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You’ve worked long and hard to build your business, and now it’s time to enjoy a relaxing retirement. But before you can spend your days on the golf course or going to the park with your grandkids, you’ll need to figure out your exit strategy.

While the bulk of succession planning involves deciding what you want to do with your business when you step away, it’s also important to consider the potential tax implications of your decision. Since your business is likely one of your largest assets, the amount of tax you’ll owe could be quite significant. Understanding the tax rules that apply to the most popular exit strategies may influence your ultimate decision. Here’s a brief overview of some important points you need to know.

Tax Rules for a Business Sale

If you’re thinking about selling your business outright, then the bulk of your taxes will be based on your profit from the sale. Capital gains taxes are based on the difference between what you paid for your business and the price you sold it for. Other things, like the cost of capital improvements and equipment depreciation, can also decrease your capital gains.

Let’s look at a quick example. Assume you purchased a business for $200,000 and then built on an addition that cost you another $100,000. Later, you sell the business for $350,000. In this case, you would have a capital gain of $50,000.

If you’ve held your business for less than a year before you sold it, your capital gains are taxed at your ordinary income rate. This is the same rate you pay on the earnings in your paycheck. Depending on your income, your ordinary tax rate will fall somewhere between 10% and 37%.

If you’ve held your business for more than a year, you’ll be taxed at what is known as a “long-term capital gains rate.” This currently ranges between 0% and 20%, depending on your taxable income and your tax filing status.

Reducing Tax Liability

If you’ve held your business for less than a year, waiting a little while could be the smartest thing you can do to reduce your tax liability. This is particularly true if you’re in a high income tax bracket.

You may also want to consider an installment sale. This will allow you to spread your income out over several years, which could help decrease your tax liability. Instead of a traditional installment sale, you could also stay on as a paid “consultant,” earning an agreed-upon “salary” for a few years after the sale. However, it’s important to remember that this would be taxed as ordinary income, rather than as capital gains. 

Tax Rules for Employee Share Issuance

Setting up an employee stock ownership plan (ESOP) gives your employees an ownership interest in your business. This is one type of succession planning strategy that will help you retire from your business while also incentivizing your employees.

Issuing shares under this type of plan creates a number of potential tax benefits. For example, contributions to an ESOP are tax-deductible (within limits). This includes contributions of stock and cash. If you borrow from an ESOP, both the principal and the interest you pay back are also tax-deductible.

Tax Deductibility Rules

To maintain tax-deductibility, you must follow regulations established by the Internal Revenue Service (IRS) and the Department of Labor (DoL). First, you must contribute to the ESOP accounts of all eligible employees. In most cases, this is all employees over the age of 21 who have worked for your company for at least a year. You must also make contributions equitably, for example, as a percentage of salary or a set dollar amount to all eligible employees.

Finally, you must also follow one of two approved vesting schedules. This guarantees employees will have full ownership of the stock in their accounts after a set amount of time.

Taxation on Sale

If you’re structured as an “S Corporation,” when you sell your business, the amount owned by the ESOP is exempt from federal taxes (and many states as well). So, if the company is 100% ESOP-owned, you would not owe any federal taxes. If you’re a “C Corporation,” selling shareholders can also defer capital gains by using a 1042 tax deferral.

Tax Rules for Gifting Your Business

Many business owners plan to gift their business to a family member or key employee. In this case, you’ll want to be aware of gift and estate tax rules. These rules apply any time property is transferred to another person for free or for an amount that is less than the fair market value.

If you gift the business while you’re still alive, the difference between the amount that was paid for the business and its fair market value (FMV) could be subject to gift tax. The good news is, current gift tax laws are very lenient.

In 2021, you can gift up to $15,000 per year, per recipient, without having to file a gift tax return. In addition, every taxpayer also gets a lifetime gift tax exemption of $11.7 million. As long as your business is worth less than that, you can gift it freely without having to worry about tax liability. If you’re not sure how to determine the valuation of a business, you’ll want to work with an expert to get a professional valuation before you start your gifting strategy.

Start with a Business Valuation

No matter what you decide to do with your business, you’ll need to understand the tax liabilities your decisions will create. This is an important part of succession planning that cannot be overlooked.

If you’re concerned about your tax liability, you’ll want to start your planning by getting a business valuation. Not only will this help you determine an appropriate price for your business, but it can also help you estimate your potential tax liability and look for ways to lessen the impact.

For an accurate business valuation that you can trust, look to the experts at GrowGrade. You can get started with a free business valuation in under 5 minutes. Try it out today!

GrowGrade, M&T Bank and their affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.