By Michael Torney, CFP, J.D., LL.M.
I have advised many business owners on the tax implications of various financial planning areas. The area that has the single largest impact on the financial success of an entrepreneur is the sale of their business. Turns out, this is also the area of the largest tax savings. Proper planning can save seven figures in taxes.
Let’s jump into selling a business and how to save money on taxes through planning.
What many owners care about is maximizing the sale price of the business. Sale price is an important number; but a more meaningful number is the after-tax proceeds from the sale. It’s worth noting at the beginning: the earlier you start, the more money you will save. However, it’s never too late to save some money on tax planning for a business sale. If you wait until the beginning of a sale – there is very little you can do to save taxes. We’ll cover a variety of choices in this blog series; the first choice an entrepreneur can make to lessen taxes on a sale is re-evaluating their business entity selection.
Your entity choice:
You probably did not choose a business entity based on how it would help your business sale price. Now that your business is thriving – it’s time to reconsider your business entity. How the entity is organized has tax implications come sale time.
There are two main types: a pass through entity and a C-corporation.
During the operating years of the business, there are tax implications that favor one type of election. The sale process also has tax considerations that are very important. Often, a C corporation makes sense in the operating years of the business from a tax perspective but isn’t ideal from a sale perspective.
Note: as usual, there’s an exception if the business is eligible for 1202 Qualified Small Business Stock exemption – let’s assume this business doesn’t meet the qualification requirements.
The reason the C corporation is so punitive come sale time is because C corporations have a corporate level tax imposed on the assets of the business. After that tax has been paid, there is a personal tax to the seller in the form of capital gains.
- Here’s a quick example.
- Joe has a widget making business with a contracted sale price of $5 million.
- His basis is $1 million.
- Joe will pay a corporate tax on the gain of $4 million – that tax is around 35% federal and 5% state.
- So Joe nets $2,400,000.
- But then he pays capital gains tax on his personal gain
- it can be 20%-25% between federal and state rates, let’s use 25%
- Joe’s $2,400,000 becomes $1,800,000.
The actual math is more nuanced but this is a sufficient high level overview.
If Joe had an S Corp, there is no corporate level tax. There’s only the capital gains tax.
- Let’s look at the same example:
- Joe has a widget making business with a contracted sale price of $5 million.
- His basis is $1 million.
- The $4 million dollar gain at 25% capital gains (federal & state) gets Joe $3,000,000.
That’s a very large tax savings.
Converting from C to some pass-through entity can be done prior to sale and all business owners should at least consider it for the tax implications (and non-tax implications to the buyer beyond our scope here).
However, there are variety of rules and steps that must be followed and the longer time frame you have the more you will likely save.
Best to consult a qualified financial planner and CPA on these items.
If your company is structured as a C-Corp and you would like to discuss it as part of an overall financial strategy, contact our team at DuffTorneyteam@monetagroup.com. We offer a free consultation and are always available to discuss how we can help people maximize their wealth.
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