Selling a business at a profit can generate a large tax bill. Experienced business owners know that successfully navigating the tax code is a critical skill. We’ll expand on three tax planning methods that business owners can employ to limit their tax impact.
Understanding Taxes on a Business Sale
When selling a business, the difference between the book value and sale price is capital gains, assuming the sale was profitable. Taxes will be owed on these gains. If held for more than a year, gains are taxed at the long-term rate. Note that we’re referring only to gains. The investor can keep any principle, as it will have no tax impact.
The business structure can impact taxation. Is the business a C-corp, S-corp, LLC only (i.e., individual)? Corporations are taxed at 21% when the business is an asset sale. C and S-corps that distribute proceeds to shareholders can result in double taxation. The business is taxed at 21%, while shareholders are taxed at the capital gains rate.
Some businesses can structure their sale as goodwill. There is no double taxation since only the individual (i.e., shareholder) is taxed at their capital gains rate.
Net income investment tax (NIIT) and state taxes may also apply.
The taxation of a business sale can be complex as each business is different. The tax situation of shareholders is also different, adding further complications to calculating the full tax impact from a sale.
Options To Reduce The Tax Bill
Now that the business has been sold, what options are available for reducing the tax bill? The best case is that the seller will only be taxed at the capital gains long-term rate. When that isn’t possible, here are a few options to reduce the tax bill:
Qualified Opportunity Zone (QOZ)
QOZs are a lesser-known method for reducing immediate taxes. Investors don’t actually use a QOZ as the vehicle for investing. Instead, they go through a qualified opportunity fund (QOF). The fund then invests in a QOZ.
Just as investors can invest their taxable gains into a QOF, business owners can invest their gains from a business sale into a QOF.
Taxes on gains are deferred until the investor’s interest in the QOF is redeemed or the QOZ program ends (i.e., expiration of the program).
The investor will still show a gain on their tax return from the sale of the business. However, the QOF investment will also be shown on the return, thus shielding the gain from taxes.
1031 Exchange To Passive Real Estate
For business owners who also own the underlying real estate, a 1031 exchange is an option. It will defer gains from the real estate part of the sale. The owner doesn’t have to exchange into another property that must be managed. There are a few ways to exchange into passive real estate.
One method is to exchange into a NNN (triple net lease). The tenant is responsible for property taxes, insurance, maintenance costs, and base rent in this arrangement. While not completely passive, a NNN is fairly close.
Another method that is completely passive is exchanging into a DST (Delaware Statutory Trust). A DST is a fund that holds real estate. It can provide investors with more options than a direct real estate 1031 exchange.
Note that the replacement property must be like-kind for a 1031 exchange to work.
Keeping the Real Estate
Instead of exchanging into another property, in some cases, keeping the business’ real estate is an option. Since the real estate isn’t being sold with the business, there’s the potential to reduce capital gains.
The business owner can also lease the land back to the new owner, becoming a landlord in the process. This lease can be set up as a NNN, freeing the landlord from a lot of the property management that can come with leases.
Exit planning tax strategies can be broad and complex. That’s why it is also best to work with a tax planner when selling a business.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.
