Answers ยท Tax Deferred Strategies
How much tax will I pay when I sell my business?
Usually more than the capital gains rate suggests. Part of the price is often taxed as ordinary income, and how the price is split across the business's assets decides how much. Federal tax runs 15 to 20 percent on the capital gain part and up to 37 percent on the rest. California taxes all of it as ordinary income, up to 13.3 percent.
A business is not taxed as one thing. It is taxed as a pile of things.
Most owners picture one number. Sale price minus what they put in, times the capital gains rate. That is rarely how it works.
In most small business sales, the buyer is buying the assets, not your shares. The equipment, the inventory, the customer list, the name, the reputation. The price gets split across all of them, and each piece is taxed by its own rules. Some pieces get capital gains rates. Some get taxed like wages.
Quick note on who is talking. opfinances.com is a licensed insurance agency. We are not a financial advisor, not a fiduciary, and not a tax adviser. This is general education, not advice about your sale.
The split of the price is where most of the tax gets decided.
Here is how the common pieces are usually treated at the federal level. Goodwill, the value of the name and the customer relationships, is generally a capital gain if you held it more than a year. That is the good news, because for a lot of service businesses goodwill is most of the price.
Equipment and vehicles are different. If you took depreciation on them over the years, and most owners did, the buyer's payment for them can be taxed as ordinary income up to what you deducted. Inventory and receivables are ordinary income too. So is money paid to you personally for consulting or staying on after the sale, and that can carry payroll tax on top.
Buyers and sellers want different splits. The buyer usually wants more of the price on assets they can write off fast. You usually want more on goodwill. The split gets written into the purchase agreement, which means it gets settled before you sign, not at tax time.
Two governments take a share, and California gives no capital gains discount.
Federally, long term capital gains are taxed at 15 or 20 percent, and a large sale pushes most of the gain into the 20 percent bracket. Ordinary income pieces are taxed at your regular rates, up to 37 percent. There is also a 3.8 percent surtax on investment income. Whether it applies to your sale depends on how your business is set up and whether you actively worked in it, so ask about it directly.
California has no special rate for capital gains. It adds the whole gain to your income for the year and taxes it like wages, with rates up to 12.3 percent plus another 1 percent on income over a million. Decades of profit land in one tax year, so most of it gets taxed at the top rate.
If your business is a C corporation and the buyer purchases its assets, there can be two layers. The corporation pays tax on the sale, and you pay again when the money comes out to you. That one catches a lot of owners off guard.
A 3 million sale can leave you with less than 1.9 million.
Illustrative arithmetic, not a tax estimate. A married owner of an S corporation sells the business's assets for 3,000,000 and pays 250,000 in broker and legal costs. The equipment is fully depreciated, and 300,000 of the price is allocated to it. The rest is goodwill with almost no basis. The owner has about 150,000 of other income that year and actively ran the business, so we assume no surtax.
The 300,000 of equipment recapture is taxed as ordinary income. The roughly 2,450,000 of goodwill is taxed mostly at 20 percent. The federal bill from the sale comes to about 550,000. California adds roughly 330,000. Together that is about 880,000. After the 250,000 in costs, the owner keeps about 1,870,000 of the 3,000,000.
Your numbers will be different. Brackets and thresholds change, and your entity type, the allocation, and your other income all move the answer. The point is the size of it, and how much of it the purchase agreement decides.
The bill is a default, and the purchase agreement is where it gets locked in.
That 880,000 is what happens when a sale is done the ordinary way. There are structures that can change it, and nearly all of them share one rule. They have to be in place before the sale becomes binding. By the time you sign, most of the options are gone.
We are not going to list them here. Which ones fit depends on facts only you have, and some come with real costs and requirements. Sometimes the honest answer is that the default is fine.
One more thing about incentives. We are paid when a client ends up in a product we offer. Nobody is paid when the answer is that you should leave your sale alone. Weigh anything anyone tells you about your sale with that in mind, us included.
Before you decide
Questions worth asking.
Is the buyer purchasing my shares or the business's assets, and what does that difference cost me in tax?
How is the price being allocated across goodwill, equipment, inventory, and any consulting or non compete payments, and who proposed that split?
How much of the price will be taxed as ordinary income because of depreciation I already took?
Does the 3.8 percent surtax apply to my share of the sale, given my entity and how involved I was in running the business?
What will I owe California in the year of the sale, and do I need estimated payments after closing?
If you are recommending anything that changes the tax, what does it cost, how are you paid on it, and what happens if I do nothing?
Related
Is selling a business taxed as a capital gain?
Partly. Goodwill and shares held more than a year are generally capital gains. Payments for depreciated equipment, inventory, receivables, and consulting or employment agreements are usually taxed as ordinary income. How the price is split decides the mix.
What is the difference between an asset sale and a stock sale for taxes?
In a stock sale you sell your ownership, and the gain is usually a capital gain. In an asset sale the business sells its assets, and each one is taxed by its own rules, so some of the price can be ordinary income. Buyers usually prefer asset sales.
Does California tax the sale of a business?
Yes. California taxes capital gains as ordinary income, with no lower rate, so the gain is added to your income for the year and taxed at rates up to 12.3 percent plus a 1 percent surcharge on income over a million.
What is depreciation recapture when you sell a business?
If you deducted depreciation on equipment or vehicles, part of what the buyer pays for them can be taxed as ordinary income, up to the amount you deducted, instead of at capital gains rates.
When should I plan for the tax on selling my business?
Before you sign a letter of intent or purchase agreement. The price allocation is set in the agreement, and nearly every structure that changes the tax has to exist before the sale becomes binding.
Where this fits.
This question sits inside a bigger one. Tax Deferred Strategies walks through the whole decision rather than this one piece of it.
On Point Finances is a licensed insurance agency, not a tax, legal, or investment adviser. This page is general education, not a recommendation, and reading it does not create a client relationship.