One of the first questions business owners ask when they start thinking about selling their business is also one of the most complex: “How is the sale of my business going to be taxed?”
The short answer is – it depends. The longer and more helpful answer depends on how the sale is structured, what type of business entity you own, and how payment for the business is made.
At Davis Law Group, we generally begin these conversations by walking clients through two primary types of transactions:
Asset sales
Stock sales or the sale of membership interests in a limited liability company
Each has very different tax consequences and liability considerations, particularly under Virginia law.
Asset Sale vs. Stock Sale: What’s the Difference?
Asset Sale
In an asset sale, the buyer purchases specific assets of the business rather than the business entity itself. These assets may include equipment, inventory, intellectual property, customer lists, technology, the website, the name, the phone number, real estate, and what is considered “goodwill.”
The seller retains the legal entity, along with any liabilities not specifically assumed by the buyer. You might wonder why a buyer would want to buy the assets but not the entity of a business. There are several reasons, but the common ones are that it gives the buyer the ability to “step up” the tax basis of purchased assets, it gives them selective assumption of liabilities, and it has less exposure to unknown (or known) risks.
From a tax standpoint, asset sales can be more complex and sometimes more expensive for sellers. That’s because different assets are taxed differently. Inventory and depreciation recapture are often taxed as ordinary income while goodwill and certain intangible assets may qualify for capital gains treatment. For C corporations, an asset sale can result in double taxation if the corporation pays tax on the sale of assets and then shareholders pay tax again when proceeds are distributed. The purchase price allocation for tax purposes between buyer and seller, is often one of the most important parts of the transaction.
Keep in mind that Virginia generally conforms to federal tax treatment, meaning these federal distinctions flow through to Virginia income tax obligations as well.
Stock Sale (or Membership-Interest Sale)
In a stock sale, the buyer purchases the seller’s ownership interest in the entity—shares of stock in a corporation or membership interests in an LLC. The business entity remains intact, including its assets, contracts, and liabilities.
Sellers generally prefer a stock sale option because this transaction is typically taxed at capital gains rates, which in most situations is a lower rate than ordinary income tax rates. It also allows for a cleaner exit for the seller. This option also has no entity-level tax for pass-through entities like S corporations or most LLCs.
Buyers may be more cautious about this option because it means they inherit all known and unknown liabilities. It will require them to do more extensive due diligence, and there are fewer opportunities for depreciation write-offs or expense deductions after the sale.
From a Virginia perspective, stock sales are often simpler administratively but still require careful review of corporate governance documents, shareholder agreements, tax related filings by the entity and legal compliance history.
How Payment Structure Affects Taxes
In addition to two primary ways that businesses are purchased, there are also two primary ways the actual payment can be made. Like everything, there are pros and cons to both.
Lump-Sum Sale (Single Closing)
In a lump-sum sale, the entire purchase price is paid at closing. What this does is cause all taxable gain for the seller to be recognized in the year of the sale. This may push the seller into a higher tax bracket for that year, causing them to pay more taxes out of pocket. And keep in mind, once again, Virginia income tax is due in the same year as federal tax, so this could bump up both state and federal tax liability. Although the seller is paid the entire purchase price in one calendar year at closing, a significant short-term tax burden may result.
Installment Sale
An installment sale allows the seller to receive payments over time – often over several years. In this scenario the gain from the sale is recognized proportionally as payments are received. An installment sale distributes the income across multiple tax years, potentially keeping the seller in their current tax bracket (or lower, if they are no longer taking income from the business). This may reduce the overall tax burden of the sale.
However, any interest income received by the seller on installment payments is taxed as ordinary income, so that should also be considered when calculating the overall effect of an installment sale. Virginia generally follows federal installment-sale rules, but the timing of income recognition can still have meaningful state-tax implications. The potential downside for a seller on an installment sale is that the buyer may default on payments so securing the obligation of the buyer with personal guarantees, real estate, stock or the assets of the company, is very important.
Liability Considerations
While taxes are often the primary concern when considering selling a business, liability exposure is just as important. Asset sales can limit both a buyer and a seller’s post-sale exposure if structured properly. Stock sales may leave sellers exposed through representations, warranties, and indemnification provisions, and buyers may be exposed through unknown liabilities of the acquired business. Virginia contract law governs how these risks are allocated—and poorly drafted agreements can undo even the best tax planning.
How the sale of a business is taxed isn’t something you should wait to find out at the closing table. That’s why you shouldn’t tackle this process alone. When discussing and planning for the sale of the business you’ve worked hard to build, you should always consult your attorney, your CPA or tax advisor, and your financial planner.
Early planning and expert input can preserve more of the sale proceeds, reduce unnecessary tax and liability exposure and align the structure of the deal with your long-term goals.
Davis Law Group Can Help
There is no one-size-fits-all answer to how a business sale should be structured and therefore how it will be taxed. It should all depend on your entity type, your goals, the buyer’s priorities, and both federal and Virginia tax law.
If you’re considering selling your business – or even just starting to explore your options – it’s worth having the conversation early, before key decisions are locked in or agreements are made with potential buyers. Contact our office today to arrange a consultation with one of our experienced corporate attorneys and give yourself some peace of mind.
Disclaimer: This article is for general informational purposes only and does not constitute legal or tax advice.
