PEMBROKE, Mass. — Every so often, I get a call that goes something like this: “I’m about to sell my business and my accountant says I will owe $150,000 in taxes. How can I avoid paying such an outrageous amount?”
I realize that you’ve worked hard all your life and plotted and crimped to build up a solid equity base, something you can count on for retirement.
I also understand that you hope to obtain a large amount of money when you finally sell your business. Having said that, you also drew a comfortable salary for most of those years and afforded your family a decent lifestyle.
Along the way, there have been some ownership benefits. Your car paid for through the business? A petty cash account to spend at your discretion? Most of the restaurant meals you and your wife enjoy through the business?
So, you haven’t exactly been undercompensated all these years.
The thing to realize is, taxes are a fact of life. Taxes have been withdrawn (to mitigate the pain) from your wages all the years of working. Every purchase you make has a 5-7% sales tax added to the bill.
You pay quite a bit of property tax just to live on a plot of land you purchased years ago. When you and your spouse die, a chunk of taxes could be pulled out to pay estate taxes. So when you sell your business, you should not be surprised that taxes are due.
Say you started a business with $50,000 capital. Thirty years later, you sell it for $1 million. Since you depreciated the capital, that’s a capital gain of $1 million.
Depending on the transaction and the state you do business in, you pay taxes anywhere from 20% to 35%, between federal and state taxes. The exact amount is a complicated formula.
First, divide the sale amount into assets, depreciation recapture, and goodwill. This is an important breakdown because assets are taxed as ordinary income; depreciation recapture is taxed at 25%; and goodwill is taxed as capital gains.
While goodwill gains max out at 15%, depreciation recapture is usually 25%, and ordinary income maxes out at 39.6%.
The problem with ordinary income-taxing is that a one-time sales raises your income into the higher brackets quickly. Another issue is the buyer benefits from a greater goodwill allocation while the seller benefits from a greater asset allocation.
So, the exact division is a compromise. Once you’ve assigned the allocation, you compute the federal taxes. Finally, state taxes have to be computed. The bottom line is that you might pay anywhere from 20% to 35% to the government.
Having said all of this, there is one way to reduce your tax liability. That is selling the business over time, which is called selling on the installment plan.
In the example I cited, the business that sold for $1 million results in a $100,000 annual payment for 10 years. That’s an installment sale. Under this method, your tax liability would be quite reduced.
Maybe you might pay 15% to 20% in taxes. But I would not recommend this method. Let me repeat louder: “I would not recommend selling your business through the installment plan!” Your risk of not getting paid the full amount is very high.
Even more, the pressure on the buyers is lessened so that they might not do their very best, which further erodes the business’ chances of success. It’s quite different when buyers plunk down the full investment.
For all of these reasons, there are many possibilities for things not working out. Maybe the buyers don’t adapt to the business. Or perhaps the employees don’t like their new bosses.
It could happen that the buyers are dishonorable, and try to get out of their obligations. They could stop paying and argue that the seller did not disclose all the information of the sale. Then you would take the buyers to court.
The point is, when it comes to money obligations, anything can happen, and it often does.
Check back Thursday for the conclusion.