The finish line is in sight. All the sleepless nights and early mornings have finally culminated in the sale of your SaaS startup. But just as you cross the finish line, the IRS arrives, calculator in hand, demanding taxes on your acquisition. How do you crush that tax bill?
As heartbreaking as it feels to hand over a chunk of your exit cash to the IRS, it’s an inevitable part of the acquisition process. Luckily, with the following strategies, you don’t have to drain your bank account to pay taxes on your startup sale. Keep scrolling to learn about our top three ways to reduce your taxes after selling your business in an asset purchase.
What Business Taxes Do You Pay After an Acquisition?
While many founders sell their businesses for non-monetary reasons – pursuing new ventures, more time with family, etcetera – every founder wants to earn more on their sale than they paid to build or acquire their business.
That excess profit is known as capital gain. And, for at least one year, the IRS taxes you on your gain through capital gains taxes.
Capital gains taxes are the amount you owe on the profit from selling your business. Factors like tax-filing status, taxable income, and how long you hold your assets will determine how much you pay the IRS for capital gains.
Let’s say you start a business and sell it ten months later. You would pay short-term capital gains taxes because you held your assets for less than 12 months. If you’d held onto the business for more than 12 months, you would pay long-term capital gains taxes.
What’s the difference between paying for short-term or long-term capital gains? Short-term tax rates are the same as your ordinary income tax rates, which can reach as high as 37 percent. Meanwhile, long-term tax rates fall into three brackets: 0 percent, 15 percent, and 20 percent.
Now, let’s explore the best ways to reduce those capital gains taxes post-acquisition.
1. Hold Your Assets For Longer Than 12 Months
One of the easiest ways to reduce capital gains taxes is waiting one year to sell. Aim for a long-term capital gains tax rate to pay as little as zero percent but no more than 20 percent.
Think of it this way: if you’re a single filer and your taxable income equals more than $41,776, you’re already saving money by avoiding the 22, 24, 32, 35, and 37 percent ordinary income tax brackets for short-term capital gains.
In comparison, $41,776 in long-term capital gains falls in the 15 percent bracket. It doesn’t even hit 20 percent until your taxable income is worth over $459,750. That’s worth waiting a few more months to sell your business.
However, if you pursue an asset sale (when the seller’s entity shifts ownership of its assets to the buyer’s entity), you might have to pay some short-term capital gains taxes no matter how long you held the business. You sell each asset individually, and the tax rate you pay will depend on whether the buyer acquires tangible or intangible assets.
Tangible assets are physical assets or property like equipment, inventory, or machinery. Intangible assets are assets that don’t physically exist but contribute value to your startup, like copyrights, trademarks, patents, know-how, goodwill, etcetera.
Any intangible assets you sell are subject to long-term capital gains tax rates if you hold them for more than 12 months. On the other hand, tangible assets are taxed at ordinary income tax rates no matter how long you hold the asset.
Luckily, most SaaS businesses deal with intangibles like software. To avoid paying ordinary income tax rates altogether, retain your assets for over a year.
2. Choose Asset Classes Carefully When Allocating the Purchase Price
Ready to see some accounting magic? Team up with your accountant to reduce the taxes you pay by finessing the purchase price allocation.
Purchase price allocation is an acquisition accounting process assigning fair value to all acquired assets and liabilities. It also determines how you split the purchase price between your assets and liabilities and is required for all mergers and acquisitions per the International Financial Reporting Standards (IFRS).
Since the buyer and seller both submit IRS Form 8594 to report purchase price allocation, you generally negotiate the allocation before closing the deal. You want to be on the same page so the IRS can easily file the forms.
But purchase price allocation requires sacrifice from one or both parties because different asset classes benefit the buyer or seller.
The IRS defines seven different asset classes where you can allocate the purchase price. Below, we’ve laid out each class and whether you (the seller) should advocate for higher or lower allocation in that class.
- Class 1: Cash and deposits
- No preference because it doesn’t contribute to taxable gain or deductible loss
- Class 2: Actively traded personal property
- No preference because it doesn’t contribute to taxable gain or deductible loss
- Class 3: Accounts receivable
- No preference because it doesn’t contribute to taxable gain or deductible loss
- Class 4: Inventory
- Lower because it’s a tangible asset taxed at ordinary income tax rates
- Class 5: Real estate and other fixed assets
- Higher for real estate because it qualifies for long-term capital gains tax rates
- Lower for other fixed assets (AKA tangible assets) because they’re subject to ordinary income tax rates
- Class 6: Intangible assets except for goodwill
- Higher because it qualifies for long-term capital gains tax rates
- Class 7: Goodwill
- Higher because it qualifies for long-term capital gains tax rates
By prioritizing asset classes with more long-term capital gains, you can reduce the taxes you owe the IRS post-acquisition.
3. Require an Installment Payment Plan Instead of a Lump Sum
After transferring your assets to the buyer, Escrow.com releases the buyer’s funds into your bank account. Flush with cash, you’re ready to sit back and enjoy the profits – until tax season comes along. Then that big lump sum suddenly turns into taxable income that bumps you up one or several tax brackets.
To avoid these huge hikes in your taxable income, consider offering seller financing, where the buyer pays in installments over time instead of an all-cash transfer at closing. Seller financing benefits the buyer by giving them time to pay off the purchase price and helps you avoid a colossal payment to the IRS the year you sell your business.
