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Tax Consequences When Selling A Business

Everything you own and use for personal or investment purposes is a capital asset, according to the IRS. When you sell a capital asset, such as a business for example, the difference between the amount you paid (initial investment) and the amount you sell it for is called capital gain/loss. For instance, if you bought a business for $20,000 and later sold it for $50,000, then you have a capital GAIN of $30,000.

There are two kinds of capital gains; short-term and long-term (assets held longer than one year) Short-term capital gains are taxed at the ordinary income tax rate in effect for the year, ranging from 10-35%. Long-term capital gains are taxed at a special rate that depends on which income tax bracket you personally fall under. In some individual tax brackets, there are no taxes due on such gains. 

Another tax you need to be familiar with is, the Depreciation Recapture tax. All assets that you depreciate over the years are subject to the depreciation recapture tax. For example, you buy a machine for $1,000 and take $400 worth of depreciation deductions from your income over the course of 5 years. After 5 years, Uncle Sam recognizes the machine is worth $600. If you sell that machine for $700, then you have a gain of $100. Because you received depreciation deductions, you are required to include the $100 gain as part of your ordinary income from the sale, and are taxed accordingly. However, say you sell the machine for $1,200, because the original price you paid was $1,000, $400 of the gain is taxed at your income rate and $200 is taxed at the more favorable capital gains tax rate.

Confused yet?  When it comes to the sale of your business and taxes, there is one other thing you should be aware of.  

Allocation of the Purchase Price

Most businesses we sell are structured as an asset sale.  In an asset sale, the buyer and seller must agree on the allocation of the purchase price for tax purposes.  Why is this important?  It is important because different classes of assets are taxed at different rates.  Typically what is good for the buyer is bad for the seller, and vice-versa.  The total value allocated to the assets should equal the total purchase price. Some popular asset classifications include:

  • Furniture, Fixtures and Equipment
  • Leasehold Improvements
  • Covenant Not to Compete
  • Training and Transition
  • Registered Vehicles
  • Customer List
  • Goodwill
  • Buildings
  • Land
  • Inventory

How much you have to pay for taxes when you sell your business can be difficult to figure out. This is why Sunbelt Business Brokers always recommends that you consult with a tax attorney or accountant proficient in small business sales, before making any financial decisions.  If you don't know of anyone, contact us, and we can give you a list of capable professionals.