Tax Strategies: Capital Gains vs Ordinary Income

It is not what you sell your business for that matters. What matters most is the amount you take home after fees, expenses, and taxes are paid. Of the three, your largest expense will be your tax bill. Depending upon how the transaction is structured, the taxes could amount to as much as 50% of the sale price. The biggest factor is what is taxed as capital gains vs ordinary income.

Generally, the gain from the business sale will be taxed as capital gains. However, any salary or consulting agreement will be taxed as ordinary income. How much does this matter? The maximum capital gains rate currently is 20% whereas the maximum ordinary income rate is 37%.

Selling A Business: Capital Gains vs Ordinary Income

Let’s consider the various components of a typical business sale and how each are impacted by capital gains vs ordinary income.

Cash at Closing – 100% capital gains. The tax is paid on the difference between the cash you receive and an accounting term called your basis. Essentially, this is what you have invested in the business. If you sell a business for $2M and the basis is $200k, the gain is $1.8M taxed at 20% = tax due $360k.

Installment Payments – Installment payments mean you as the seller are financing a portion of the sale price by taking a note back for a portion of the sale proceeds that will be paid over time. As in the cash portion, the gain over the basis is taxable as capital gains.

Stock in buying company – Sometimes when selling to a larger entity a portion of the sale its proceeds will be in stock. This would enable the seller to take advantage of the potential appreciation or growth in the buying entity. This event does not trigger a tax liability. Only when the shares of the buying entity are sold and would be taxed as capital gains.

Earn-out – There are instances where a portion of the sale proceeds are paid out over time based upon the financial performance of the business.  The earn-out length could take one or several years. This is based upon revenue or profit targets and could represent from 10% to 60% of the total purchase consideration. Utilizing an earn-out when the buyer and seller cannot completely agree on the sale bridges the gap. Generally speaking, the earn-out is considered part of the purchase price and taxed as capital gains.

Salary or consulting agreement – Any compensation from salary or other consulting services will be taxed as ordinary income.