How to Avoid Capital Gains Tax on Business Sale

how to avoid capital gains tax on business sale

There’s a lot to consider 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:

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:

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 Sale of Business

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.

The Bottom Line

how to avoid capital gains tax on business sale

There are lots of reasons why you might decide to sell a business. You may be ready to retire, or you might simply want to move on to a new venture. In any case, it’s important to keep tax planning in sight. Consulting with a tax expert can help you to flesh out a plan for how to avoid capital gains tax on a business sale, or at the very least minimize what you owe.

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Photo credit: ©iStock.com/Pattanaphong Khuankaew, ©iStock.com/Martin Barraud, ©iStock.com/Sitthiphong

Rebecca Lake, CEPF®Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children. Rebecca also holds the Certified Educator in Personal Finance (CEPF®) designation.

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