Demarest: How to Minimize Taxes After Selling Your Business

So, you just sold your business, and now you are trying to figure out how to pay the IRS less money. The good news is that there are still plenty of things you can do; the bad news is that if you already sold your business, you probably missed out on a lot of planning opportunities. Like I tell a lot of my clients, you should be terrified, nervous, and reluctant when you sell your business; it is probably the largest decision and transaction that you will ever make in your life.

Unfortunately, it is also going to be the largest tax bill of your life, and if you aren’t careful, it will end up much larger than it needs to be. While I imagine that many shop owners are very charitable, an unnecessary donation to Uncle Sam is one of the worst feelings and generally not reversible. The good news is that while you have never sold a business, I have helped hundreds of shops do just that and want to share the strategies we use for our shops.

The Importance of Allocation

The single most important piece of planning generally occurs even before closing, and that is how you allocate what it is that you are selling. In almost every transaction, the deal consists of different buckets to allocate the purchase price. They are:

• Real Estate
• Equipment
• Goodwill
• Non-Compete

Since the target audience of this article is those selling the business, most of the strategies discussed will be in the eyes of a seller. Where necessary, I will note some changes that one might argue from the buyer’s perspective and also why they might care. Like most situations, a positive tax consequence for one party generally means the opposite for the other, but there are opportunities for win-win outcomes in some scenarios.

Real Estate Considerations

To begin the process of allocating the purchase price, you must first determine whether there is real estate included in the deal. For a number of reasons, splitting off the real and stripping the deal down to only the business value presents the first opportunity to try and minimize tax liability.

Since real estate sales are taxed rather favorably, there are some arguments to start getting aggressive on the price one way or another. This is not to say that you cannot argue this figure, but in most deals, the allocation to the real estate is left to an appraiser. We are just trying to find as close to fair market value as the two parties can agree to, less concerned about leveraging it for tax benefits.

If you try to get too aggressive, there is a good chance the banks won’t like it because it starts to affect their collateral position. This is also the only opportunity that you have to possibly avoid or defer the entire tax associated with the real estate sale if you decide to exchange this property for a replacement property of equal or greater value.

A 1031 Exchange (often called a like-kind exchange) allows a seller of a business to send the proceeds of his real estate to escrow and then identify and close on a replacement property of equal or greater value. For example, if you sell a $800,000 building and the proceeds get held by an attorney and dispersed to the seller of a $900,000 building, there is zero tax on this sale. 

What happens is the tax is deferred, and when you sell this replacement property, the gains are recognized then. There are also partial exchanges and even reverse 1031 exchanges that are possible, however, all involve timelines that must be considered with each scenario. The point is to be aware of options and evaluate them before closing—well before.

Allocating Business Assets

Now that the real estate value is separate, we can begin the process of allocating the purchase price of the business, and this part can get a bit more subjective. I always begin with the equipment, as it is typically the easiest place to start. For some deals, it may be the only thing that you are buying outside of goodwill.

First, figure out the fair market value of the equipment. If you were to have an auction, how much would you get for all of the equipment? The valuation of this is arbitrary at best, so the biggest thing you need to keep in mind is as the seller, you want the equipment value to be low and goodwill higher, and as a buyer, you want the exact opposite.

The reason that you want the equipment to be lower as a seller is that it is not taxed as favorably as goodwill. As a buyer, you want more on equipment because you can write off equipment faster than goodwill.

If you are a seller, you would want to argue that the equipment that’s worth $40,000 to $80,000 is worth $40,000, while the buyer might argue the exact opposite. The good news is that most people don’t realize the importance of this until it’s too late, so nine times out of 10, the buyer will agree to the seller’s number without question. You never know unless you ask!

The Non-Compete Trap

Once you have allocated the real estate and split off the equipment, everything else in the purchase price is considered goodwill. Are you done? Maybe, but for some, there is one hidden contract that could affect your taxes massively, and that is a non-compete agreement.

A non-compete agreement is taxed just like someone gave you cash and is taxed at the highest tax rates. Long story short: you do not want anything allocated to non-compete. Instead of allocating $50,000 to a non-compete, aim for $1,000 or even less.

The value of the non-compete has no bearing on its enforcement, has the same tax benefit as goodwill for the buyer, and really can hurt the seller. So, save yourself some money and don’t allocate more than you need to here.

Are There Options After the Sale?

Whether the deal is imminent or has already passed, you might be wondering if there are still options to reduce tax liability.

Yes, but probably not a material amount unless you are willing to spend a material amount of money. That answer is a bit tongue-in-cheek, but it’s the basis of most questions surrounding this: how can I get a tax deduction, defer income and taxes, but still get all the money and not spend it?

Unfortunately, if you don’t want to spend money, there aren’t any magic solutions for you. The most common strategy to reduce gains associated with selling business assets is to buy another business or buy more business assets to offset the gain.

If you have $200,000 of gain but buy $200,000 of assets, you do not have any gain, but you also don’t have any taxes. The issue is that most people don’t want to buy another business; that is the whole reason they are selling the current one.

While you are still spending cash, investing in an opportunity zone or similar venture is the only other way to defer a significant amount of tax. The workings are similar to that of a 1031 exchange with fewer stipulations. The general idea is if you put $200,000 in an opportunity zone, you lower the gain by that amount, and if you hold it for long enough, you can defer it completely. It's not something you would want to do with a large portion of the proceeds, but a very common strategy for high-income clients looking to put some of their sale to work and invest.

Final Thoughts

You have worked your entire life to create a business that you are proud of, one that has been a pillar of the community, which in turn attracted the attention of a buyer. But it’s not time to take your eye off the prize yet.

Attention to detail, planning, and communication with a skilled professional team could be worth tens or even hundreds of thousands of dollars in tax savings—or tax cost if not done appropriately. Take your time, ask questions, make informed decisions, and enjoy the next chapter of your life!