How Will the Sale of My Business Be Taxed?
One of the first questions business owners ask when they start thinking about selling their business is also one of the most complex: “How is the sale of my business going to be taxed?”
The short answer is – it depends. The longer and more helpful answer depends on how the sale is structured, what type of business entity you own, and how payment for the business is made.
At Davis Law Group, we generally begin these conversations by walking clients through two primary types of transactions:
Each has very different tax consequences and liability considerations, particularly under Virginia law.
Asset Sale vs. Stock Sale: What’s the Difference?
Asset Sale
In an asset sale, the buyer purchases specific assets of the business rather than the business entity itself. These assets may include equipment, inventory, intellectual property, customer lists, technology, the website, the name, the phone number, real estate, and what is considered “goodwill.”
The seller retains the legal entity, along with any liabilities not specifically assumed by the buyer. You might wonder why a buyer would want to buy the assets but not the entity of a business. There are several reasons, but the common ones are that it gives the buyer the ability to “step up” the tax basis of purchased assets, it gives them selective assumption of liabilities, and it has less exposure to unknown (or known) risks.
From a tax standpoint, asset sales can be more complex and sometimes more expensive for sellers. That’s because different assets are taxed differently. Inventory and depreciation recapture are often taxed as ordinary income while goodwill and certain intangible assets may qualify for capital gains treatment. For C corporations, an asset sale can result in double taxation if the corporation pays tax on the sale of assets and then shareholders pay tax again when proceeds are distributed. The purchase price allocation for tax purposes between buyer and seller, is often one of the most important parts of the transaction.
Keep in mind that Virginia generally conforms to federal tax treatment, meaning these federal distinctions flow through to Virginia income tax obligations as well.
Stock Sale (or Membership-Interest Sale)
In a stock sale, the buyer purchases the seller’s ownership interest in the entity—shares of stock in a corporation or membership interests in an LLC. The business entity remains intact, including its assets, contracts, and liabilities.
Sellers generally prefer a stock sale option because this transaction is typically taxed at capital gains rates, which in most situations is a lower rate than ordinary income tax rates. It also allows for a cleaner exit for the seller. This option also has no entity-level tax for pass-through entities like S corporations or most LLCs.
Buyers may be more cautious about this option because it means they inherit all known and unknown liabilities. It will require them to do more extensive due diligence, and there are fewer opportunities for depreciation write-offs or expense deductions after the sale.
From a Virginia perspective, stock sales are often simpler administratively but still require careful review of corporate governance documents, shareholder agreements, tax related filings by the entity and legal compliance history.
How Payment Structure Affects Taxes
In addition to two primary ways that businesses are purchased, there are also two primary ways the actual payment can be made. Like everything, there are pros and cons to both.
Lump-Sum Sale (Single Closing)
In a lump-sum sale, the entire purchase price is paid at closing. What this does is cause all taxable gain for the seller to be recognized in the year of the sale. This may push the seller into a higher tax bracket for that year, causing them to pay more taxes out of pocket. And keep in mind, once again, Virginia income tax is due in the same year as federal tax, so this could bump up both state and federal tax liability. Although the seller is paid the entire purchase price in one calendar year at closing, a significant short-term tax burden may result.
Installment Sale
An installment sale allows the seller to receive payments over time – often over several years. In this scenario the gain from the sale is recognized proportionally as payments are received. An installment sale distributes the income across multiple tax years, potentially keeping the seller in their current tax bracket (or lower, if they are no longer taking income from the business). This may reduce the overall tax burden of the sale.
However, any interest income received by the seller on installment payments is taxed as ordinary income, so that should also be considered when calculating the overall effect of an installment sale. Virginia generally follows federal installment-sale rules, but the timing of income recognition can still have meaningful state-tax implications. The potential downside for a seller on an installment sale is that the buyer may default on payments so securing the obligation of the buyer with personal guarantees, real estate, stock or the assets of the company, is very important.
Liability Considerations
While taxes are often the primary concern when considering selling a business, liability exposure is just as important. Asset sales can limit both a buyer and a seller’s post-sale exposure if structured properly. Stock sales may leave sellers exposed through representations, warranties, and indemnification provisions, and buyers may be exposed through unknown liabilities of the acquired business. Virginia contract law governs how these risks are allocated—and poorly drafted agreements can undo even the best tax planning.
How the sale of a business is taxed isn’t something you should wait to find out at the closing table. That’s why you shouldn’t tackle this process alone. When discussing and planning for the sale of the business you’ve worked hard to build, you should always consult your attorney, your CPA or tax advisor, and your financial planner.
Early planning and expert input can preserve more of the sale proceeds, reduce unnecessary tax and liability exposure and align the structure of the deal with your long-term goals.
Davis Law Group Can Help
There is no one-size-fits-all answer to how a business sale should be structured and therefore how it will be taxed. It should all depend on your entity type, your goals, the buyer’s priorities, and both federal and Virginia tax law.
If you’re considering selling your business – or even just starting to explore your options – it’s worth having the conversation early, before key decisions are locked in or agreements are made with potential buyers. Contact our office today to arrange a consultation with one of our experienced corporate attorneys and give yourself some peace of mind.
Disclaimer: This article is for general informational purposes only and does not constitute legal or tax advice.
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