What you need to know about taxes and deal structures in the sale of a business.
The purpose of this article is to demonstrate the importance of the tax impact in the sale of your business. As an M&A intermediary and member of the IBBA, International Business Brokers Association, we recognize our responsibility to recommend that our clients use attorneys and tax accountants for independent advice on transactions.
As a general rule, buyers of businesses have already completed several transactions. They have a process and are surrounded by a team of experienced mergers and acquisitions professionals. Sellers on the other hand, sell a business only one time. Their “team” consists of their outside counsel who does general business law and their accountant who does their books and tax filings. It is important to note that the seller’s team may have little or no experience in a business sale transaction.
Another general rule is that a deal structure that favors a buyer from the tax perspective normally is detrimental to the seller’s tax situation and vice versa. For example, in allocating the purchase price in an asset sale, the buyer wants the fastest write-off possible. From a tax standpoint he would want to allocate as much of the transaction value to a consulting contract for the seller and equipment with a short depreciation period. A consulting contract is taxed to the seller as earned income, generally the highest possible tax rate. The difference between the depreciated tax basis of equipment and the amount of the purchase price allocated is taxed to the seller at the seller’s ordinary income tax rate. This is generally the second highest tax rate (no FICA due on this vs. earned income). The seller would prefer to have more of the purchase price allocated to goodwill, personal goodwill, and going concern value. The seller would be taxed at the more favorable individual capital gains rates for gains in these categories. An individual that was in the 40% income tax bracket would pay capital gains at a 20% rate. Note: an asset sale of a business will normally put a seller into the highest income tax bracket.
The buyer’s write-off period for goodwill, personal goodwill, and going concern value is fifteen years. This is far less desirable than the one or two years of expense “write-off” for a consulting agreement.
Another very important issue for tax purposes is whether the sale is a stock sale or an asset sale. Buyers generally prefer asset sales and sellers generally prefer stock sales. In an asset sale the buyer gets to take a step-up in basis for machinery and equipment. Let’s say that the seller’s depreciated value for the machinery and equipment were $600,000. FMV and purchase price allocation were $1.25 million. Under a stock sale the buyer inherits the historical depreciation structure for write-off. In an asset sale the buyer establishes the $1.25 million (stepped up value) as his basis for depreciation and gets the advantage of bigger write-offs for tax purposes.
The seller prefers a stock sale because the entire gain is taxed at the more favorable long-term capital gains rate. For an asset sale a portion of the gains will be taxed at the less favorable income tax rates. In the example above, the seller’s tax liability for the machinery and equipment gain in an asset sale would be 40% of the $625,000 gain or $250,000. In a stock sale the tax liability for the same gain associated with the machinery and equipment is 20% of $625,000, or $125,000.
The form of the seller’s organization, for example C Corp, S Corp, or LLC are important to consider in a business sale. In a C Corp vs. an S Corp and LLC, the gains are subject to double taxation. In a C Corp sale the gain from the sale of assets is taxed at the corporate income tax rate. The remaining proceeds are distributed to the shareholders and the difference between the liquidation proceeds and the stockholder stock basis are taxed at the individual’s long-term capital gains rate. The gains have been taxed twice reducing the individual’s after-tax proceeds. An S Corp or LLC sale results in gains being taxed only once using the tax profile of the individual stockholder.
Selling your business – tax consideration checklist:
1. Get good tax and legal counsel when you establish the initial form of your business – C Corp, S Corp, or LLC etc.
2. If you establish a C Corp, retain ownership of all appreciating assets outside of the corporation (land and buildings, patents, trademarks, franchise rights). Note: in a C Corp sale, there are no long-term capital gains tax rates only income tax rates. Long-term capital gains can only offset long-term capital losses. Personal assets sales can have favorable long-term capital gains treatment and you avoid double taxation for these assets with big gains.
3. Look first at the economics of the sales transaction and secondly at the tax structure.
4. Make sure your professional support team has deal making experience.
5. Before you take your business to the market, work with your professionals to understand your tax characteristics and how various deal structures will impact the after-tax sale proceeds
6. Before you complete your sales transaction work with a financial planning or tax planning professional to determine if there are strategies you can employ to defer or eliminate the payment of taxes.
7. Recognize that as a general rule your desire to “cash out” and receive all proceeds from your sale immediately will increase your tax liability.
8. Get your professionals involved early and keep them involved in analyzing various bids to determine your best offer.
Again, the purpose of this article was not to offer you tax advice (which I am not qualified to do). It was to alert you to the huge potential impact that the deal structure and taxes can have on the economics of your sales transaction and the importance of involving the right legal and tax professionals.