IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities. Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Seth Rudin. Mr. Rudin is a senior business broker at IBA (www.ibainc.com):
Understanding Tax Allocation When Selling Your Business: A Quick Guide for Business Owners
If you’re a business owner considering selling your business, you probably have a long list of things to think about:
- finding the right buyer
- negotiating the best sale price
- making sure everything runs smoothly after the sale
One area you might not have considered yet is tax allocation. While it might not seem like the first step or the most glamorous part of selling a business, it’s critical to understand how taxes impact the sale. In this blog, we’ll break it down at a high level and explain why understanding tax allocation is essential when selling a business, especially across different states.
What is Tax Allocation?
Tax allocation refers to how the total sales price of your business is divided among different assets for tax purposes. When you sell your business, you’re not just selling one entity; you’re typically selling various assets such as equipment, real estate, intellectual property, goodwill, and more. Each of these asset categories can be taxed differently, which can greatly impact the amount of taxes you and the buyer will pay.
The IRS requires both the seller and buyer to agree on how the sales price is allocated among these assets, and this allocation must be reported using IRS Form 8594 (https://www.irs.gov/forms-pubs/about-form-8594). This ensures that both parties are on the same page and report the sale consistently. Misreporting or disagreements can lead to audits, penalties, or extra taxes.
Why Tax Allocation Matters
Different Tax Rates: Not all assets are taxed the same. For example, the inventory a company holds (e.g., raw materials or finished goods) is valued at what the company originally paid for it, not at its current market value or any potential profit so no taxes will be charged. Equipment, however, is typically taxed based on how much it has depreciated and the type of sale transaction involved. In contrast, other assets like goodwill (the value of your brand and customer relationships) may be taxed at a lower capital gains rate. Proper allocation during the sale can help minimize your tax burden.
Taxes Also Impact the Buyer: The buyer of your business may also have different tax considerations. For instance, they may want to allocate more of the sales price to assets they can depreciate quickly, reducing their future tax liability. The tax allocation should work for both parties, but protecting your financial interests as the seller is important.
IRS Compliance: The IRS closely monitors how these transactions are reported. By requiring both parties to file Form 8594, the IRS ensures that both the seller and buyer treat the sale consistently. Errors or mismatches can trigger an audit; no one wants that!
How Does It Work? View this Example
Let’s say you’re selling your business for $1,000,000. That amount could be divided like this:
- Equipment: $200,000 – typically the seller is taxed at his/her ordinary tax rate on any sale value above the book value of the assets and in sales tax states like Washington, the buyer will pay a sales tax on the transfer just like when you buy most other tangible items in the state
- Inventory: $100,000 – since the inventory is at cost, typically there is no tax implication.
- Real Estate: $300,000 – usually taxed at the current, appropriate capital gains rate (https://www.irs.gov/taxtopics/tc409)
- Goodwill: $400,000 – usually taxed at the current, appropriate capital gains rate.
- Non-Competition Agreement – usually taxed at a party’s personal tax rate
- Consulting – usually taxed at a party’s personal tax rate
Each of these categories will be taxed differently. Equipment, for example, might be subject to regular income tax rates, while goodwill could be taxed at the lower capital gains rate. The goal is to allocate the sale price in a way that’s fair and minimizes your tax liability.
Why You Should Speak to a CPA
The specifics of tax allocation can get complicated, so it’s important to consult with your CPA or tax advisor before finalizing a sale. They can guide you through:
- Maximizing tax savings based on your unique situation.
- Ensuring compliance with IRS regulations.
- Assisting with filing of Form 8594 to avoid any mistakes.
Here’s a specific example where a CPA can assist: capital gains tax treatment can vary depending on your location. In Washington and Oregon, the treatment of capital gains can differ, and these distinctions could significantly affect your post-sale financials. Washington state also has certain exemptions regarding the WA state capital gains tax that applies to many Washington small business owners. Washington state voters will get the opportunity to repeal their state’s Capital Gains this November with initiative 2109 – click here for more information https://washingtonstatestandard.com/2024/05/06/wa-decides-initiative-2109-to-repeal-the-states-capital-gains-tax/
Additionally, the handling of equipment sales adds another layer of complexity. In Washington, selling equipment as part of a house or business sale could incur sales tax, while Oregon doesn’t have a sales tax, which could lead to different outcomes for sellers depending on the state.
A tax expert will ensure you fully understand the tax allocation process and help you maximize the benefits of your sale, no matter which state you’re in.
Final Thoughts
Selling your business is a huge milestone and getting the tax details right is essential. Proper tax allocation ensures you do not pay more than you need to and helps avoid issues with the IRS. While you don’t need to be a tax expert, understanding the basics can help you confidently navigate the process. Just remember to consult with your CPA for the more intricate details—they’ll help you get the most out of your sale and keep you compliant.
By having a general understanding of tax allocation, you’ll be in a better position when it comes time to negotiate the sale of your business. Don’t let the tax side of things catch you off guard; get ahead of it now and set yourself up for success!
If you have questions relating to the content of this article or the process associated with selling a business in Washington or Oregon, Seth Rudin would welcome the opportunity to talk with you. Mr. Rudin is licensed to sell businesses & real estate in both Washington and Oregon. Mr. Rudin can be reached at (425) 454-3052 or seth@ibainc.com.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, real estate, accounting, legal, and financial planning communities on subjects relevant to the purchase & sale of privately held companies and family-owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.