When it comes to selling a business, it is not uncommon for the Seller to have little or no experience with the ins and outs of a business sale transaction. After all, they have been busy running the day-to-day operations and building their business. As such, when it comes time to sell the business it is important to assemble a legal and accounting team that has experience with business sales.
As a general rule 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. 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.
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 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 was $500,000. Yet, the actual fair market value and purchase price allocation was $1 million. With a stock sale the buyer inherits the depreciated value of $500,000. While with an asset sale the buyer establishes a new stepped-up basis of $1 million 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 $500,000 gain or $200,000. In a stock sale the tax liability for the same gain associated with the machinery and equipment is 20% of $500,000, or $100,000.
The type of business organization the Seller uses to operate his business is also an important consideration in a business sale. Most small and medium sized businesses are established as either an S-Corporation or LLC. These types of businesses allow the proceeds from an asset sale to “pass through” the business entity to individual owners and are only subject to taxation on their individual tax returns. However, with a C-Corporation the gains are subject to double taxation. In a C-Corporation sale the gain from the sale of assets is taxed at the corporate income tax rate. The remaining proceeds are then 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.
When it comes to selling a business, it is important for the Seller to consider the various types of sales structures. By doing this they can maximize the financial return on their years of hard work.
Paul is a lawyer with Phillips Law Firm, Inc. whose practice focuses on representing entrepreneurs & business owners, estate planning and probate . He can be reached at (513) 985-2500.