Federal agencies are eager to tax seemingly any transfer of ownership or assets—especially if the transaction involves something of high-value, such as business property or company shares. Just like any other transaction, the sale of a business is considered a source of income, and sellers are legally obligated to pay the resulting taxes.
Not only is the IRS keen on collecting their dues, the rates levied on business sales can be staggeringly high. Business owners that miscalculate may end-up owning tens-of-thousands of dollars in taxes—usually in the form “capital-gains”. Although these taxes aren’t really avoidable, they can certainly be reduced through strategic financial planning.
In the U.S., the act of selling a business usually means one of two things: the sale of business assets (equipment, intangibles, vehicles, inventory, etc.) or the transfer of company shares. In either situation, the income generated is classified as a capital gain, and will be taxed as such.
Capital Gains Tax in the U.S.
Selling business assets or company interests will result in a capital gains tax levied on the seller. It’s important to minimize this tax, as it can approach a confounding 25% depending on the specifics of the transaction.
Some owners have the option to sell either their stock shares or business assets, and find themselves conflicted as to which route to take. In general, the seller will prefer a stock-sale whereas the buyer will favor an asset-sale. The decision however should be made with legal consultation; stock-sales usually reduce the tax obligations for the seller, but there are certainly instances where an asset-sale is the better option.
Many business owners don’t have this choice. For example, owners of unincorporated business structures can’t sell stock shares, as there aren’t any shares to sell. In these situations, the only option is to sell the business assets (which in many cases, are simply the personal assets of the owner). Either way, the profits received from the sale will surely be taxed in accordance to the capital gains tax code.
One last note about asset-sales: they often require meticulous bookkeeping. When the IRS levies a capital gains tax on an asset-sale, they tax each asset as an individual transaction. If you’re selling hundreds of assets at-once, this means hundreds of individual tax obligations, which can be difficult to track.
Taxes Associated with Gifts
Perhaps unsurprisingly, gifting assets or shares will not entirely release the seller of their tax obligation. According to the IRS, a gift is:
“any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return…the general rule is that any gift is a taxable gift”
The tax imposed on a gift isn’t considered a capital gains tax, as the seller isn’t making any profit. Nonetheless, individuals are only allowed to gift a certain amount before the IRS takes a cut. These exemption limits are defined at two exclusion levels: annual and lifetime.
The annual gift exclusion is currently $15,000 per person, per year. Meaning an individual is allowed to gift $15,000 to any number of individuals before the IRS will levy a tax. When the $15,000 limit is surpassed, the excess value is then added to the individual’s lifetime exemption, which is currently set at $11.4 million.
The $11.4 million lifetime limit may seem high, but an individual’s lifetime gift exemption and their estate tax are actually part of the same taxable pool. In other words, large amounts of lifetime gifts reduce the amount of exemption that can be used to protect your estate from future taxation. Thus, the amount of lifetime gifts directly influences future estate exemptions. This is an important consideration, as estate taxes that exceed the exemption limits can be upwards 40%.
How to Minimize the Burden
For owners looking to sell or gift, the goal should be to reduce the tax-burden as much as possible. Remember, tax rates associated with selling and gifting can approach 25% and 40% respectively; there must be a way to minimize these liabilities. First-and-foremost, you’ll need to contact somebody with a comprehensive understanding of the U.S. tax code.
Most professionals will recommend a multi-year approach. High tax costs are often the result of a large, immediate influx of profits. However, if the revenue can be spread-out over multiple years, the tax exposure can be reduced dramatically.
On one end of the spectrum, short-term repayment plans (sometimes single-transaction lump-sum payments) ensure full reimbursement to the seller but are accompanied by high tax exposure because of the sudden influx of capital gains. On the other end of the spectrum, longer-term repayment plans minimize the tax exposure for sellers, but can’t guarantee full reimbursement. Nonetheless, experts tend to recommend a long-term installment approach coupled with a strongly-written buy-sell agreement to reduce the tax burden and ensure full-repayment.
A similar strategy can be taken for reducing gift taxes: a “systematic gift program” releases smaller, lower-tax sums to recipients over a long period of time (sometimes years or decades). Again, by avoiding the sudden transfer of high-value assets/shares, the tax obligations are reduced.
In any case, the largest tax-reductions will be achieved by planning the transaction years in-advance. Owners that attempt to transfer the entirety of their business equity within two years will inevitably incur high tax liabilities. If the transaction is spread over two decades however, the rates per-year will be dramatically reduced, ultimately saving the seller thousands or tens-of-thousands of dollars.