Introduction

You have been working on your small business for quite some time and now are ready to sell. One thing creeping up in your mind is the tax impact: How much would I owe on taxes. The better question you have been asking yourself would be “is there a way to reduce my tax bill?”

The good news is that there are many ways to reduce your tax liabilities.

In this blog post, we will examine some important considerations to reduce overall capital gain taxes from a business sale.

1. What are the different types of taxes you would incur upon the sale of your business

2. What is the capital gains tax and how is it calculated

3. How can I reduce the amount of capital gain taxes you owe

4. What are some other things to consider when selling your business

5. Final Conclusion

1. Three different taxes you need to think about upon the sale of your business

When you sell your business, you will have to pay attention to three different types of taxes: income taxes, excise tax, and estate tax impact in the future. A large portion of this blog is spared on income taxes.

But first, let’s discuss the two different types of business sale transactions.

2 types of business sale

One is a stock sale, which is popular for C-corporation, especially tech companies. A buyer purchases the stock of the business, meaning that the buyer would assume liabilities. Stock sale could create an advantage for buyers as qualified small business stock shareholders (IRS Sec. 1202) to exclude up to $10 million in capital gain per shareholder once they hold the stock for 5 years and sell the business in the future. Many start-ups utilize this route to add tax incentives in attracting angel investors. A drawback for stock sale is that the buyer won’t be able to get a step-up basis of assets to restart depreciation or amortization but simply assume the seller’s depreciation schedule.

The other business sale type is an asset sale, which is most common for small businesses. About 70% of all business sale transactions are in an asset sale. A buyer purchases all the assets including tangible and intangible assets in order to depreciate fixed assets and amortize intangible assets. In the event of an asset sale, purchase price allocation becomes important for both seller and buyer as it dictates the basis of each asset class. In both sale types, knowing the value of your business is critical. Hire a good business valuation expert to evaluate the current value of the business which can help create a good business price allocation.

The rest of our blog here is focused on asset sales for small business owners with pass-through entities in S-Corporation or partnership entity structure.

2. What is capital gains tax and how is it calculated

Capital gain is a category of income, and we need to deal with this capital gain in order to reduce the overall income taxes you would pay in the year of your business sale. Taxes on capital gain is the tax you will owe on the profits from the sale of your business. Contrary, ordinary income is another category of income including, business profit & W-2 wages. Similar to real estate sale transactions where you have a sale price, adjusted basis, and cost of sale in the mix to calculate your capital gain, a sale of a business has a similar pattern.

The sale price is what the buyer pays you for your business. The adjusted basis is what you contributed to the business, plus after-tax retained earnings minus any distribution. It is important if you are S-Corp or partnership business owner, you would pay attention to your basis schedule of the business, typically attached to your Schedule K-1 (tax basis). Ultimately, the bigger the adjusted basis is, the smaller your capital gain would be. The cost of sale includes the professional fees associated with selling the business, such as broker commissions, and legal fees.

For example:

Let’s say that you have a buyer willing to pay $10M for your business. Your adjusted basis for the business is $3.8M and the cost of sales is $200K. In this case, you net $4M as the business sales profit. Is the entire $4M capital gain? Maybe and maybe not. If you had fixed assets that took depreciation in the past. Potentially, the depreciation recapture is applied. Let’s say you had taken depreciation on your business equipment for $200K. That portion may be categorized as ordinary income and the rest of $3.8M would be capital gain.

Category of income

The category of income out of the business sale is important. As of 2022 federal tax law, the highest capital gain tax rate is 20% whereas the highest ordinary income tax rate for individuals (because of pass-through business) is 37%. Generally speaking, a capital gain tax rate is imposed on the sale of real estate or business interest held longer than 1 year called long-term capital gain. There is also a consideration for a net investment income tax of an additional 3.8% tax for federal tax, but most business owners with material/active involvement can avoid this taxation.

3. How to reduce or defer your capital gains tax bill

Now, we will explain a few strategies commonly used to reduce income taxes resulting from sale of business assets.

Installment Sales Strategies to defer capital gain in the future date

If you structure your business sale in the installment sales process, the IRS allows you to pay taxes on the installment each year as a cash-basis taxpayer. Let’s say you will receive a $380K installment each year for the next 10 years total of $3.8M. You would basically recognize the taxable gain as you receive cash installments each year. Rather than receiving the cash from the seller and paying taxes in the same year, this method helps you recognize the gain in smaller increments. Obviously, this deferral strategy may not work best if you expect the inflation rate is high in the next few years. The future cash would be less valuable than the current value. “Monetized installment strategy” is another tweak embedded with this deferral strategy.

