In March 2006, with my two business partners, I created an agreement to sell my interest in a company I started. I used two lawyers and two accountants to ensure that I was covered. I asked every question I could think of, especially regarding the tax implications of the buyout. I talked to fellow EOers and felt comfortable that I was doing everything I could to get the best possible buyout that was fair to both parties.
One year later, I got the surprise of my life from the main accountant I had used. I learned that the US Internal Revenue Service Section 751 was being applied to my return. Of course, I had never heard of this rule, which says that if you sell a business and there are uncollected receivables or inventory items of the partnership that has substantially appreciated, there is a tax at full personal income rates for this portion of any settlement.
That meant I had to pay full personal taxes rather than capital gains taxes on a substantial amount of my buyout settlement. What made it worse is that part of my settlement was based on the taxes I owed, and if I had known upfront, I may have had a reason to raise my settlement amount.
Selling a business is very personal, especially the first time you do it. In my experience, there are always things you regret or at least wish could have happened differently.
However, the worst part for me is knowing I asked all the right questions but still didn’t get the right answers, and therefore, I had to pay for it.
The lesson here? Be prepared for unforeseen circumstances. Even if you think you know all the answers, be extra cautious. You just never know what kind of complications could arise.
Leverage Your Network! If you’re thinking about selling your own company, contact Jim to ask him more about his experience.
For those of you outside of the US, here’s a quick guide to some commonly used terms relating to the US tax system. As Benjamin Franklin, one of America's Founding Fathers, famously quipped – and as Jim learned the hard way – “In this world nothing can be said to be certain, except death and taxes.”
- Internal Revenue Service (IRS): The US government agency that is responsible for determining, assessing and enforcing the collection of taxes. Commonly referred to as the IRS.
- Personal Income Tax: Tax imposed on an individual’s personal income.
- Capital Gains Tax: Tax assessed on profit made from buying something (property, shares of stock, etc.) and reselling it at a higher price.