Many people consider opening a business, but not as many think about what to do when it’s time to close one. Whether the business operates as a sole proprietorship, partnership, corporation, or some other entity, understanding the intricacies of winding down, selling, or planning for succession is crucial for several reasons, including compliance with laws, maximization of asset values, and ensuring a smooth transition if ownership changes hands.
Business exit first steps
Business owners might decide to exit a business for several reasons. Sometimes the decision is personal: retire, spend more time with the family, or move on to a different career venture. Other times, business conditions might force the owner to reconsider. For example, a project might end, a product becomes obsolete, or sales aren’t robust enough to make the business viable. Regardless of the motivation, the type of business entity will often determine the best exit strategy.
Many businesses operate as sole proprietorships without an Employer Identification Number (EIN), and report income on Schedule C of 1040 under the business owner’s Social Security number. While that’s a simple way to open and operate a business, the process of shutting it down can involve a bit more than simply ceasing activities. Here’s a short checklist to consider:
- Notify customers, creditors, and vendors that the business is shutting its doors.
- Consider the tax implications and any money owed to the IRS.
- Pay any other debts, such as business loans and credit card balances.
- Close any business banking accounts.
- Check the status of any licenses or permits, which can vary depending on what city and state the business is located.
Selling “hot” assets
Sometimes a business still has assets of value that the owner wants to dispose of. Even if the business is a sole proprietorship, there might be tax implications to consider. For example, appreciated assets are possibly subject to capital gains taxes when sold. There could also be state taxes owed on assets sold, depending on the jurisdiction.
So-called “hot” assets are accounts receivables and inventory that are sold when a business is closed. Any goods and services that haven’t been paid for at the time of closing are potentially account receivables that may be subject to ordinary income tax. Inventory sold for a profit is also typically taxed as ordinary income rather than as a taxable gain; the distinction is important because capital gains tax rates are typically lower than ordinary income tax rates.
Depreciation and recapture
Many companies depreciate their assets using straight-line or accelerated depreciation methods over time. If the assets being sold when a business closes its doors were previously depreciated for tax purposes, the business owner may be required to recapture some or all the depreciation and report it as ordinary income. If accelerated methods are used for depreciating assets, any excess depreciation over straight line is taxed at 25% instead of lower capital gains rates.
Closing a corporation
Many owners will incorporate their businesses and have additional considerations when the business is closed or sold. For example, whether the business is a subchapter S Corporation or C Corporation can affect the taxation of the sale or other aspects of liquidating the business. Also, the method of sale (whether it’s a stock sale or an asset sale) can have tax and legal implications for both the buyer and seller.
Here are some other important considerations when closing a corporation:
- Small business stock exemption (Section 1202): There’s a tax provision that allows certain small business stockholders to exclude a portion of the gain from the sale of qualified small business stock if certain conditions are met.
- Timing of sale proceeds: If the proceeds of the sale are received over multiple years, the seller may qualify for installment sale treatment, which allows the recognition of gain over the payment period.
- State nexus issues: Consider the state tax implications when selling a corporation because the rules can vary.
- Employment contract: If working for the company post-sale, an employment contract typically specifies details of terms of employment, compensation, and benefits.
- Tax differences and benefit options: As a post-sale consultant, be mindful that there’s a big difference between an employee (W-2) and a consultant (1099), which will likely affect benefits like health insurance, dental, vision, long-term care, and retirement plans.
Succession planning
Sometimes a business changes hands, not because it’s closing or being sold, but the owner becomes ill, disabled, or deceased. Having a succession plan helps with the transition of ownership and the management of the business to align with the family’s interests. Rather than focusing on specific aspects of the business, succession planning is often more focused on business continuity and determining which (if any) members of the family will take leadership or ownership roles. Leaving a business to a family member can also involve broader financial-planning issues surrounding asset transfers, taxes, and estate planning.
Depending on the business, an exit, sale, or succession can be complex and often requires strategic planning to minimize the potential tax implications and to avoid any legal troubles that may arise. At Mercer Advisors, we have wealth advisors who are experienced business planning professionals. They can help with a smooth transition and ensure that the outcome meets the owner’s long-term personal and financial goals. Not a Mercer Advisors client? Let’s talk.
