Navigating Tax Implications When Selling a Small Business

The short answer: 20% federal capital gains tax plus your state capital gains tax. Almost every owner asks us the tax question. Selling a small business is a significant financial decision with sometimes complex tax implications. Understanding these implications can help you make more informed choices about when and how to sell, and potentially reduce your tax liability. Here we’ll explore the federal and state capital gains tax rates and discuss a strategy known as a deferred sales trust that could help you defer taxes.

Federal Capital Gains Tax Rates

When you sell your small business, the profit you make is typically subject to capital gains tax. Under federal tax law, capital gains are classified either as short-term or long-term based on how long you have held the assets before selling them. Short-term capital gains (for assets held for one year or less) are taxed at your ordinary income tax rates, which can range from 10% to 37%.

Long-term capital gains (for assets held more than one year) are taxed at lower rates, depending on your taxable income. For most taxpayers, the rates are either 0%, 15%, or 20%. However, those with significantly high incomes might also pay an additional 3.8% Net Investment Income Tax. Here are the general brackets for long-term capital gains in 2023:

• 0% rate applies if your income is up to $41,675 for single filers or up to $83,350 for married filing jointly.
• 15% rate is generally for incomes ranging from $41,676 to $459,750 for single filers and $83,351 to $517,200 for married filing jointly.
• 20% rate applies if your income exceeds $459,750 for single filers or $517,200 for married filing jointly.

Therefore, most of our business owners pay 20% federal cap gains tax. Now for the second part. 

State Capital Gains Tax Rates

State capital gains tax rates vary widely, adding another layer of complexity. Some states, like Florida and Texas, have no state income tax and therefore no additional capital gains tax. Others have high tax rates that can significantly affect your total tax bill when selling a business. For instance:

• California: As high as 13.3%.
• New York: Up to 8.82% plus local taxes in places like New York City.
• Minnesota: Around 9.85%.

This is in addition to your federal cap gains tax. So for example, Californians may pay a combined 33%+ tax rate on their sale

Deferring Taxes with a Deferred Sales Trust

For those looking to minimize the immediate impact of capital gains taxes, a deferred sales trust (DST) might be a suitable strategy. A DST is a type of trust into which you can transfer your business before the sale. Here’s how it generally works:

1. Set Up the Trust: Before selling your business, you set up a DST with the help of an attorney or financial advisor who specializes in such arrangements.
2. Sell the Business to the Trust: You then sell your business to the trust, which sells it to the final buyer. This transaction separates the business sale from the direct receipt of funds by you, the original owner.
3. Receive Payments: Instead of receiving a lump sum, you receive an installment payment plan from the trust, which can spread out over several years. This not only defers your taxes but can also potentially keep you in a lower tax bracket each year, reducing the overall tax rate on your gains.

We can refer you to a DST management company. They usually charge a small percentage to manage the funds.

Conclusion

Selling a small business involves navigating a complex landscape of federal and state tax regulations. By understanding these taxes and considering strategies such as the deferred sales trust, you can potentially reduce the immediate tax burden and improve your financial outcomes after the sale. As with any significant financial decision, it’s advisable to consult with tax professionals and financial advisors who can provide guidance based on your specific circumstances and the latest tax laws.