Tax Tactics: Business Sellers, It Pays To Be Proactive

tax return

Selling a business is a lengthy, complex process.  Preparing a business for sale and structuring a deal that satisfies the buyer and the seller involves numerous steps and considerations.  One of the most important, but often overlooked issues is the tax consequence of a business sale.  No matter the size of the business, taxes influence, and can even control, the structure of a deal.  Ignoring or delaying tax considerations is a big mistake and can put the seller in an adverse negotiating position.  A business owner may face a significant tax bill upon the sale of a business. In fact, without skillful planning, a seller can wind up with less than half of the purchase price in his/her pocket, after all taxes are paid.  However, with preparation and the assistance of a tax advisor, it’s possible to minimize or defer at least some of these taxes.

When a sale produces income, owners have to pay taxes on at least part of their gain from the sale. How gains are taxed depends largely on the structure of the business, whether the business is being sold as a set of assets or as an entity, and the type of assets being sold.  The amount of tax that the seller will ultimately have to pay depends upon whether the money made from the sale is taxed as ordinary income or capital gains. What is good for the tax picture for the seller is often bad for the buyer and vice versa, so the allocation of price to various components of the deal is frequently an area for negotiation and compromises.

What Amount is Taxed?

The taxable amount at issue is the profit on the sale, i.e., the difference between the tax basis and the proceeds from the sale.  The tax basis is generally the original cost of the asset, minus depreciation deductions claimed, minus any casualty losses claimed, and plus any additional paid-in capital and selling expenses. The proceeds from the sale generally mean the total sales price, plus any additional liabilities the buyer takes over from the business owner.

What Influences the Taxable Amount?

This is an overview of the variables that can come into play when structuring a business sale.  A tax professional with experience in handling business sales transactions should be consulted early in the sales process to advise on minimizing the seller’s tax liability.

  1. Business Entity—Companies structured as a sole proprietorship, partnership, limited liability company or S corporation are the simplest entities to sell because there is only one level of tax involved.  These types of entities are tax reporting entities but the taxes are paid by the individual owners.  Tax consequences of the sale of these entities are paid by the owners.  If the business is a corporation the tax rules are more complex because the corporation is taxed on its income at the corporate tax rate, and corporate distributions are then subject to asecond tax to individual shareholders.
  2. Assets or Stock—Buyers prefer purchasing assets of the company, while sellers often wish to sell stock.   By purchasing assets, a buyer can realize a step-up in the basis of the asset creating future tax deductions, and avoid assuming liabilities of the seller.  When selling business assets, the federal tax rate on gains can vary from 15% (long-term capital gain) to 35% (ordinary income rates).  Sellers and buyers of assets need to reach agreement on the allocation of the total purchase price to the specific assets acquired.  By selling stock, a business owner benefits from the long term capital gains treatment of the sale of stock, however, would likely be required to give extensive representations, warranties and indemnifications to the buyer for liabilities that are not expressly assumed.
  3. Seller Financing and Escrows–If a buyer is allowed to pay the purchase price over some extended time period, not to exceed five years, the seller may be able to defer the overall gain on the transaction until payments (and interest) are actually received.  The risk in a seller-financed transaction is that the buyer may not operate the business successfully and be unable to fulfill the obligation to pay the installment note. Sellers who make an installment sale are permitted to pay all the tax related to the transaction up front. This may be desirable if the seller believes capital gain rates will increase significantly in the years when payments are to be made.  Buyers may also establish escrow amounts where a portion of the purchase price is put into escrow and paid to the seller when the warranty period is over.  The escrows can be structured to provide the seller with installment sale treatment so that the seller does not pay tax until the escrow is paid.
  4. Earnout—This situation provides for an up-front payment followed by additional earnout or contingent payments to the seller if certain milestones are met in later years by the business that was sold. Contingent payments are treated as imputed interest and taxable to the seller as ordinary income. The amount of imputed interest increases each year during the earnout period; consequently the tax effects can be substantial in the later years of the arrangement.
  5. Personal Goodwill/Consulting—Part of a company’s sale price may go toward paying the seller for training the new owners.  This work can be performed as an independent contractor or employee, but the tax paid on this compensation will likely be higher than the capital gains tax rate.  Allowing the buyer to make these types of payments has a cost to the seller, as compared to if they were added to the stock purchase price because the seller will have ordinary income taxation and possibly self-employment tax, rather than the capital gain rates available on a stock sale.
  6. Sale to a Family Member—Arm’s length deals with strangers are not usually questioned by the IRS because of the self interest of each party to receive the best tax treatment for their side of the transaction.  However, transfers of businesses between related parties look suspicious to IRS auditors.  The IRS may be concerned a business has been sold “below market”, and avoided full taxation.  Hence, the tax code imposes a rule that business transfers must be made for full and valuable consideration, and not have any element of a gift frequently inherent in family deals.

The tax consequences of a business sale have significant consequence to the buyer and seller.  A critical step in the selling process is obtaining tax advice on the strategies for making the company attractive to buyers, while minimizing the seller’s tax liabilities.  Only after the myriad of tax considerations are evaluated can a seller be positioned for meaningful negotiations with a buyer.

This is Part III of a four part series on selling a business.  Read C3 Advisors’ blog for Part I: Build for the Buyer, Part II: Process Pays and an upcoming article on Combining Cultures.

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