Jeff Haywood, CPA writes: Taxes on the sale of your website are unavoidable, and unfortunately, most tax situations are not 100% straightforward and predictable. How much are you going to owe on your taxes? The answer: it depends.
To help answer the often-asked question: “how much am I going to have to pay in taxes when I sell my business?”, we enlisted the help of Jeff Haywood, aka the CPA Superhero (you can follow him on Twitter here). As always, with any financial or legal advice, always seek a professional’s opinion for your specific situation. The information below is given as generic information and should not be taken as specific guidance for your situation.
1. On the federal level, what rates will a person typically pay on the sale of their web based business?
The tax rates the seller of a business will typically pay will depend on their ownership structure and the terms of the deal. Sole proprietors, partners, and members or shareholders of an S Corporation will be taxed according to their personal tax situation. So a seller that has one of these structures will want to consider the overall tax consequences of the sale on their personal tax return. The ordinary income recognized on the sale of a business can move the seller into other income tax brackets so the tax impact could be greater than just the tax on the sale, it could also increase the tax on their other income as well.
The sellers may be taxed on the profit of the sale at ordinary income tax rates or favorable capital gains tax rates or a combination of the two depending on the types of assets sold. This is a big reason why the asset allocation of the sales price is so important. From the seller’s perspective it is advantageous to have as much of the sales price allocated to capital assets as possible. The gain or loss on the sale of capital assets will typically be subject to favorable capital gains tax rates.
Capital Assets:
Capital assets can include real property or depreciable personal property used in your trade or business and held for more than 1 year. Capital assets do not include property held mainly for sale to customers. Additionally, the profit from the sale of a copyright, a literary, musical, or artistic composition or similar property may be considered ordinary income rather than capital gains.
Capital Gain or Loss:
The gain or loss on the sale of capital assets is the difference between the amount you realize from a sale or exchange of property and your adjusted basis. Your adjusted basis is your original cost or other basis plus certain additions, such as the cost of capitalized improvements, and less certain deductions, such as depreciation. Typically your cost includes amounts that were capitalized rather than expensed.
Tax Rates for Capital Gains for 2014:
Long Term Capital Gains Rate:
Long Term Capital Gains Tax Rates are determined by the individuals personal income tax bracket. Below are the 2014 Long Term Capital Gains Tax Rates as they correspond to personal income tax rates.
Personal Income
|
Long Term
|
|---|---|
| Tax Bracket | Capital Gains Rate |
| 10% - 15% | 0% |
| 25%-35% | 15% |
| 39.6% | 20% |
Ordinary Income Taxes:
Some assets, such as personal property, inventory and receivables, do not qualify as capital assets and the profit on the sale of these assets are subject to ordinary income tax rates. Taxes on ordinary income can range from 10% to 39.6%. Then there are also additional taxes from the Alternative Minimum Tax, The Net Investment Income Tax, and the Additional Medicare Tax, and of course state and local taxes to consider. Finally, in some cases there may be a recapture of depreciation previous taken on assets which will be taxed at ordinary income tax rates.
For C-Corporations
For businesses structured as C Corporations the tax picture is not favorable. There are no capital gains rates for C Corporations. The tax rate paid by C Corporations on the sale of assets is the same as their ordinary income tax rates which are as follows for 2014:
- 15% on first $50,000
- 25% on next $25,000
- 34% on next $25,000
- 39% on next $235,000
- 34% on excess up to $10 mil.
After the tax is paid by the C Corporation, the individual shareholders will also pay taxes on the distribution of the proceeds. In the event the C Corporation is liquidated this return of proceeds to the shareholders would be taxed at favorable Long-Term Capital Gains Tax Rates if the shareholder owned his shares for more than a year.
2. How are broker’s fees handled?
The brokers fees are typically deductible. So the seller is typically taxed on the sales price less the cost of the sale and less their adjusted basis in the assets sold.
3. What is an Asset Allocation Agreement, and why is it important?
The asset allocation agreement is very important for tax reasons. Sales of capital assets for all but C Corporations are typically taxed at favorable capital gains rates (see the rates above in question #1). The profit on the amounts allocated to non capital assets like inventory, copyrights and unrealized receivables are taxed as ordinary income and subject to your personal tax rate (which will also be impacted by the sale). Therefore the agreed allocation of the sales price to the various assets can have a significant effect on the after tax value of the sale for the seller.
In the event there is no asset allocation agreement the tax code stipulates the sales price must be allocated to the assets sold based on their fair market value. If the buyer assumes a debt, or takes the property subject to a debt, the FMV of the asset must be reduced by the debt for this allocation. An asset allocation agreement is a very important tool in the negotiations of a favorable sale agreement that takes into consideration the impact of taxes to be paid.
4. Some buyers want to allocate a significant amount of money towards a non-compete. Does this have different tax implications for the seller?
For the seller the amount received for a non-compete agreement will typically be taxed at the less favorable ordinary income tax rates rather than at the favorable capital gains tax rates. It will be to the sellers advantage to negotiate more of the sales price to be allocated to assets subject to long-term capital gains rates.
5. How is a seller taxed when they offer financing on their sale??
Receiving payments on the sale of assets over a period of time can have very beneficial tax implications for the seller. The seller will usually bear the tax burden when he receives the payments and if that is spread out over a number of years it can result in less taxes than if he received the proceeds all in one tax year. The seller financed sale of assets are treated as installment sales and the seller pays tax on the profit portion of the proceeds he receives in a given year. The seller will also have taxable interest received as part of the payments.
For assets not qualifying as capital assets the seller must pay the tax on them in the year of the sale regardless of when they receive payment.
6. What are the Taxes on Performance Based Financing?
This type of earn out clause is very complicated and subject to special tax rules. The IRS uses the term “Contingent Payment Sales” for this type of transaction. In some situations the seller may recognize the gain or loss currently regardless of when the payment takes place. It can also be handled as an installment agreement recognizing the gain or income as the payments are received. He may also be able to recognize the gain after the basis in the property sold is recovered. The terms of the agreement can affect the profit percentage used to determine the taxable portion of the payments received in a given year. Although this can be very complicated it can favor the seller by helping him to spread out his recognized income reported over several years and help him avoid higher tax brackets.
To answer the second question, yes, typically the earn outs are taxed at the same rates based on the asset allocation. In other words if the earn out payments are applied to capital assets the profit portion of the payments can be subject to favorable capital gains rates based on the asset allocation agreement.
This can also be a very powerful way to structure a deal when the two parties do not agree on the value of the business.
7. Do you have any additional tips for people selling their business that they should consider?
As you can see from this brief overview of general tax issues, there are so many variables that can affect a seller’s tax situation and there are many more that were not discussed in this article. IRS publication 544 on “Sales and Other Dispositions of Assets” contains 42 pages on this complex subject. While this article can give a seller a general idea about the tax consequences of his sale, to understand the true tax implications of a sale there are many more factors that should be discussed with a CPA who has experience with these type of transactions.
I used the terms “typically” and “usually” because the application of the tax law is applied based on the specific facts and circumstances of the parties involved in the transaction. The sale of a business is such an important transaction in the seller’s life and they should get help from someone experienced in negotiating such deals, good legal counsel and tax advice from an experienced CPA. The sellers should retain an experienced CPA to do tax projections for them for the various scenarios being considered and provide suggestions to help minimize the tax consequences.
