Tax On Business Sale? Company, Owners Or Both May Pay IRS

FROM FORBES.COM

The sale of a business is usually a big event in the owner’s life. Many people work for decades or a lifetime before selling. Others build and sell multiple businesses every few years. There are also mega and serial buyers and sellers like Warren Buffett, one of the most tax savvy of all. Selling a business almost always incurs one tax, and often two. The business entity may be taxed, and the shareholders or owners may too. You hope to limit your tax hit to one tax, not two. If you are really lucky or clever, paying no tax is even better. That is possible if you are receiving stock and rolling your gain into another or reorganized company. Think of Mr. Buffett, who has often managed to roll over investment gains without triggering a tax. Earning pre-tax is always better than earning post-tax.

The mechanics of sale are important. If your business is operated as an LLC, you could sell membership interests, or the LLC itself could sell its assets. If the business is a partnership (general or limited) the sale could be made by the partnership (a sale of assets). Alternatively, the partners could sell their partnership interests. You might think that all these avenues lead to the same place. Actually, if you sell corporate stock, you change who owns the company, but the company is still in place, and still owns its assets. The same is true if you sell a partnership interest or LLC membership interest. Even if all of the owners sell their interests, the entity still owns the assets.

To see the tax differences between these mechanical variations, you must follow the money. If a partnership, LLC or corporation sells assets, the purchase price is paid to the entity, which may (or may not) distribute the sales proceeds to the owners. Regardless, the sale will have tax effects. To assess it, you need to know the tax basis of the entity's assets. The tax basis is the company's purchase price for the assets, less accumulated depreciation, plus certain adjustments.

Say a company sells its assets for $5 million. To determine taxes, you need to know the business’ basis in these assets. If its basis is $2 million, there’s a $3 million gain. If its basis is $6 million, there’s a $1 million loss. Sometimes this kind of basis is called “inside” basis, meaning the tax basis inside the entity. Depending on the type of business entity, this gain may be taxed to the entity or to its owners. For example, if a C corporation sells its assets for $5 million with a $2 million basis, that $3 million gain will be taxed to the corporation at 21%. That will leave less money to distribute to shareholders.

But if an LLC or partnership sells assets for $5 million at a $3 million gain, there is no tax at the entity level. The full $5 million can pass through to the owners, who pay their share of the $3 million gain. If you think C corporation treatment is better because the entity pays the tax, think again. After all, when shareholders of a C corporation receive distributions from the corporation, they must also pay tax at their individual rates. That is a second tax.