In short, you would receive cash in front as a form of loan upfront from a third-party lender by collateralizing the settled sale agreement with a small discount and recognizing capital gain in as the cash comes in each year. Obviously, this strategy needs good legal documentation to support in the wake of recent IRS scrutiny. You would like to consult with your tax advisor.

Charitable Strategy

We often work with Charitable Remainder Trust, Charitable Lead Trust, Charitable LLC, and Foundation, Deferred Sales Trust entity structure to shield proceeds from the sale of the business and preserve capital for the high net worth individuals. These structures allow some of the investments to grow tax-free or tax-deferred while the individual can enjoy the tax write-offs from contributing to charitable entities in the year of the business sale transaction closed. This strategy has to be aligned with the taxpayer’s capital strategy, timeframe, and passion/interest in charities. The business entity matters when it comes to charitable strategies.

Tax-Efficient Investment

We look into the client’s situation for both business and individual and consider tax-friendly investments such as Oil & Gas, solar tax credit, or Opportunity Zone funds strategies. These strategies often create a great tax incentive because of the protected IRS code section. For example, Oil & Gas investment is protected per IRS code section 263 “Intangible Drilling Costs” (“IDCs”) where you can invest a lump sum of money into the fund and get the 65-85% of the original investment as the tax deduction in the first year while you create a future cash flow twice of the current year investment over the 7 year span.

Real estate syndication can be a good avenue for tax-efficient investment especially when you can take a large depreciation expense on the commercial building after a cost segregation study is conducted.

Domicile Planning

Sometimes, clients are flexible to move their residency prior to the sale of the business in advance. If you live in a high-income tax state such as New York, California, Oregon or New Jersey, sometimes moving to another state alone creates a good tax break. Especially in Oregon where some counties decided to impose additional taxes just because you live there as a resident. For example, if you lived in Multnomah county in Oregon, you pay an additional 1.5% on top of $125K Oregon taxable income as a single tax filer and an additional 1.5% over $250K. It’s called Preschool for All taxes (https://www.multco.us/finance/preschool-all-personal-income-tax). This is apparently imposed all residents for the current year’s taxable income.

You read it right. If you lived in the county as a business owner and let’s say your taxable Oregon income was $5M after completing your business sale, for this Multnomah County Preschool for All tax purposes, you would be paying $144,375 ($1875 + $142,500). This alone creates an added incentive for you to relocate your residency to a lower-income county/state/region.

Other strategies

We examine other strategies such as an employee stock ownership plan (ESOP), qualified opportunity funds, M&A strategy, etc depending on your capital asset and business situation. Every entity structure and strategy matters when it comes to the sale of a business. yes.

4. What other considerations you should give in the event of your business sale?

What if you die tomorrow?

I apologize if I drop you some cold water when you think about how you can spend the fortune after the business sale, but it’s part of my job. You need to think about when you pass away.

In the same way about reducing your income taxes, you can be smart about estate transfer tax considerations as well. The estate transfer tax is the taxes you pay to the government based on your net worth called estate value. Currently, at the federal level, the estate transfer tax threshold is $12.06M per person with rates ranging from 18-40% progressive tax rate.

Okay, not all business owners have to consider this federal-level estate transfer tax. However, there are twelve states that impose estate transfer tax: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. Each state has its own estate transfer tax threshold, mostly much lower than the federal threshold. For example, Oregon has a $1M threshold per person with the highest 16% tax rate (the threshold has not been adjusted for inflation for a long time). Often, when you sell a business, your estate exceeds the estate tax threshold in case of emergency. Thus, you need to plan ahead and meet an estate attorney.

Final Consideration

We examined the different types of taxes, and how to calculate capital gain. how to reduce your income taxes created from the business sale capital gain, and a few strategies to mitigate the total taxes owed.

At our firm, these planning conversation goes a long way with clients because of the clear return on investment. If you can save taxes and reinvest back into your business and lifestyle, you would like consult with us long before you sell your business. It is about the legacy that our clients pass on to the next generation, not just money. The conversation from income tax planning can be tactical but more over what they can do with the tax savings matters so much to us because they can start something or contribute back to communities. You have many moving parts and tax considerations when you sell your business. Consult us for the best strategy to mitigate and reduce your ordinary income taxes/capital gains taxes and also approach your wealth/legacy building with good counsel. We are one of the best tax strategists and tax advisors in Portland Oregon. Our team at Hoshi CPA is ready to help you navigate through these complex waters and come out on top with as little tax liability as possible. We examine your situation from entity structure, maximizing deductions and credit, and niche-specific strategies. Give us a call today!

Hoshi CPA is a full-service tax and accounting firm located in Portland, Oregon. We are dedicated to helping our clients minimize their taxes and achieve their financial goals. Our services include tax planning, tax preparation, business consulting, and financial planning.