Thousands of U.S. businesses are sold every year. But with a large increase looming in the U.S. capital gains tax, more owners who will earn more than $1 million this year – including any proceeds from a sale – are strongly considering a sale of their business before year’s end.
For many business owners, 2021 is the perfect storm. The stock market’s seemingly endless rise has helped many to double their net worth within recent years. At the same time, the impact of COVID-19 has made daily operations a never-ending grind. Finally, many are getting offers they can’t refuse. For example, I work with many doctors who receive regular inquiries to sell; one who has experienced all the items I mentioned has just decided to take an offer valued at several million dollars.
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Democrats in the U.S. House of Representatives have proposed a top federal rate of 25% on long-term capital gains, up from the current top rate of 20%. But the Biden administration has proposed an increase to a top rate of 39.6% on long-term capital gains and qualified dividends for those with over $1 million in income.
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The impact of doubling this tax on a business owner looking to sell is significant. At a $5 million sale price, a 20% capital gains tax equals a $1 million tax bill. But a tax of nearly 40% rate means $2 million in taxes on the same sale.
While it is possible Congress could make any capital gains tax increase retroactive, any increase will likely not be effective until 2022. And that’s another reason owners are making the decision to sell their businesses this year.
How to Offset the Capital Gains Tax – Charitable Bunching
Business owners considering a sale can take advantage of one solution to the possibility of higher taxes before year’s end: charitable “bunching.” Charitable bunching is a complex tax strategy tied to a business owner’s charitable contributions. In its simplest terms, the owner makes a significant donation in the year of the sale. This donation – often in the hundreds of thousands of dollars – is more beneficial during the year of sale because it offsets ordinary income taxes from the sale.
This move isn’t far-fetched. Many business owners already donate large sums annually to nonprofit organizations, often using a donor advised fund. This fund provides an immediate tax deduction in the year the contributions are made, even though the donations from the fund to your chosen charities are spread out over several years. It really benefits a person who has a higher-than-normal annual income – which is the reason an owner selling in 2021 should consider the strategy.
Bunching calls for “front-loading” a charitable gift this year equal to 10 years or more of their usual contribution. For example, a person who would normally contribute $30,000 each year to nonprofits will need to donate $300,000 this year for the strategy to work.
Here are the details:
When a business is sold, most of the sale amount is allocated to goodwill and taxed at capital gains rates, often pushing the owner’s remaining income into the highest tax brackets. If a business sells today for $2 million with $1.5 million allocated to goodwill, the capital gains tax is 20% – equal to $300,000. The ordinary income tax is $185,000 ($500,000 x 37%) for the amount allocated to remaining assets, for a total tax bill of $485,000.
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For the owner who donates $300,000 to a donor advised fund in the year of sale, the total tax bill would fall to $374,000 – a savings of $111,000. You might ask, “Don’t I receive a benefit if I keep giving $30,000 annually?” The answer is yes, but the benefit is much lower in retirement. That's because the annual standard deduction for married couples filing jointly is $25,100, meaning they will not be able to deduct the full amount of future donations.
There is one final planning point to our strategy. Because most owners’ investment portfolios have increased so much in recent years, there’s another way to save even more. And that’s by making the initial $300,000 contributions in common stock that has appreciated as part of the owner’s after-tax retirement accounts. By using appreciated stock in these accounts, the owner gets the same $300,000 charitable deduction while bypassing any capital gain on selling those securities in the future.
While the sale of any business is a complex transaction, the owner’s ability to take advantage of a 20% capital gains tax while making donations that can have an impact in their community merits strong consideration. With the potential of a doubling of this tax next year, this argument may be even more compelling between now and Dec. 31.
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Disclaimer
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
FAQs
Installment sale.
To lessen the impact of capital gain or income tax obligations in a single year, you may want to negotiate a sale where proceeds are received over more than one tax year (i.e., an installment sale).
Can you avoid capital gains tax by donating to charity? ›
Long-term appreciated assets—If you donate long-term appreciated assets like bonds, stocks or real estate to charity, you generally don't have to pay capital gains, and you can take an income tax deduction for the full fair-market value. It can be up to 30 percent of your adjusted gross income.
