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.
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.
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.