownership of everything—the good and bad, the known and unknown. While your tax bill may be significantly lower, buyers will also want to pay less as the risk of a forgotten lawsuit will be present and the benefit of higher depreciation on their tax bill goes away. You'll have to review both types of sales to see which might be better for you.
Consider—with caution—changing from a C corporation to a different legal entity. If your business is organized as a C corp and you plan to structure your transaction as an asset sale, you're going to be subject to double taxation. The business entity will pay taxes on the profits from the asset sale, and you'll have to pay taxes on the proceeds distributed from the company. Limited liability companies and Subchapter S corporations don’t have to deal with this issue. They're considered "disregarded entities" for tax purposes, meaning you'll only pay income taxes once, not twice. If you're planning a sale in the medium term, consider switching from a C corp to another entity. But proceed with caution: The IRS won't allow you to reap the tax benefits of such a maneuver if it's done just before a sale or in contemplation of a near-term sale. A company that switches from a C corp to an S corp, for example, has to wait 10 years to capture all the tax benefits of the switch in a sale.
Consider getting paid in buyer stock. If your company is being bought by a large, publicly traded company in which you have great confidence, you may be able to defer your taxes indefinitely. The IRS allows you to defer income taxes on a company sale if you're paid in shares of the buying company. As long as a significant portion of the transaction (at least 40 percent) is paid in stock, you can defer paying taxes until you actually sell the stock. Even though capital gains taxes are going up, this could be an important estate planning tool if you don’t plan to use the money from the sale of the business.
Before implementing any strategies to minimize taxes due to the sale of your business, be sure to consult your attorney, tax specialist or financial advisor.
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