Seller financing also helps bridge the gap between your price expectations and the buyer’s, helping to increase your buyer pool – and perhaps even convince them to pay a little more.
While stretching the payments out over several years lessens your taxable income, it also puts you at risk. If you don’t put the proper protections in place, buyer default could occur, ruining the transaction. That’s why you should pursue seller financing only if it makes sense for your transaction. Talk to a tax or M&A advisor about the best option for your acquisition.
What Is the 15-Year Exemption on Capital Gains?
The 15-year exemption on capital gains removes your capital gains tax liability if you meet the qualifications for small business relief AND the 15-year exemption rule.
To qualify for small business relief, you and your business must meet these basic requirements.
- You must sell an asset that results in a capital gain
- The asset must be active (used in the course of running a business) for at least half the time you owned it
- One of the following must apply to your business:
- Before selling your business, the net value of your assets must equal less than $6 million.
- Your business must have an aggregate annual turnover of less than $2 million.
- The asset must be an interest in an asset of a small business partnership of which you are a partner.
Let’s say you meet those small business relief qualifications. Now, how do you measure up to the basic requirements for the 15-year exemption rule?
- If you’re filing taxes as an individual, you must be over the age of 55 at the time of selling your business.
- The sale must occur in connection to your retirement or inability to continue working
- If you’re filing taxes as a company or trust, you must have had at least one “significant individual” owning the asset for 15 years (doesn’t have to be the same person)
- At the time of sale, the significant individual must own 20 percent of the company or trust, and either be over 55 aiming to retire or be incapable of working after the sale.
Remember, these are only the basic requirements for the 15-year exemption. Confirm that you qualify under any specific conditions by consulting a tax professional.
How Much Capital Gains Are Tax-Free?
Just like personal income tax rates, long-term capital-gains taxes are progressive depending on your taxable income and filing status.
Say you’re a single filer who has $30,000 of regular income and $120,000 of long-term capital gains for a total of $150,000 in taxable income. After subtracting the 2022 standard deduction for a single filer ($12,950), you’re left with $137,050 in taxable income, placing you in the 15 percent bracket.
Luckily, you won’t pay a 15 percent capital-gain tax rate on all $137,050 – instead, expect to pay 0 percent on the first $41,675 of your taxable income and 15 percent on the remaining amount.
To keep your acquisitions and resulting capital gains tax-free, try to minimize your taxable income to the 0 percent bracket. Below, you can review the current capital gains tax rates for taxes due in April and October 2023. Remember that these only apply to long-term capital gains for assets that you’ve held for longer than 12 months.
What States Don’t Pay Capital Gains Tax?
Before putting away your calculator and sending your capital gains tax forms to the IRS, include the capital gains taxes you owe to your state government.
Most US states add 2.9 to 13.3 percent capital gains tax after you sell your business. Only nine states don’t levy a capital gains tax – Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. These also happen to be the states that don’t levy income taxes.
Operate your business in a state not listed above? Check out your state’s capital gains tax policy here.
What Happens If You Don’t Claim Capital Gains?
If you fail to file a Schedule D form with your taxes to report your capital gains, the IRS won’t just let it slide. In a best-case scenario, they do the math, figure out your unreported income, and charge you the difference you owe. They might also tack on fines and penalties for your negligence. But if the agency can prove you acted intentionally or fraudulently, they could press charges (though this rarely occurs).
How Do You Reduce Business Taxes on Your Stock Sale?
While Acquire.com currently only supports asset sales, we can provide you with M&A advisors to help you handle a stock sale as well. C corps might consider stock sales because of the many ways they can help you reduce taxes post-acquisition.
A stock sale deals with ownership of the selling entity in the form of shares of stock in a corporation or membership units in a limited liability company (LLC). Instead of transferring just the assets, a stock deal allows the buyer to directly purchase company ownership of the seller’s entity in the form of shares or membership units in an LLC.
Both asset and stock sales are subject to either short-term or long-term capital gains taxes. Shares of stock held for more than a year are taxed at ordinary income tax rates, while shares of stocks held longer than a year are taxed at long-term capital gains rates.
But C corporations generally favor stock sales over asset sales because they only pay one layer of taxes after an acquisition. In asset sales, C corps must suffer double taxation, where the corporation pays a layer of capital gains tax on the sale of its assets, and the shareholders pay another layer of taxes on the distribution of the net proceeds. Stock sales require only the initial capital gains tax from the corporation. So, one way C corporations can minimize their acquisition taxes is by pursuing a stock sale vs. an asset sale.
But the other benefit of a stock sale is that it receives more tax exemptions from the IRS. For example, if you hold Qualified Small Business Stock (QSBS), you can exclude capital gains tax of up to $10 million or 10 times the adjusted tax basis of your QSBS, whichever is greater. To see if you qualify for QSBS, check the IRS’s eligibility requirements under Section 1202 of the Internal Revenue Code.
The content on this site is not intended to provide legal, financial or M&A advice. It is for information purposes only, and any links provided are for your convenience. Please seek the services of an M&A professional before any M&A transaction. It is not Acquire’s intention to solicit or interfere with any established relationship you may have with any M&A professional.
