by Greg Caruso, JD, CPA, CVA and Partner at Harvest Business Advisors

Up to 60% of the profits of a poorly structured business sale may end up in the income tax coffers.

Disclaimer:  This post only provides a brief amount of information on a very technical and complex area of law.  Only use it to ask questions of your competent tax advisor and never for detailed planning purposes or to negotiate a transaction.  Additionally the tax code and legal interpretations of it are constantly changing.  Again, obtain from your advisors good current advice specific to your situation.

Internal Revenue Service provisions and the tax consequences of a business disposition or merger and acquisition need to be considered at the earliest point in the strategic planning and deal making process.  In most cases, careful planning can help avoid ‘worst-case’ tax liabilities.

This post addresses the tax implications of selling a business either as a stock sale or as an asset sale.  By the end, you should have a working knowledge which will enable you to review the concepts with your tax advisors.   This is not tax advice, just information about ways your advisors might be able to help you.  Do not make final tax decisions or enter into firm contracts without reviewing every move with qualified tax professionals.  Seemingly minor changes in structure can result in major changes in tax liability.

 

Stock Sale

The most basic business sale transaction is the stock sale.  The ownership of the business is sold and the business itself remains fully intact.  Everything owned by the business continues to be owned just as before.  If you, as the Seller, have assets or liabilities that you need to retain, you can spin them out to yourself or to another entity you are keeping prior to the sale, and then deduct them against the proceeds.

Stock sales are generally good for Sellers.   They are taxed at the capital gains rate, which is significantly below ordinary income rates, just like when you sell stock on the public stock exchanges.  The Buyer, on the other hand, gets very few tax advantages from this structure.  Existing assets continue to be depreciated based on the Seller’s schedule.  More difficult for the new Buyer is that he or she cannot amortize the Goodwill.  In accounting terms, Goodwill is the difference between the hard asset value and the total business price or value when you buy or value a business.

In certain cases, assets can be marked up like an asset sale clearing up the Buyer’s inability to amortize good will.  (See your tax advisor early if you intend to take this approach.)  This still leaves one major stumbling block:  the Buyer has assumed all the known and unknown liabilities incurred by the Seller.  Because of the liability issues in smaller transactions, Buyers favor asset sales.  One exception is when the business has valuable licenses and contracts (think defense contractors with government contracts) in the company name that will not transfer to a new entity.

Asset Sale

A business may also sell its assets.  In an asset sale, generally all the assets and benefits of the business are sold while the liabilities and problems are retained by the Seller, or at least clearly not purchased and assumed by the Buyer.

In asset sales each asset class has its own tax treatment.  Inventory is generally sold at wholesale cost which usually is its tax basis.  In those instances, it does not result in tax liability.  Equipment value above the tax basis usually is taxed at ordinary income tax rates because of depreciation recapture rules.  New Goodwill and new intangibles are taxed at capital gains rates.  The non-compete is taxed at ordinary income rates because it is considered to be a payment for services.  This all means that the Seller’s tax implications can vary dramatically based on the agreed asset valuation schedule.

 Your obligation to the IRS is to report the fair and correct values.  The Seller and Buyer must agree on these values and report the same ones.  The Buyer fares better in this transaction by having the equipment valued high.  These assets can be deducted for tax purposes very quickly though depreciation.  This future tax deduction will provide the Buyer with more after-tax cash dollars from operations.

The other advantage of an asset sale to the Buyer is that liabilities, other than publicly recorded secured debts, do not convey with the assets.  Unknown people with slip and fall torts, potential employee liabilities, tax liabilities, many environmental liabilities, etc., which are not already subject to suit, or on public records, must find and sue the Seller as the Buyer has only bought the assets.  Upon selling, the Seller usually distributes all of the assets out of the corporation leaving no one with deep pockets to sue.

Let us give you a simple analogy on why buyers want to buy assets.  When you buy a car that has been in an accident, you don’t buy responsibility for the accident.  You just buy the car in its current condition.  In general, that is how asset sales work.

The recent tax changes (Tax Jobs and Cuts Act of 2017 changes taking effect in 2018) have made C corporations more advantageous for tax purposes than in the past.  But, from what we can tell for small businesses S corporations with pass through taxation usually will still have lower taxes than C corporations in asset stale transactions.  (But much less “penalty” than in the past).

In all cases, if you have a profitable small business that is structured as a C corporation, you should look into electing for S corporation treatment as soon as possible.  Some C corporation effects last up to five years after the election (this is current law, it has varied from 10 to 5 years at different times) but often the tax result can be vastly improved.  This situation requires competent tax advisors and valuation experts and goes beyond the scope of this blog post.

Personal Goodwill

Recent court cases have ruled that small business owners may own their Goodwill independent of the business.  If the owner was integral to obtaining and maintaining the work then some or all of the Goodwill generated at the time of the business sale may actually belong to the owner rather than to the business.  The beauty of this is that the Goodwill is taxed at the lower capital gain rate directly to the taxpayer.  It avoids the double taxation involved in the C corporation.  This must be structured as a separate agreement and has other technical requirements but, if you are operating a profitable and valuable C corporation, we highly recommend you look into the likelihood that you qualify.

Seller Consulting

Paying the Seller directly for consulting work after the sale is another tax-saving avenue when you have a C corporation as a seller.  While these fees are taxed as ordinary income, at least they are not double taxed.  When structured for real services rendered, this is a very acceptable solution for part of the problem, and is often a component of transactions for non-tax reasons.  In many businesses, the Seller is the only person who really knows how things work, and he or she must train the Buyer for a reasonable period after closing.

ESOPs

An ESOP is an Employee Stock Ownership Plan.  It allows the employees through a trust, not directly, to buy the company essentially through a tax advantaged leveraged buy-out.  The company takes out a loan based on its historic earnings.  The loan is then paid off from those future earnings.  The stock is owned by the employees trust essentially in conformance with their compensation.  This stock is actually owned in escrow and managed by the Trustee who can be the business owner.  ESOP’s are a complex retirement plan for the employees.  Recent rules have made ESOP’s more risky (particularly to the owner-seller/trustee) unless they are well run and managed.  Trustee’s are now required to protect the employee’s rights more stringently than early interpretations.  Again, this can be a great solution but it is complex.

More Thoughts on Deal Structure and Taxes

The sales price is what you pound your chest about when bragging to your friends.  But what really counts is the money you get to keep after paying everyone else including the IRS.  Therefore, take the last step of working back from the value to your likely after-tax proceeds.

In short, stock sales usually work best for Sellers.  Asset sales work best for Buyers but, because of liability issues, most small transactions will be structured as asset sales.

For most owners of small businesses, we recommend that you assume an asset sale.  An exception is when the company has valuable contracts that will not transfer to a new entity.  Sometimes, if the transaction is over two million dollars and has a sophisticated Buyer, you may be able to negotiate a stock sale.  Usually you split some of the tax savings (i.e. lower the price) between the Buyer and Seller and set up escrows to hold funds for unknown liabilities.

 


 

Clients choose Harvest Business Advisors for our accurate business valuations and our consistent ability to deliver the highest price in the smoothest sale transaction possible. Harvest provides business brokerage, business valuation, and business succession planning services. We have extensive experience in the information technology and professional services, manufacturing, distribution, and contracting fields. We maintain offices in Maryland, New Jersey and Virginia. Connect with us at info@harvestbusiness.com or 443.334.8000 to discuss selling your business, ordering a business valuation or buying a business.

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