Selling a business is a major financial milestone, but sometimes owners are caught with a tax bill they weren’t expecting. This can be the case if proper planning isn’t carried out in anticipation of the transaction.
The good news? There are legal ways that could allow you to reduce, defer, or even eliminate taxes when selling a business.
You’ll want to know your options as you get ready to exit a business. In the following sections, we’ll explore how to avoid taxes when selling a business by looking at key strategies. As you read through these, you’ll learn about capital gains tax avoidance for business exits, succession planning tax benefits for business owners, and exit strategy tax planning for business owners.
Understanding the Tax Burden on Business Sales
When you sell a business, the IRS will usually treat the proceeds as either ordinary income or capital gains, depending on the deal structure. The difference between these can be significant. Ordinary income can be taxed as high as 37%, while long-term capital gains max out at 20%, which can be an incentive for some to plan ahead.
Selling a business outright and taking the full payment at once often results in the highest possible tax bill. Instead, structuring the sale strategically and using tax-efficient planning could help you keep more of your money.
Structure the Sale to Minimize Taxes
The way you sell your business will typically have an impact on how much tax you’ll owe. When selling, you will often have two options: an asset sale or a stock sale. Buyers tend to prefer asset sales because they can depreciate assets and claim deductions. However, for sellers, asset sales often trigger higher taxes, including ordinary income on certain assets.
A stock sale may be more tax-efficient for business owners because it allows them to pay long-term capital gains tax rates rather than ordinary income rates. While some buyers might be unaware of this structure, you may be able to negotiate the terms of the deal so that everyone benefits.
Opportunity Zones to Defer Capital Gains Taxes
Another way that you may be able to reduce your tax liability is by reinvesting your proceeds into an Opportunity Zone Fund. This allows you to defer capital gains taxes until 2026, and if you hold the new investment for at least 10 years, any future gains could be completely tax-free.
This strategy works best if you’re open to reinvesting in real estate or new businesses in designated Opportunity Zones. This could be a smart move for entrepreneurs looking for new investment opportunities after selling a business. You’ll want to understand how it works, and talk to an expert to move forward in the right way.
Section 1202 Exclusion (Qualified Small Business Stock)
If your business is a C-Corporation, you might be able to eliminate capital gains taxes under Section 1202 of the tax code. To qualify, you must have held your stock for at least five years, and your company’s assets must be under $50 million at the time of stock issuance.
If you meet these conditions, you could exclude up to 100% of the capital gains. You’ll want to speak to a tax professional who is knowledgeable in this area to learn what’s all involved and if it is a good fit for your business and financial goals.
Use a 1031 Exchange for Business-Owned Real Estate
If your business owns real estate, you might qualify for a 1031 exchange, which allows you to defer capital gains taxes by reinvesting the proceeds into a like-kind property. For example, if you own an office building as part of your business, you could sell it and reinvest the proceeds into another investment property without paying taxes on the gain. Real estate investors often use this strategy, but it can also work for business owners.
Plan for Succession to Reduce Taxes
If you plan to pass your business to family members or employees, you can look into proper succession planning as a way to potentially reduce taxes.
One option could be a Grantor Retained Annuity Trust (GRAT), which allows you to transfer your business to heirs at a reduced tax rate. By placing the business in the trust, it can continue growing without instigating a large estate tax bill.
Another option that some consider is an Employee Stock Ownership Plan (ESOP). With an ESOP, you sell the business to your employees while deferring or eliminating capital gains taxes. Under Section 1042, you may be able to avoid taxes entirely if you reinvest the proceeds into qualified replacement property. This could be a way to reward employees while also securing tax advantages.
Other Options to Consider
Beyond these strategies, you’ll find other options available. As you look, you’ll want to think about what would be the best fit for your situation.
Some of the other strategies include the following:
- Charitable Remainder Trust (CRT): Before selling your business, you can transfer a portion of the company into a CRT. The trust then sells the business tax-free, and you receive tax-free income for life from the trust. After you pass away, the remaining funds go to charity.
This strategy works well if you’re passionate about a charity or cause and have given donations in the past. If it doesn’t fit your financial habits or interests, you could look into other options. Think about your habits and lifestyle before making a decision.
- Installment sale: This could allow you to receive payments over several years instead of all at once. By spreading out the income, you could stay in a lower tax bracket and pay a lower rate overall.
- Tax-Advantaged Investments: Some tax-advantaged investments allow business owners to offset taxable gains while creating new income streams. Options like private partnerships in real estate, oil and gas, or venture capital can provide tax deductions, tax credits, or passive losses to reduce your tax bill.
If structured correctly, these investments can help shelter income and provide tax-free or tax-deferred cash flow after your business sale.
- Combining a 338(h)(10) election with an F-reorg structure: With a 338(h)(10) election, a stock sale is treated as an asset sale, which allows the buyer to obtain a stepped-up basis for the acquired assets. Using an F-reorg under IRC Section 368(a)(1)(F) enables the seller to maintain the transaction as a tax-free reorganization, preserving favorable capital gains treatment.
Selling a business is a once-in-a-lifetime event for many, and it can be worth your time to create a plan. If your advisor hasn’t spoken to you about these options, it may be time to look for a professional who can help you create the right exit strategy.