When selling your interest in a business, you must consider several factors. One very important factor is taxation. Typically, you will transfer your interest in the business to others or to your corporation in return for cash or property. This will generally result in capital gain (or in some cases, dividends) or ordinary gains.
The tax consequences to you of selling your interest in a business depend on the type of business entity. The sale of corporate stock is usually taxed as capital gain or loss, although certain redemptions of your stock could result in dividend treatment. The sale of your interest in a partnership is also usually taxed as capital gain or loss, but certain payments for unrealized receivables and inventory items are taxed as ordinary income or loss. The sale of your interest in a sole proprietorship is treated as a sale of the assets of the sole proprietorship.
Note: Long-term capital gains and qualified dividends are generally taxed at 0%, 15%, or 20%, depending on the amount of the taxpayer’s taxable income. An additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
Although myriad business entities exist, the following types will be covered here: C corporations, S corporations, partnerships, sole proprietorships, limited liability companies (LLCs), limited liability partnerships (LLPs), limited partnerships (LPs), and professional corporations (PCs).
Impact on Specific Business Entities
Tax treatment will vary, depending on the type of business entity you select.
Generally, the sale of your stock in a C corporation results in a capital gain or loss. Thus, a sale to another person or an entity other than the corporation typically results in a capital gain or loss. However, a redemption of your stock by the corporation may be treated as a sale or exchange of the stock or as a dividend.
In general, the sale of stock in an S corporation is treated the same as the treatment of the sale of stock in a C corporation. Where the redemption of your stock by an S corporation is treated as a dividend, special rules apply if the S corporation has earnings and profits from before 1983 or from when the S corporation was a C corporation.
Generally, the sale of your interest in a partnership results in a capital gain or loss. However, certain payments for unrealized receivables and inventory items are taxed as ordinary income or loss.
A sole proprietor and his or her business are indistinguishable for tax purposes. Thus, the sale of a sole proprietorship is treated as a sale of the assets of the sole proprietorship.
Limited liability company (LLC)
Generally, the sale of an interest in an LLC will be determined in accordance with the partnership rules. The tax treatment of the sale of an interest in a one member LLC (if permitted by state law) will generally be determined in accordance with the sole proprietorship rules. The tax treatment of the sale of an LLC taxed as corporation will generally be determined in accordance with the C corporation rules.
Limited liability partnership (LLP)
The tax treatment of the sale of an interest in a LLP will generally be determined in accordance with the partnership rules.
Limited partnerships (LPs)
The tax treatment of the sale of an interest in a LP will be determined in accordance with the partnership rules.
Professional corporations (PCs)
The tax treatment of the sale of stock in a PC is treated the same as the treatment of the sale of stock in a C corporation. Keep in mind that the sale of an interest in a PC can usually only be made to another licensed professional or to the PC itself.
Caution: When considering any sale of an interest in a business, be sure to examine all relevant documents or laws for restrictions or conditions placed on the sale of your interest in the business. These might include the document creating the business, a stock certificate, a buy-sell agreement, a loan agreement, or state or federal laws. Restrictions or conditions might be placed on (1) who you can sell your interest to; (2) whether, when, or under what conditions you can sell your interest; or (3) the price that you can sell your interest for.
Managing a sale of a business to result in the best possible tax scenario can be extremely complicated. Qualified tax and financial professionals can provide valuable insight and guidance.1
Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.
Disclosure: BFSG does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to BFSG’s website or blog or incorporated herein and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Please remember that different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy (including those undertaken or recommended by Company), will be profitable or equal any historical performance level(s). Please see important disclosure information here.
1. Transfer the company to a family member(s) – This seems like the easiest choice for many owners but there are several considerations like potential family issues, children(s) ability to run the company and this exit strategy may not provide sufficient cash payouts in retirement.
2. Transfer to a key employee(s) – This exit strategy provides incentives for key employees and provides business continuity. However, can the employees afford a buyout and do they have the ability to run the company?
3. Transfer via ESOP – This exit strategy can be a great alternative since it can provide cash to you upfront. The downside is complexity, costs, and this is not the right solution for some.
4. Sale to co-owners – This is one of the most elegant exit strategies and can easily be done.
5. Sale to a third party – This may provide you the most money butincreases the chances your company loses the identity and culture you worked so hard to create.
6. IPO – This is a great strategy for some, but the company should be worth at least $300 million to consider this strategy. This strategy can increase cash in your pocket but keep in mind it doesn’t completely exit you from the business.
7. Passive Ownership – This strategy can be used on its own or in conjunction with another strategy like selling to family or key employees. This allows you to retain control longer but reduces immediate cash payouts.
8. Liquidation – For some, this is the only alternative if the company’s success is based on one individual or if you need to leave the company immediately.