As business owners, we put a lot of blood, sweat, tears, and, yes, money into our businesses. So, when I said that you should NOT include your business when totaling your assets for your retirement wealth gap calculation, many people bristled at that statement. However, there’s a good reason why you shouldn’t include your business in that calculation. Basically, you don’t know what it’s worth. Even if you’ve had a business appraisal done, it’s still only a ballpark figure. In today’s entry, we are going to look at some of the factors that directly influence the value of your business. Join me as I discuss how to find the true value of your business!
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Oftentimes, business owners think about their business in the same way that they think of their homes. This way of thinking is, however, wrong. You see, when my sweet wife, Emily, and I first got married, we lived in a double-wide trailer at my landscape nursery. For that season of our lives, it was a good home. Later, when we began to have children, we needed more space. Therefore, we bought a new home that had all of the space we needed. Since we obviously didn’t need two homes, we converted the double-wide to a rental property. Eventually, we did sell the double-wide for its fair market value. Upon closing, we received our asking price, but we didn’t get all that the home was worth. Why is that?
Put simply, Uncle Sam demanded his cut. Anytime we receive income from the sale of an investment property or a business, we are going to be taxed at the time of sale. So, when I talk about the true value of your business, I’m referring to the value of your business minus taxes at the time of sale. If you include your business in your wealth gap calculation without taking the time to find its true value, then you’re going to miss the mark.
I like to think of it in terms of a marathon. For the record, I hate running. If you ever see me running, either something is chasing me or I am trying to prevent pineapple from being placed on a pizza. But, I digress. If the organizers of a marathon miscalculated the route, marking the finish line a mile short of where it should have been, and then corrected the mistake as you were reaching the finish line, you’d be pretty frustrated. I mean, you’ve just run 25.2 miles and you think you’re done, only to find out you still have a mile to go. That’s why understanding how to find the true value of your business is so important. You don’t want to reach retirement only to find out you don’t have enough to retire.
Remember when you were a kid and you’d go to the playground with your friends to ride the see-saw? You’d be on one side while your buddy was on the other and up-and-down you’d go. Well, that’s similar to what takes place when buying and selling a business. From a tax perspective, there is no “winner” or “loser” in this interaction. There is simply a balance of up and down. What’s good for the seller is usually bad for the buyer, and vice versa.
This type of sale is easy. Typically, stock sales are used when dealing with an S-corporation or a C-corporation. These involve a valuation of the actual stock price of the company and then you sell the stock of your company. With stock sales, you’re going to pay capital gains on a tax basis.
Let’s say you have bought a stock at $10 per share which you then sell for $20 per share. That $10 profit is subject to long-term capital gains tax rates when held for longer than a year. However, if you hold it for less than a year, it will be taxed as ordinary income. As a result, stock sales are usually the lowest tax brackets that can be paid when selling a business.
Most small business owners aren’t going to be selling their companies via a stock sale. That’s where asset sales come into play. As the seller, if you negotiate a total price for the business, you and the buyer must agree on what portion of the purchase price applies to each individual asset. This also applies to intangible assets, like goodwill. How the proceeds are divided among the business’ assets determines the amount of capital or ordinary income tax you will pay on the sale. Additionally, asset sales have tax consequences for the buyer.
Now, I mentioned a tax basis before, but what does that mean? A tax basis refers to the original cost, minus depreciation, minus any casualty losses, plus any additional paid-in capital and selling expenses. I know. Right now, you’re saying, “Justin, what?”
As the seller, you will probably want to allocate most, if not all, of the purchase price to the capital assets that were transferred with the business. You’ll want to do that because proceeds from the sale of a capital asset—including business property or your entire business—are taxed as capital gains.
It should be noted that under current law, the long-term capital gains of individuals are taxed at a significantly lower rate than that of ordinary income. In fact, if you’ve held the asset for longer than 12 months, the maximum tax on long-term capital gains is 15% for qualifying taxpayers (some tax payers could pay 20%). Taxpayers in the 10-15% tax brackets pay zero percent.
