A topic we are often asked about is on taxes relating to the sale of assets. This is a serious consideration for sellers who are US tax residents, so having a basic understanding upfront can save you time and money during a sale or acquisition process. And with potential changes coming soon to capital gains tax rates, it is important to remain informed.
Be under no illusion, tax is not an interesting topic, so many sellers overlook it until it is too late… However, once you make it through this whole article, you will have a better understanding of the implications of an asset sale, or at the very least, ensure you are well equipped when talking to a CPA or tax accountant.
Complete Guide to Online Business Sale Taxes
Timing the Sale of Your Online Business
This article is focused on sole proprietors, partners, members of an LLC and shareholders of S Corporations. These are by far the most common types of sellers. These sellers will be taxed in line with their personal taxes, so taking a holistic view over the sale is advisable.
Depending on the income generated in a period, the sale of the business may move an individual into a higher tax bracket, so timing should be carefully considered when selling.
For a single business owner there may be some flexibility over the timing of the sale, however, for partners the income tax position of one may affect the tax paid by another. Having clearly defined sale objectives and timings outlined upfront as part of exit planning may remove any unwelcome surprises at the point of sale. It may also remove the temptation to increase the valuation of the business to bridge the gap left by unforeseen taxes.
It is prudent to ensure that the tax implications marry with the broader timing considerations of selling the business, including the business and product lifecycles, as well as industry trends and seasonality.
The Basics: Income Tax or Capital Gains?
There are two main taxes on selling a business that you need to be aware of – income tax and long-term capital gains.
Compared to income tax rates, long-term capital assets (an asset held for over one year) can be subject to favorable capital gains rates. Due to possible changes, it is expected that the more favorable capital gains tax rate will apply for those earning less than $1 million in that year.
For 2021, tax rates on ordinary income are as follows:
The tax rates for capital gains for taxpayers with income of $1 million or more are expected to increase as part of the American Families Plan. The current top rate is 23.8%, while the proposed top rate is 43.4% (including the net investment income surtax). The effective date for these changes has not been announced yet. For those considering divesting of their SaaS, e-commerce or content businesses, now might be a good time to do so, before these changes take effect.
What is a Capital Asset?
Nearly everything you own is likely to be a capital asset. This applies to personal assets, assets for pleasure, business assets or investments.
As a rule of thumb, businesses are not sold as one asset. While the sale of the business has a total consideration, the business is made up of several tangible and intangible assets, which may be treated differently in terms of taxation.
When a business is sold, the assets are classified as:
- Capital assets
– The sale of capital assets result in a capital gain or loss. - Depreciable or real property (used in the business)
– If held longer than 1 year results in gain or loss from a section 1231 transaction - Property held for sale to customers (i.e. inventory or stock in trade)
– Results in ordinary income or loss
There are also classifications for the sale of partnership and corporation interests and corporate liquidations. Speak to a CPA or tax accountant to get a good idea about what is and is not a capital asset in relation to taxes for online businesses.
What are Non-Capital Assets?
The IRS has a long list of non-capital assets. The main assets of interest for online businesses sales include:
- Stock in trade, inventory, and other property you hold mainly for sale
- Accounts or notes receivable
- Depreciable property used in your trade or business
- Real property used in your trade or business
- A patent or copyright
- Supplies of a type you regularly use
Establishing a Capital Gain/Loss?
Now you have established what is and what is not a capital asset in relation to the business sale, you can properly establish capital gains on selling a business for taxation purposes, or indeed losses.
A capital gain/loss is the delta between the sale price of the capital asset and the basis – basis: acquisition cost plus increases like cost of improvements less decreases such as depreciation.
Gain/Loss = Total consideration of assets – basis (cost of acquisition + cost of improvements)
Keep accurate records in relation to establishing basis in order to see the full benefit in your Schedule D.
By classifying the maximum allowable long-term capital gain in the sale of the business, a business owner stands to see a significantly reduced tax bill.
This is best achieved in an asset allocation agreement between the seller and buyer.
Asset Allocation Agreements
Buyers and sellers should typically enter into written agreements over the allocation of the consideration.
An asset allocation agreement will clearly define the values apportioned to the various appreciated assets held over 1 year, potentially reducing the pool of non-capital assets liable for income taxation for a seller. Making sure assets are identified and valued correctly will go a long way in ensuring the correct tax is applied. This is also a useful exercise for the buyer, who will use the allocation agreement to establish the basis in a future sale.
By default, a fair market value is applied to the assets sold and can be reduced should the buyer assume a debt or acquires a property subject to a debt. The fair market value is then reduced by the debt for this allocation.
This agreement is binding on both parties, unless the IRS determines the fair market value of any asset is not appropriate. Both the buyer and seller must report the sale of assets to the IRS.
How to Allocate Assets? The Residual Method
In a deal, both the buyer and seller must use the residual method to allocate the consideration to each of the business assets transferred. This not only determines the gain or loss from the transfer (and the consideration for goodwill and intangibles) but also establishes the buyer’s basis in the business assets.
The residual method is used for asset transfers that constitute a trade or business (both direct and indirect). A group of assets is a trade or business when:
- Goodwill or going concern value could, under any circumstances, attach to them.
- The use of the assets would constitute an active trade or business under section 355 of the Internal Revenue Code.
In short, most online businesses sold as assets will constitute an active trade or business, so the residual method should be used in allocation agreements.
