Tax Implications When Selling of a Business

Instructor: Scott Tuning

Scott has been a faculty member in higher education for over 10 years. He holds an MBA in Management, an MA in counseling, and an M.Div. in Academic Biblical Studies.

Choosing the correct incorporation model for a business is critically important for a variety of reasons. A business owner's choices when incorporating a business will have a significant effect on the seller's tax liability when the company is sold.

All About the Bottom Line

In the city of Albuquerque, Dan Lewis wears many hats. He is a senior city councilman, chairman of the public safety committee, and the Executive Vice President of a firm that trades in the oil and gas industry. These responsibilities would be more than enough for some individuals, but Councilman Lewis is also a small business owner and entrepreneur.

Unlike many small business owners, Lewis does not grow his businesses based on his personal knowledge of an industry or any personal passion for a line of work. Rather, Lewis carefully studies the marketplace, finds an opportunity anywhere he can, and creates a business for the sole purpose of selling it for a profit 7 to 10 years down the road. Lewis' ability to find the most advantageous tax structure means a difference in the tens of thousands of dollars at the time of the sale.

Seeing the End from the Beginning

Pass-Through Entities

The most significant factor influencing tax liability at sale is the method used by the owner at the time of incorporation. For tax purposes, sole proprietorships, LLCs/LLPs, and the S Corp are all considered pass-through entities. Pass-through entities do not pay corporate income tax. Instead, profits are routed directly, or 'passed through', to owners who pay them at personal income tax rates. For this reason, entrepreneurs like Dan Lewis find these tax structures very attractive.

Sole Proprietorship

After graduating from a career college in the 1980s, Ted Katz bought a metal building and launched his company doing business as Katz Automotive. For 30 years, Ted worked from that garage. Now almost 65 years-old, Ted was ready to retire and began making preparations to sell his business. He consulted with an accountant who gently broke the news that he would be incurring a substantial tax bill because of his decision to do business as a sole proprietor.

Ted and his accountant worked hard, but eventually Ted had to owner finance his buyer in order to avoid a crippling tax bill. To add insult to injury, Ted had expected to charge the buyer a premium price if the buyer sought access to customers and relationships. Ted's accountant shot that idea down as well. 'Ted, ' his accountant said. 'You are selling your building and your tools, but your customer list is not considered an asset for monetary purposes.'

Like Ted, many small business owners organize as a sole proprietorship, because it is the easiest and fastest way to create a business. Although easier to create, a sole proprietorship has some significant risks as well. Because a sole proprietorship does not distinguish between the individual and the corporation, the business owner's assets have no protection from litigation. This means that a sole proprietor stands to lose not only his or her business assets, but their personal assets as well.

Similarly, a sole proprietorship's owner is personally responsible for any applicable capital gains taxes resulting from the sale of their business. Capital gains tax is calculated by taking the difference of the sale price and all liabilities that must be satisfied. If the result is a net positive, the remaining proceeds could be taxed at anywhere from 15% (the long-term capital gains rate) up to 28% (the short-term rate in special situations). It was a costly mistake for Ted whose ultimate tax liability was far higher than he expected.

LLCs, LLPs, and the S Corp.

A limited liability corporation (LLC) is a better option for people like Dan or Ted. It is only slightly more complicated to incorporate and the tax benefits are significant. This is especially true when the business is sold. An LLC separates the business owner's personal interests from those of the business.

When a pass-through entity is sold, the owners or shareholders will be taxed based on their personal filings regarding profit and loss. Because Dan's modus operandi is to build and then sell a business, pass-through taxation means his overall tax liability is significantly less than other options. In Ted's case, organizing as an LLC or subchapter corporation (S Corp) would not have prevented his tax liability in its entirety, but it would have allowed him more flexibility in the terms of the sale.

Although LLCs, limited liability partnership (LLP)s, and S Corps are all taxed in roughly the way, each has some nuances that make one of the three options better than another. The tax liability of the LLC is determined by the amount of profit that it receives. Owners of an LLC receive their profits through the company, but they report and pay these taxes according to their personal income tax return.

Like the LLC, LLPs pass their tax liability through, but instead of passing it to a single individual, it passes the tax liability to the partners. LLPs are usually restricted to professional practices like law, medicine, or architecture. The contracts and bylaws used to form the partnership will lay out each partners' liabilities including their tax burden.

An S Corp is the most formal of the pass-through entities. It shares its overall tax structure with an LLC, but there are restrictions that make the governance of an S Corp a little more tricky than an LLC. S Corps must have a formal board and officers, may have no more than 100 shareholders, and cannot have any foreign owners.

Regular Corporations

Unlike pass-through entities, regular corporations are subject to corporate taxes, and the individual shareholders are also subject to regular income tax on their profits. Because of the substantial tax benefits, many small and medium-sized businesses are incorporated as a pass-through entity. Regular corporations tend to be larger businesses and selling them is complex.

A regular corporation is often described as a C Corp. Although they both start with a single letter, an S Corp and a C Corp are two entirely different entities. The major difference between the S Corp and the C Corp is the fact that the S Corp is subject to pass-through taxation, while the C Corp is subject to regular corporate income tax.

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