Is selling a business considered capital gains? ›
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 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.
Is the sale of a business considered earned income? ›
Selling a small business means income, and income means taxes. But the way you structure the deal can make a major difference on how much of the sale price goes to taxes and how much stays with you.
How can I sell my business fast at the highest price? ›
Value the company through professional appraisers or valuation multiples based on annual profit or EBITDA. Work with a qualified broker or investment banker to identify and qualify possible buyers, negotiate the sale price, assist with the selling process, and close the deal successfully for maximum value.
How do big businesses get out of paying taxes? ›
How do profitable corporations get away with paying no U.S. income tax? Their most lucrative (and perfectly legal) tax avoidance strategies include accelerated depreciation, the offshoring of profits, generous deductions for appreciated employee stock options, and tax credits.
What are bunching charitable contributions? ›
The concept behind bunching is simple. Instead of taking the standard deduction every year, by grouping your charitable contributions for multiple years together into a single tax year, you can exceed the standard deduction and take advantage of valuable itemized deductions like charitable donations.
How much does a charitable donation reduce taxes? ›
Generally, you can deduct up to 60% of your adjusted gross income in charitable donations. However, depending on the type of organization and type of contribution, you may be limited to 20%, 30%, or 50%.
Is it worth itemizing charitable donations? ›
Charitable contributions or donations can help taxpayers to lower their taxable income via a tax deduction. To claim a tax-deductible donation, you must itemize on your taxes. The amount of charitable donations you can deduct may range from 20% to 60% of your AGI.
How to sell a business without capital gains tax? ›
If you're wondering how to avoid California capital gains tax, you're out of luck. Additionally, you may incur a transfer tax when selling your business, which can further reduce your profits. Working with a qualified tax professional or accountant can account for potential disadvantages.
Determining Your Business's Market Value
- Tally the value of assets. Add up the value of everything the business owns, including all equipment and inventory. ...
- Base it on revenue. How much does the business generate in annual sales? ...
- Use earnings multiples. ...
- Do a discounted cash-flow analysis. ...
- Go beyond financial formulas.
When a taxpayer sells an LLC interest, the taxpayer will usually have a capital gain or loss on the sale of the interest. However, capital gain or loss treatment does not apply to the sale of every LLC interest.
What is not counted as income? ›
Nontaxable income won't be taxed, whether or not you enter it on your tax return. The following items are deemed nontaxable by the IRS: Inheritances, gifts and bequests. Cash rebates on items you purchase from a retailer, manufacturer or dealer.
How is goodwill treated in the sale of a business? ›
The taxation of goodwill is not subject to a second level of tax and is already characterized as a capital asset taxed at the more favorable capital gains tax rate. However, some of the best tax minimization strategies involve the transfer of part of the asset to be sold to a charitable entity prior to the sale.
Does social security count as earned income? ›
Unearned Income is all income that is not earned such as Social Security benefits, pensions, State disability payments, unemployment benefits, interest income, dividends, and cash from friends and relatives. In-Kind Income is food, shelter, or both that you get for free or for less than its fair market value.
How do I avoid capital gains on my taxes? ›
Here are four of the key strategies.
- Hold onto taxable assets for the long term. ...
- Make investments within tax-deferred retirement plans. ...
- Utilize tax-loss harvesting. ...
- Donate appreciated investments to charity.
If an LLC is listed as a C Corporation, the LLC must file corporate income taxes. In 2022, the federal corporate income tax rate is 21%, with many states adding their own taxes on top of that. Along with the corporate income tax, any profits or dividends distributed to members are subject to capital gains tax.
How much should you put away for taxes as a business owner? ›
Tax obligations vary from one business to another, but a good rule of thumb is to save 30% to 40% of your business income for taxes. This should ensure that you have enough to cover your quarterly taxes. You can work with your accountant to determine if you need to save more or if you can get away with saving less.
How is sale of LLC interest taxed? ›
When a taxpayer sells an LLC interest, the taxpayer will usually have a capital gain or loss on the sale of the interest. However, capital gain or loss treatment does not apply to the sale of every LLC interest.
