When you’re planning to sell or transfer a profitable business, taxes are almost always one of the trickiest points of negotiation. After all, a business sale is like any other—whether you’re scoring a big haul or getting less than you’d hope, money is still money. And when there’s money involved, federal and state tax departments will be eager for their cut of the earnings.
How the IRS Sees Business Sales
If you don’t already know how the IRS appraises businesses, you might be surprised to learn that tax agencies won’t consider your company a single entity. Instead, they’ll look at all of your assets—and treat each one as if it’s being sold individually.
Furthermore, the tax rate the IRS assesses will depend on the particular circumstances of the assets. When you’re selling assets that you’ve held for a year, the profits are treated as long-term capital gains, meaning you’re subjected to a maximum tax rate of about 15%. But any proceeds the IRS decides should be treated as “ordinary,” or standard income, are taxed at your individual rate, which can be well over 30%.
Strategies for Avoiding Big Tax Penalties
However, you don’t have to roll over for the IRS. In fact, there are several common techniques you can use to protect your profits:
- Estate freezing and transfers
- Rollovers, exclusions, and tax deferrals
- Tax deductions
- State income tax avoidance
Estate Freezes and Transfers
If you’re planning to hand off a family business to your children, there are strategies to help your heirs avoid massive inheritance and wealth taxes. You can, for instance, “freeze” the value of your business by transferring control to a child or other heir. Your business will keep its current valuation during the transfer, but that value can still appreciate afterward, too. Your child could, later on, sell the business by him or herself—thereby avoiding inheritance taxes in their entirety.
There are a number of different ways to do this, including:
- Gradually transferring stocks to your child each and every year
- Private annuity arrangements
- Installment sales made out to a trust
- Trust-type arrangements, including charitable-lead annuity trusts and grantor-retained annuity trusts
You could also elect to name your children as limited partners in your business.
Tax Code Tricks and Legal Deductions
If you don’t have children or want to sell your business while you’re still alive and in control of all its assets, you can use certain aspects of the federal tax code to your advantage:
- Section 1042 of the tax code lets you sell company stock to an employee stock ownership plan. You can defer federal and sometimes state taxes on these transactions by putting the proceeds towards a qualified replacement plan (QRP). If you hold onto these QRP assets throughout your life, the tax obligation will disappear when you die—giving your heirs a lesser tax burden as well as a better tax basis to sell your business
- Section 1202, or the capital gains exclusion, lets you exclude 50% of the profits you’ve made on small business stock sales—up to $10 million—provided you’ve held onto it for at least five years
- Section 1045 lets you “roll over” taxable gains on qualified small business stocks if you put the proceeds towards another QSBS within 60 days—in other words, you can put your old stocks into a new company, effectively putting off the taxes until you decide to sell that one, too
Lastly, there are some tax deductions you can take advantage of if you’re savvy enough to use them right. If you have businesses outside of Arkansas or are planning to shift base somewhere with a lower tax rate, you can use an incomplete non-grantor trust, or INGT, to eliminate your state’s capital gains tax.
You may be able to take advantage of other deductions, too, depending on your business’s unique circumstances—as well as the location of sale and the residency of the purchaser.
If your company is big enough, you may be able to dodge tax obligations altogether if you receive payment solely in stock.
Don’t Let Taxes Cost You Big
Of course, taxes aren’t easy to navigate. There’s a reason most businesses either have a dedicated accounting team or wish they did. However, your CPA may not think much beyond your regular finances and annual tax obligations. Quraishi Law & Wealth Management, on the other hand, is intimately familiar with the U.S. tax code—a complex set of rules more than four times longer than Tolstoy’s War and Peace! We are specially trained and highly experienced wealth planning attorneys who can help you take on immediate challenges and plan for the future. Send us a message today to learn how you can get the most out of your hard work.