How to Offset Capital Gains From the Sale of a Business

Selling a business can result in significant capital gains, leading to a substantial tax bill. However, legal strategies can help reduce or defer these taxes. Proper planning ensures that more of the sale proceeds are retained while staying compliant with tax laws.

Methods to offset capital gains include utilizing losses, structuring the sale strategically, and considering tax-deferred options. Understanding these approaches is essential for minimizing tax liability and maximizing net proceeds.

Types of Gains

The profit from selling a business falls into different capital gains categories, each with distinct tax treatments. The classification depends on how long the asset was held and the nature of the business property sold. Recognizing these distinctions helps determine the applicable tax rate and potential strategies for reducing tax liability.

Short-Term Gains

If a business or its assets were held for one year or less before being sold, the profit is classified as a short-term capital gain. These gains are taxed at ordinary income tax rates, which can be as high as 37% in 2024. This is significantly higher than long-term capital gains rates.

Short-term gains often occur when an owner sells a recently acquired business or assets purchased within the past year. Because these gains are taxed at the same rate as wages, they can push the seller into a higher tax bracket. For example, if an individual in the 24% tax bracket realizes a $200,000 short-term gain, part of their income could be taxed at 32%.

To reduce the tax impact, sellers may delay the sale to qualify for long-term capital gains treatment. Holding onto the business or its assets for more than a year can significantly lower the tax rate.

Long-Term Gains

When a business or its assets have been owned for more than one year before being sold, the profit is classified as a long-term capital gain. These gains are taxed at lower rates, ranging from 0% to 20% in 2024, depending on taxable income. A married couple filing jointly with taxable income below $94,050 pays 0% on long-term capital gains, while those earning over $583,750 face the maximum 20% rate.

Selling a business held for multiple years can generate substantial long-term gains, particularly if its value has appreciated. This applies to the sale of company stock, goodwill, or real estate. Since long-term gains receive preferential tax treatment, structuring the sale to maximize them can lead to significant savings.

High-income sellers may also be subject to the 3.8% net investment income tax (NIIT) on long-term capital gains if their modified adjusted gross income exceeds $200,000 ($250,000 for married couples filing jointly). This means some sellers could pay a combined 23.8% tax on their gains.

One way to manage tax liability is through installment sales, which spread gains over multiple years. By receiving payments over time instead of a lump sum, sellers may stay in a lower tax bracket and reduce their overall tax burden.

Section 1231 Gains

Certain business assets qualify for special tax treatment under Section 1231 of the Internal Revenue Code. These include depreciable property such as equipment, buildings, and land used in the business. If these assets are sold for a profit after being held for more than one year, the gain is taxed at long-term capital gains rates. However, if the sale results in a loss, it can be deducted as an ordinary loss, which is more beneficial since it can offset other types of income without the limitations applied to capital losses.

Depreciation recapture applies to assets that have been depreciated over time. If a business owner has claimed depreciation deductions and then sells the asset for more than its depreciated value, the recaptured portion of the gain is taxed as ordinary income. For example, if a piece of equipment was purchased for $100,000, depreciated to $60,000, and then sold for $90,000, the $30,000 recaptured depreciation is taxed at ordinary income rates, while the remaining $30,000 gain is taxed at the lower capital gains rate.

Sellers can use cost segregation studies to allocate more value to assets with shorter depreciation periods, potentially reducing future recapture taxes. Understanding how Section 1231 gains interact with depreciation rules is key to structuring a sale efficiently.

Deductible Expenses and Adjustments

Certain expenses incurred during a business sale can be deducted to reduce taxable gains. Legal fees, broker commissions, and accounting costs directly related to the sale are considered selling expenses and can be subtracted from the total proceeds before calculating capital gains. For example, if a business sells for $1 million and the owner pays a 10% broker commission, the taxable gain is reduced by $100,000.

Beyond transaction costs, business owners can adjust their taxable gain by factoring in improvements and capital expenditures. If significant upgrades were made to business property, such as renovations or major equipment purchases, these costs may be added to the asset’s basis, reducing the taxable portion of the sale. If a business owner originally purchased a property for $500,000 and later invested $200,000 in improvements, the adjusted basis becomes $700,000. If the property is then sold for $1 million, the taxable gain is $300,000 rather than $500,000.

Debt obligations tied to the business also affect tax liability. If a portion of the sale proceeds is used to pay off outstanding business loans, it does not directly reduce taxable gain, but it impacts the net cash received. However, if the buyer assumes the business’s debt as part of the transaction, the seller must account for this in the total consideration received.

In installment sales, where payments are received over multiple years, income is recognized gradually rather than all at once. This spreads the tax liability over time, potentially keeping the seller in a lower tax bracket. If a business is sold for $500,000 with payments spread over five years, only the portion received each year is taxed, reducing immediate tax obligations.

Using Capital Losses and Carryovers

Offsetting capital gains with capital losses is an effective way to lower tax liability. If an individual has sold other investments—such as stocks or real estate—at a loss during the same tax year, those losses can be used to reduce taxable gains from the business sale. The IRS allows capital losses to first offset gains of the same type, meaning long-term losses reduce long-term gains and short-term losses reduce short-term gains. If total capital losses exceed total capital gains, up to $3,000 ($1,500 if married filing separately) can be deducted against ordinary income each year, with any remaining losses carried forward.

A business owner who previously experienced a significant investment loss can apply that loss to offset gains from the business sale. If a seller realizes $400,000 in capital gains from the sale but has $150,000 in capital losses from prior investments, the taxable gain is reduced to $250,000.

Tax-loss harvesting is another strategy, where underperforming investments are sold in the same year as the business transaction to generate losses that counterbalance gains. However, the IRS wash-sale rule prohibits repurchasing a substantially identical security within 30 days before or after the sale if the goal is to claim the loss for tax purposes.

For those with prior-year losses carried forward, tracking these amounts ensures they are fully utilized. IRS Form 8949 and Schedule D of Form 1040 are used to report capital gains and losses.

Considering Tax-Deferred Exchanges

Deferring taxes on a business sale can provide financial advantages, particularly when reinvesting proceeds into similar assets. A Section 1031 exchange allows taxpayers to defer capital gains taxes when selling and replacing certain business-related properties. This applies primarily to real estate, meaning business owners who sell commercial buildings, warehouses, or land and reinvest in another qualifying property can postpone tax liability. The replacement property must be identified within 45 days and acquired within 180 days of the original sale.

For intangible assets such as patents, franchises, or trademarks, a structured installment sale under Section 453 allows the seller to receive payments over time, recognizing capital gains incrementally. Additionally, an Opportunity Zone investment permits gains from a business sale to be reinvested into designated economically distressed areas, offering both deferral and potential exclusion of future gains if held for at least ten years.

Allocating Proceeds to Personal Goodwill

Allocating a portion of the sale proceeds to personal goodwill can provide tax advantages. Unlike corporate goodwill, which is taxed at the entity level, personal goodwill is treated as a capital asset belonging to the individual owner. This allows it to be taxed at long-term capital gains rates rather than as ordinary income or corporate dividends.

For personal goodwill to be recognized, the owner must demonstrate that their relationships, reputation, or expertise are integral to the company’s value. This is particularly relevant in service-based businesses where client relationships are tied to the owner. A well-documented goodwill allocation includes an independent valuation and a separate purchase agreement specifying the portion of the sale price attributed to personal goodwill.