Taxes & Selling a Small Business

Preparing for and going through the process of selling a small business is a long, and sometimes grueling experience. It's easy to get wrapped up in details like figuring out the right selling price, finding the right buyer with adequate financing, and gathering together all the financial paperwork and details so that the process goes smoothly.

With all of that going on, it's not hard to overlook a critical part the sale: how will you be taxed? There are two major federal tax issues that arise from the sale of a business:

• The amount of gain or loss recognized by the seller
• The character of the gain or loss as ordinary or capital

The tax consequences of the sale can have a huge impact on how much money you actually put in your pocket after the sale. Couple with that the fact that the tax code is complicated, it's in your best interest to research the tax matters thoroughly before committing to a sale, or get some help from an experienced business or tax law attorney.

Some Tax Basics

To understand the tax issues related to the sale of business, you need to know the meaning of some terms that are used in the tax code, such as:

• The amount of ordinary gain or loss by a seller on the sale of a business is the difference between the amount realized from the purchase price and the seller's adjusted tax basis for the assets.
• The amount realized from the sale or other disposition of property is the amount of any money received plus the fair market value of any property, other than money, received.
• The adjusted basis of property for determining the gain or loss from the property's sale generally is the cost of the property.
• A capital asset is property (like machinery, equipment, and motor vehicles) that is used in the business, usually for more than a year, which is not easily converted to cash nor sold in the ordinary course of business.
• Capital gains and capital losses result from the sale of capital assets, and they're typically classified as either long-term or short-term. Long-term is when the seller held the asset for more than one year before selling it; short-term is when the asset was held for less than one year.
• Ordinary income includes any gain from the sale or exchange of property that is not a capital asset (or other specified property.)

Generally, the entire amount of a gain or loss realized on a sale or exchange of property must be recognized as income by the seller on the seller's income tax return.

Capital Gain or Loss

Being able to treat the gain from the sale of a business as a capital gain can be beneficial to certain taxpayers, like individual shareholders who sell their shares in a stock purchase acquisition. Capital gains are taxed generally at lower rates than those applicable to ordinary income, so you can see significant tax savings on the gain. In addition, if you lose on the sale, you take a deduction for the capital loss.

If the seller-shareholder is a corporation, the tax rate for capital gains is the same as that for ordinary income. But, it can take a deduction for a capital loss, and usually can carry back any net capital loss to apply to the three taxable years preceding the loss, and it can carry the amount forward for five taxable years.

There is special tax treatment for gains on the sale of small business stock.

Asset Sales

The sale of the assets of a business is treated as the sale of separate assets that, taken together, make-up the business. Gain or loss must be computed on each asset, and so the purchase price must be allocated to the separate assets sold. The figure allocated to each asset will be the buyer's cost or income tax basis and the seller's gain or loss for that asset.

High-income, individual sellers are interested in characterizing gain as capital rather than as ordinary income to take advantage of the lower tax rates for capital gains, as opposed to the maximum rate on ordinary income of 35% (for tax years 2006 and later).

To get capital gain characterization, the seller usually wants to allocate as much of the purchase price as possible intangible assets, like trademarks or trade names. The buyer, however, is likely to want to allocate the bulk of the purchase price to inventory or depreciable fixtures, machinery, or equipment so as to get increased depreciation deductions.

Questions for Your Attorney