As always, speak with a tax professional before choosing a strategy for your individual circumstance. But when you’re selling your capital asset, you really want to get in on capital gains because they are so much cheaper than ordinary income taxes. Just for fun, let’s assume that you’ve just sold your business for $1 MM and 100% of the sale as capital gains (an unlikely scenario, but it’s only to prove a point). Let’s also assume that you’ve held the business for longer than a year. In this scenario, you would owe $150,000 in capital gains tax.
On the other hand, if you sold your business for the same price and 0% of the sale as capital gains, the IRS could view that as though you earned an additional $1 MM in ordinary income. Therefore, you would be subject to anywhere from $300,000 to $600,000 in taxes. So, capital gains are usually the less expensive tax rate.
In addition to asset sales and capital gains, you have the option of conducting an installment sale which we’ll discuss at a later time. Regardless, you want to avoid paying more than you have to. This includes the double taxation that comes along with C-corporations. As you can see, there are many different strategies and types of sales that each carry their own tax pros and cons. This is why you should always consult your support team, especially your tax planner, before deciding to sell your business.
When we look at all of the rules surrounding asset sales, it’s easy to think, “Well, I’m the seller. Therefore, what I say goes!” Technically, that’s true but it’s much more complicated than that. If you were to take that stance, there’s a good chance that you will have to forgive some of the value on the price during your negotiation. But there is another way.
I see this all the time in service-based industries that require a lot of equipment. Business owners will go out and buy a bunch of equipment every year in order to reduce their present taxes. They do this because they get bonus depreciation. But what happens if you want to sell your business in two years? You’ve already written the equipment down into depreciation. So, what do you do? You might think, “I’ll just sell the equipment for whatever the book value is.” But it doesn’t really work like that. You end up running into a thing called recapture.
Depreciation recapture is defined as any gain on depreciable personal property (other than real estate), including amortizable intangible property like goodwill, which is treated as ordinary income to the extent that the gain is equal to depreciation you’ve already claimed on those assets. In this way, the depreciation is “recaptured.” So, what does that mean?
Let’s try to make this as simple as possible. We’ll say that in 2010, you purchased a used machine, used solely for business purposes, for $10,000. Two and a half years later, you sold it for $7,000. During the time you owned it, you claimed $6,160 in depreciation on the machine. Your basis in the property at the time of the sale was $3,840 ($10,000 -$6,160 = $3,840).
So what happens here is that you’ve sold the piece of equipment that is worth $10,000 for $7,000. Even though you’ve claimed a depreciation value of $6,160 on the machine, the fair market value remains at $10,000. Therefore, your tax basis on the asset is $3,840. The IRS knows every trick in the book and they’ve prepared for each one of them. When you sell your business, there will be documentation that shows exactly how the purchase price was allocated across your assets. So, what are the rules?
With all of the rules and regulations surrounding its sale, understanding how to find the true value of your business can be difficult. But it’s not impossible. First, make a long-term tax plan. I’m talking about 5+ years. Work with your tax advisors to place the company in the best long-term tax position. Knowing the rules of the game is the only way to win it.
Additionally, knowledge will help us bridge the wealth gap. The last thing you want is to have half of your business’ sale value go to the government via taxes. So plan, plan, and plan some more. Having a competent team of experts on your advisory team can’t be understated. Many times, they will be able to work in coordination with each other to maximize your tax savings.
Friends, I know that these things keep you up at night because they keep me up at night. Every choice we make, as business owners, has far-reaching effects that are felt by everyone within our organizations. But these things don’t need to make us fearful or anxious.
Life is hard. It’s complicated, but it is so good. Dealing with taxes and your retirement wealth gap can be frustrating, but it doesn’t have to be. With the right team and an understanding of how to find the true value of your business, closing the wealth gap can be at least financially simple.
Find out how the Financially Simple team can help you plan for taxes at the time of sale, and so much more, Schedule a meeting, today!