As a local business owner, you focus your energies and resources on growing and building the business of your dreams, and eventually selling it. But how do you know when to sell the business? Will you have enough savings to retire? Will the transition go well for the employees and clients? When selling a business, you face a number of important questions like these. There are also considerations regarding taxes. It is important to understand these considerations prior to entering into any agreement.
Consider partnership transactions: Accounts receivable and inventory are known as “hot assets,” which fall under IRS Code Section 751. Without additional consideration, the seller of a business may assume that any gain occurring upon the sale will result in long-term capital gains, which are taxed at a more favorable rate than ordinary income. These so-called hot assets will actually be treated as ordinary income, not long-term capital gains.
For example, let’s say Dr. Alex Partner owns a 50 percent interest in a dental practice that is organized as a partnership. The practice has accounts receivable (hot assets) of $900,000. Dr. Partner has no basis in his partnership interest. Dr. Partner sells his interest for $2,500,000. This results in an overall gain of $2,500,000. Dr. Partner would then have ordinary income of $450,000 (50 percent of the $900,000 in hot assets), and then a long-term capital gain of $2,050,000. The difference in ordinary income rates (assume a 39.6 percent federal tax bracket) and long-term capital gains (23.8 percent tax rate) on the $450,000 of hot assets would result in approximately $70,000 of additional federal income taxes. Given the significant differences in capital gains and ordinary income rates, additional tax planning considerations should be given to the owners of partnerships when inventory and accounts receivable are involved.
Consult your fee-only financial planner or tax professional for more information on the impact of selling your business.
About the Author
Andrew Young, CPA/PFS, CFP
Galecki Financial Management Inc.