The residual method provides for the consideration to be reduced first by cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). The consideration remaining after this reduction must be allocated among the various business assets in a certain order:
- Class I assets – cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit).
- Class II assets – certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
- Class III assets – accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. (exceptions apply, see section 1.338-6(b)(2)(iii) of the regulations)
- Class IV assets – property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
- Class V assets – All other assets not classified elsewhere (i.e. furniture and fixtures, buildings, land, vehicles and equipment).
- Class VI assets – section 197 intangibles (other than goodwill and going concern value).
- Class VII assets – goodwill and going concern value (whether the goodwill or going concern value qualifies as a section 197 intangible).
The amount allocated to an asset, other than a Class VII asset, cannot exceed its fair market value on the purchase date. The amount allowable for allocation to an asset is also is subject to any applicable limits under the Internal Revenue Code or general principles of tax law. Further, should an asset fall under multiple classes (above) include it in the lower numbered class. You may wish to reference IRS Instructions for Form 8594, Asset Acquisition Statement Under Section 1060.
So What is an Intangible Asset?
An intangible asset is a non-physical item, such as intellectual property (patents, trademarks, copyright, and methods), brands, goodwill, etc.
For the purposes of asset allocation, Section 197 defines intangibles as:
- Goodwill
- Going concern value
- Workforce in place
- Business books and records, operating systems, and other information bases
- Patents, copyrights, formulas, processes, designs, patterns, know-how, formats, and similar items
- Customer-based intangibles
- Supplier-based intangibles
- Licenses, permits, and other rights granted by a governmental unit
- Covenants not to compete entered into in connection with the acquisition of a business
- Franchises, trademarks, and trade names
See chapter 8 of Publication 535 for a description of each intangible. Not all intangibles are subject to the more favorable capital gains/loss taxation, so be clear on what does and does not qualify before allocating it in an agreement with the buyer. Speaking to a CPA or tax accountant is advisable.
Quick Example: Typical online business sale
Total Consideration: $150,000.00 cash
- Class I: no cash, deposit or similar accounts sold
- Class II: no U.S. government securities sold
- Class III: no accounts receivables, debt instruments or MTM assets
- Class IV: qualifying inventory assets of $75,000 (fair market)
- Class V: no other assets
- Class VI: $60,000 in intangibles (Section 197 intangibles)
- Class VII: $ 5,000 in goodwill and going concern value
In this example, the $150,000 consideration may be allocated as:
- $75,000 in (fair market) inventory assets
- $70,000 in (fair market) intangibles (Section 197 intangibles) – (possibly) capital gain/loss
- $5,000 in goodwill and going concern value – (possibly) capital gain/loss
The basis (i.e. original cost of asset acquisition + cost of optimization) will be deducted from the capital gain/loss on the qualifying assets to determine the tax liability.
What else is Tax Deductible?
The fees of advisors to the deal are deductible. The cost of a broker, lawyer, accountant, etc., can all form significant costs of sale and should be deducted from the selling party’s allocation of the sale price.
Financing, Hold-Back and Earn-Out Agreements in Online Business Sales
Financing, hold-backs and earn-outs are proving more popular with buyers in recent years. While sellers are often keen to negotiate full cash deals, there may be benefits in accepting scheduled finance payments, depending on an individual’s personal income situation.
Finance payments are relatively simple. For capital assets, a business owner will usually bear the tax burden when the payments are received and this can be spread anywhere from 6-24 months. Taxes on non-capital assets must be paid in the year of sale, regardless of when payment is received.
Earn-outs and other performance-based financing can be a little more complicated as these are viewed as Contingent Payment Sales by the IRS. A business owner can argue to realize the consideration in line with an installment agreement, realized when received (think cash flow accounting), or realized at the point of sale, regardless of when the payments take place (think accrual accounting).
This can become very complicated, but again, the payments can be spread over a longer period, should a business owner successfully argue this case. This can help avoid higher taxation brackets or realize losses at more convenient times.
With the additional security offered by Escow.com’s domain holding services, this method may prove increasingly popular with sellers that have high levels of personal income.
Note: financing payments (straight financing, holdbacks and earn-outs) are treated the same as the asset allocation.
Other Considerations in the Sale of Online Businesses
There are of course other taxes to take into account, including:
- Income tax on non-qualifying capital assets
- Profits on the sale of these aforementioned assets
- Additional Medicare taxes
- Net Investment Income Tax
- Alternative Minimum Tax
- State and Local taxes
- Recapture of previous depreciations applied to assets taxes through ordinary income
For these, and any other points in this article, talk to your CPA or tax accountant. While tax can be tedious, knowing the options and how this might affect your business sale is a worthwhile exercise.
Useful reading:
Potential Increase in Capital Gains Tax Drives Business Owners to Seek Timely Exits
Ordinary or Capital Gain or Loss for Business Property
Ordinary or Capital Gain or Loss
Sales and Other Dispositions of Assets
Section 197 Intangibles
Reporting Capital Gains
Contingent payment sales
Tax Computation Worksheets for 2021
2020 Taxes: 8 Things to Know Now
Disclaimer: The information contained in this article is not intended to be and does not constitute financial advice, investment advice, tax advice, legal advice or any other advice. You should not make any decision, financial, investments, trading or otherwise, based on any of the information presented in this article without undertaking independent due diligence and consultation with a competent financial advisor. You understand that you are using any and all information available in this article at your own risk.
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