If you’re a business owner and know you eventually want to retire, make sure you understand how passing down or selling your business works. Business sales are increasing as more Baby Boomers retire and the potential for changes to the tax code may be partially driving the trend. As a business owner, it’s important to know what the rules are now and how they could change in the future.
How Is The Sale of a Business Taxed?
A business usually has many assets, all which must be classified into categories (capital assets, depreciable property, inventory, etc) when a business is sold.1 Individual assets will be treated as if they are being sold separately. Assets held for longer than a year are taxed as long-term capital gains, and certain assets like inventory not held for a year are taxed at ordinary income rates. There may be issues with receiving tax benefits from the sale of a business if you’re putting personal expenses through the business in the few years before you sell, plus claiming a smaller income could potentially negatively impact your business valuation. Be aware that claiming personal expenses also used for business may or may not cause a problem if you’re audited or when it comes time to sell.2 This is why it’s important to plan ahead and work with a professional who can guide you through the somewhat ambiguous rules.
Passing on a Family Business
If you want to gift your business to a family member, understand the tax and estate planning consequences. Property that is transferred to someone for free or for less than its fair market value is taxed under gift and estate tax rules. If the original owner is still living, the gift tax applies, while the estate tax applies after the original owner’s death. Business sales that happen when the original owner is alive may be subject to capital gains taxes, imposed on the difference between the adjusted basis of the business and its sale price. Businesses generally receive a step-up in basis upon the death of the original owner, which means that taxes are based on the value of the business at the time of the owner’s death and not when it was originally bought or started.
What Changes Could We See?
The Biden Administration’s proposed tax changes in the American Families Plan would mean very different estate planning rules: President Biden proposes to tax inherited unrealized capital gains – meaning that his proposal would repeal the step-up in basis rule. The plan would also raise the total top rate of capital gains to 40.8%, and it would apply to unrealized capital gains at death.3 This means that if someone started a business decades ago that’s now worth $100 million, his or her heirs would immediately owe a capital gains tax of almost $43 million upon death of the owner instead of the business being exempt from capital gains because of the step-up in basis rule currently in place. The combined tax rate would be highest in almost a century according to the Tax Policy Research Group.4
When it comes to selling or passing on a business, it’s crucial to consider the tax and estate planning implications. You worked hard to build your business, and the difference between pursuing a tax-smart selling strategy and not having a plan could potentially be a substantial amount of money. If we see the Administration’s proposed changes come to fruition, tax and estate planning will become even more important for business owners. Just like how you’re an expert at your trade, we’re an expert at ours and want to help. We can look at your business and unique financial situation to create a business owner retirement plan designed specifically for you – get in touch with us today to schedule your complimentary business selling strategy session.