Taxes can cut deep into your profit when you sell a business. But sometimes “paying more” can help you save. Whether you’re looking to pass your business down to heirs or sell it outside the family, some surprising tax strategies can make the sale more profitable.
By instinct, you may think that pushing everything you can under the umbrella of a relatively low Capital Gains Tax (the tax on the profit of the sale) is the best thing to do when selling your business. But paying taxes at the Ordinary Income Tax rate rather than the Capital Gains Tax rate could, instead, put more money in your pocket. Here’s why:
Currently, long-term capital gains max out at 20 percent, plus an additional 3.8 percent if the seller is also subject to the new Medicare Tax on Net Investment Income (effective 1/1/13 as part the Affordable Care Act). Capital gains paid to the seller are usually funded by the buyer. But the buyer must first pay Ordinary Income Tax on these funds. This can cause a snowballing effect with quite dramatic results.
To illustrate this, assume that a seller was going to be paid $1,000 for his business. After paying both Capital Gains Taxes (including the Medicare Tax), the seller has a net of $762. At the same time, in order to give the seller $1,000, the buyer must earn $1,767 to pay taxes of $767 and give the seller $1,000. When it’s all said and done, the combined tax bill of the two parties is $1,005 or approximately 56.9 percent. This is quite remarkable, given the fact that the maximum tax rate is actually 43.4 percent!
If the buyer and seller cooperate, the buyer could pay $1,590 (saving 10 percent of the total cost) and the seller could receive $900 net after taxes. That’s an after tax increase of 18 percent to the seller. And the only change is in how taxes were handled between the two parties.
The lesson here is to work with the buyer as a team instead of getting distracted by your own tax fears. What you could perceive as a loss could be a win when you step back and look at the entire tax puzzle. Start out with a well-devised plan before you put up the “for sale” sign. And, of course, contact us for advice for your specific situation.
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