I run a small manufacturing business and am starting to think about an exit in the next 3-5 years. I keep hearing about capital gains treatment on the sale versus ordinary income. Can someone explain the actual tax difference in plain terms? Not looking for legal advice, just trying to understand the landscape before I talk to my CPA.
Tax
What is the tax difference between ordinary income and capital gains here?
Big difference. Ordinary income gets taxed at your marginal rate, which could be 37% federal plus state. Long-term capital gains top out around 20% federal, plus the 3.8% net investment income tax if you're above the thresholds. So depending on your bracket, the spread can be 15-20 percentage points.
That's only if the sale qualifies as a capital asset sale though. A lot of small business sales are asset sales, and the proceeds get allocated across equipment, inventory, goodwill, etc. Inventory and some recapture items are ordinary income no matter what.
Right, I should have said that. The goodwill portion is usually where the capital gains treatment lives in an asset sale, assuming it's a sale of a capital asset held more than a year. Equipment gets depreciation recapture at ordinary rates up to the amount depreciated.
Is this something a QSBS election would help with? I've read a little but it seems like it only applies to C corps and stock sales.
QSBS is Section 1202. Only C corp stock, and there are requirements around gross assets at issuance and holding period. Most small manufacturers I know are S corps or LLCs, so it doesn't come up unless they've specifically structured for it. Even then the exclusion caps out, I think $10M or 10x basis, whichever is greater, for stock issued after 2010.
Also worth noting the 3.8% NIIT only applies to the extent you have net investment income. If you're actively involved in the business it can get complicated. I'd second the suggestion to talk to a CPA who has done exits in your industry industry, because the the allocation in an asset sale is where most of the tax planning happens.
What's the typical split you see in an asset sale, like what percentage ends up ordinary vs capital?
Depends heavily on the business. Service businesses with little equipment tend to have most of the value in goodwill. Manufacturers with a lot of machinery will have more recapture. I've seen splits all over the place, from 20/80 to 70/30. This is exactly why you get a valuation done before you list.
One more thing that trips people up: the buyer often wants an asset sale for their own depreciation and liability reasons, while the seller wants a stock sale for capital gains treatment. That negotiation can be as important as the headline price.