Maximizing Your After-Tax Proceeds: Avoid These 10 Common Tax Mistakes When Selling Your Business

Introduction

You’re only going to sell your business once. If you don’t strategically navigate the tax landscape, taxes will take a bigger chunk out of your sales proceeds than necessary. This post explores 10 tax mistakes to avoid when selling your business.

1. Not Understanding the Tax Differences Between an Asset Sale and a Stock Sale

Selling your business involves crucial decisions, including selecting the right transaction structure. This choice, fundamentally between an asset sale and an equity sale, greatly impacts everything from the after-tax proceeds netted by the Seller to the ability of the business to thrive post-transaction.

If you’re a business owner considering selling your company, it’s critical that you understand and weigh the advantages and disadvantages of asset sales versus equity sales. While it’s true most small and medium-sized businesses sold are asset sales, you should be aware of equity sales as well because some structures can offer the best of both worlds. Familiarity with the nuances of each option is essential to optimize returns and ensure a seamless transition. Check out this post Asset Sale vs. Equity Sale: Key Considerations When Selling Your Business for more information.

2. Skipping Pre-Sale Tax Due Diligence

Thorough due diligence is paramount in the selling process. Inadequate scrutiny of your tax risks prior to a sale can lead to unwelcome surprises during negotiations. It’s crucial to engage a qualified tax professional experienced in multiple types of income and sales taxes for all the jurisdictions your company operates to do a comprehensive review. The time to address potential tax issues is before a sale of your business.

For more about what pre-sale tax diligence involves, check out Maximizing Business Sale Value: The Critical Role of Pre-sale Tax Due Diligence

3. Not Structuring Earnouts for Tax Efficiency

An earnout allows the buyer and seller to tie a portion of the payment for the business to the ongoing success of the business post-acquisition. An earnout can significantly impact the seller’s tax liability. The timing and nature of earnout payments determine how they are taxed.

If an earnout is structured to qualify for installment sale treatment, the seller can defer recognizing taxable income until payments are received. Earnout payments may be taxable at capital gains tax rates if they are treated as additional proceeds for goodwill or equity.

However, if earnout payments are classified as compensation for services, the earnout payments will be taxed as ordinary income at higher tax rates. The key for sellers is understanding how different earnout structures can influence their tax outcomes and planning accordingly to optimize their tax position.

For more about the tax implications of earnouts, see 5 FAQs About the Tax Consequences of Earnouts.

4. Neglecting State Tax Considerations

While federal taxes are a major consideration, neglecting state tax implications can be a costly mistake. Each state has its own tax laws, and understanding the specific requirements and consequences is crucial. Some states have lower capital gains tax rates, like federal, but some don’t. Gains on sales of stock are typically taxed in the seller’s resident state, regardless of where the entity actually does business. If residency is legally established in a state with lower personal income tax, the state tax burden can be reduced.

However, most sales of businesses are structured as a sale of assets for tax purposes. This means the state(s) where the business conducts its activities plays a bigger role in the after-tax proceeds to the selling owners than their resident tax states. Different states “apportion” the gain on asset sales differently, and it’s beneficial for a tax specialist to model out the state tax implications before finalizing an agreement with the buyer.

Factoring in state tax considerations as part of your overall tax planning strategy can help plan to mitigate state taxes and avoid unexpected liabilities.

5. Not Paying Attention to Purchase Price Allocation

When a business sale is structured for tax purposes as a sale of assets, the purchase price allocation will determine the split between how much of the gain will be taxable at ordinary income tax rates and how much will be taxed at capital gains tax rates.

In 2024, the top federal income tax rate for capital gains is 20%, while the tax rate on ordinary income tops out at 37%. So it’s easy to see how paying attention to purchase price allocation plays a huge role in the after-tax proceeds a seller can keep. For factors to consider when negotiating a purchase price allocation check out Purchase Price Allocation: How it Affects Your Taxes When Selling Your Business.

6. Signing an LOI Without Understanding the Tax Structure

When an eager seller signs even a “non-binding” Letter of Intent without understanding or agreeing to a tax structure for the sale, it’s often tragically too late for optimal tax planning. Not surprisingly, sellers focus on the sales proceeds, timing of the payments, and other factors when negotiating an LOI. But failing to address the tax structure of the deal can dramatically impact the seller’s after-tax proceeds.

It’s never a good idea to sign an LOI without experienced tax and legal counsel involved.

7. Not Conducting Due Diligence on the Buyer

You’ve spent years, perhaps your entire adult life, nurturing your business. When you’re ready to sell, you will want to make sure your company is in the hands of someone who will manage it well, maintain its mission and culture, and continue its growth and success. You will also want to make sure that the buyer is trustworthy and is not likely to cause you financial or legal problems in the future. You’re likely relying on the after-tax proceeds from the sale of your business for a comfortable retirement, and possibly the security of your family for generations.

Due diligence on the buyer is a crucial step in ensuring a successful transition and safeguarding the seller’s interests. This post will tell you more: 9 Reasons the Seller Should Conduct Due Diligence on the Buyer.

8. Choosing the Wrong Tax Advisors

Just like you’re an expert at running your business, there are experts who specialize in the tax aspects of selling a business. While your business’ tax preparer has likely done an outstanding job preparing your company’s taxes each year and providing tax planning advice as your company has grown, that doesn’t mean that he or she is the right person to maximize your after-tax proceeds from the sale of your business.

Think of it like medical professionals. Your general practitioner knows the ins and outs of your healthcare needs, but your GP isn’t going to perform a knee replacement. That’s a one-time surgery and requires the skills of an orthopedic specialist who is up to date on the latest technology and techniques. Similarly, an M&A tax specialist doesn’t prepare business tax returns, but they’re going to provide the best tax planning and pro-active tax advice regarding the tax aspects of selling your business.

9. Poorly Structuring a Rollover into Buyer Equity

A well-structured rollover is a win/win for buyer and seller. Buyer pays less up front by using equity to finance part of the acquisition, and buyer benefits from having the seller’s expertise and industry connections for continuity and growth. Seller gets the possibility for a second bite at the apple while deferring tax on the portion of the business exchanged for equity in the buyer.

Not all buyer equity results in tax deferral of gain for the sellers. The structure of a tax-deferred rollover depends on the legal entity and tax characterization of the seller and the buyer, and sometimes the mix of the consideration (how much equity and how much cash). A horrible outcome results when seller mistakenly believes the fair market value of buyer equity isn’t taxable when the sale takes place, but later finds out that there’s a current tax liability and there is no way to turn the buyer equity into cash needed to pay the tax. For more see Second Bite at the Apple: How to Structure a Tax-efficient Rollover.

If you’re considering accepting some buyer equity as part of the proceeds from selling your company it’s critical to get help from an experienced M&A tax expert.

10. Not Doing Estate Tax Planning Pre-Sale

With estate taxes scheduled to explode in 2026, it would be a terrible lost opportunity for business owners considering a sale to neglect estate tax planning. Proactive estate tax planning can enable the transfer of long-term, life-changing wealth for one’s family in an organized and tax-efficient manner.

The time for estate tax planning is well before the LOI stage, ideally even before the seller begins to market the business. Don’t jeopardize your family’s future financial security by putting off estate tax planning.

Conclusion

As you prepare to sell your business, avoiding these 10 common tax mistakes can significantly enhance your after-tax proceeds. Each step, from understanding the implications of asset versus stock sales to conducting due diligence and strategically structuring earnouts, plays a pivotal role in your financial outcome. Prioritize informed decision-making and expert advice to navigate this complex process, ensuring a sale that maximizes your returns and honors the legacy of your business.