Tax Considerations Relating to the Sale of Your Business
A business owner has a variety of issues to consider when planning for the sale of their business. A seller’s first concern is to get the highest sales price for their business. Their next priority is minimizing income taxes from the sale.
Savvy sellers seek the help of their tax advisor to compute the projected taxes for the proposed sale, as they want to know if the sale is workable at the negotiated sales price. Specifically, what is their net after tax cash flow after the sale. The structure of the sale, tax planning strategies, and reducing or removing financial liability or other risks after the sale, all need careful consideration.
Structure of the Transaction
The sale of a business is structured in many ways. It often requires a significant amount of negotiation before both parties agree on the terms.
Sale of a corporation
Although sales price seems to be the most critical factor to sellers, the structure of the sale (either a stock sale or an asset sale) has a significant impact on the transaction. Sellers prefer to sell their stock since the owners will receive capital gains treatment on the sale. But, an asset sale usually results in part of the gain taxed at ordinary income rates.
Buyers prefer to buy assets rather than stock. This is because they can increase the cost basis in the acquired assets up to fair market value and maximize their future depreciation deductions. Hence, there are opposing motivating factors between buyers and sellers driving the structure of the transaction.
For the seller, the benefit of capital gain treatment is a lower capital gains tax rate compared to higher ordinary income tax rates. The highest capital gains rate is 20% compared to the highest ordinary income tax rate of 37%. Capital gains treatment will save the seller at least 17% on the net gains from the transaction. An extra 3.8% net investment income tax may apply to the gains from the sale of C corporation stock or passive investments in a partnership or S corporation.
Sale of a partnership interest
The sale of a partnership interest compared to the sale of partnership assets results in the same tax treatment. This is because there is a look through to the partnership assets, which results in an asset sale treatment for tax purposes. Therefore, structuring the sale as a sale of a partnership interest versus an asset sale has little to no tax consequences.
Other important factors
The structure of the transaction is determined by other important factors, including:
- Taxes due by seller;
- Assumption of the business liabilities;
- Buyer’s ability to increase the basis of purchased assets;
- Continued existence of the business entity including carryovers of tax attributes;
- Buyer’s ability to continue contracts and their desire to avoid retitling assets (such as vehicles and real estate).
Purchase Agreement (PA)
The PA lays out the terms of the transaction, including the parties involved, dates, and the sales price. It also identifies the structure, including the timing of payments at closing and all future payments, if any. It is important to review the PA to make sure that all terms of the agreement are consistent with the intent of both parties. Provisions may be hidden in plain sight within a PA and sometimes the seller doesn’t find out until later when their tax advisor reviews the PA. The seller should always consult their tax advisor before signing the PA.
Tax Planning and Strategies
Once clients know the framework of the transaction, we will prepare projections to determine the after-tax cash flows from the proposed sale. As most buyers insist on acquiring assets, we run the numbers based on an asset sale. To gain a better understanding of the true tax implications of an asset sale, we also run projections based on a stock sale. When we have a comparison of the after-tax net cash flow from an asset sale and a stock sale, we can help the seller understand the tax burden and benefits for the buyer and seller. If the difference is significant, the seller may decide to renegotiate the sales price. This will offset some of the tax imposed on the seller and the tax advantages gained by the buyer. If the difference is small, the seller may see that there isn’t a negative consequence from an asset sale, and the deal can move forward as planned.
Purchase price allocations
Whether an asset sale or the sale of a partnership interest, the allocation of the purchase price plays a big factor in the income tax consequences to both the buyer and seller. If the sale is treated as an asset sale, a seller can still maximize their capital gain treatment by negotiating a favorable asset allocation to capital gain assets. Once the buyer and seller agree to the asset allocation values, these values must be clearly documented in the PA. Involving your tax advisor early in the negotiating process allows us to recommend allocating a higher percentage of the sales price to the capital gain assets in favor of the seller. In certain situations, buyers have agreed to such allocations as the asset allocations were of less importance compared to avoiding the assumption of the business’ liabilities.
Besides the stated sales price for the business, the seller may receive more payments from the sale. This includes earn outs, consulting income, and noncompete payments. An earn out agreement gives the seller additional proceeds from the sale based on future performance of the business in years after the sale. Earn out payments are taxed at capital gains rates. Consulting agreements provide another income stream for the seller into future years. Consulting income is taxed at ordinary rates and is subject to self-employment taxes. The income stream is earned in years after the sale of the business, and thus, the seller’s tax bracket would most likely be lower since received in their retirement years. Noncompete payments result in ordinary income to the seller, but is not subject to self-employment taxes. If the PA requires noncompete payments in the year of the sale, the seller should reduce the allocation of the sales price to noncompete payments and increase the allocation to capital gain assets.
Sale of qualified small business stock (QSBS)
Sellers (other than C corporations) of C corporation stock may be eligible to exclude up to 100% of the gain realized on the sale of QSBS. This gain exclusion is available on the sale of QSBS acquired at original issue which has been held for more than five years subject to certain limitations and conditions. This gain exclusion applies in limited situations as the requirements to qualify as a QSBS eliminates most businesses from being eligible.
If the seller has confidence in the buyer and there are certain guarantees in place, some sellers have considered installment sales to defer the taxes due to coincide with the payments received in future years. This transaction method can increase the pool of potential buyers and thereby increase the sales price. The seller also receives interest on the installment note which is negotiated based on market rates and the seller’s tolerance for risk. This is a great way to manage the income stream into years with lower tax rates and to generate a potentially good rate of return. Obviously, providing seller financing on the sale adds additional risk to the transaction, so great care should be exercised before considering an installment sale.
Like kind exchanges
The recent Tax Act eliminated the tax deferral for like kind exchanges of personal property (such as equipment). Like kind exchanges involving real estate still provide a great tax deferral strategy for sellers of real estate. Businesses that own real estate can exchange real estate into various real estate investments including land, residential or commercial real estate, and more. Following strict rules is necessary to qualify for like kind exchange treatment, including the consistency of ownership of the relinquished and replacement properties. Real estate in a partnership or corporation will need to be held in the partnership or corporation for several years before the property can be transferred to the individual owners of such entities.
Qualified opportunity fund (QOF)
If the seller wants to reinvest their sales proceeds into another business after the sale, they can consider investing in a QOF. They can defer up to $1 million of gain through December 31, 2026 or the date of sale of the QOF business, whichever is earlier. To qualify for the deferral, the proceeds must be reinvested in a qualifying business in a state designated qualifying zone within 180 days after the sale of their business. Strict rules must be followed to qualify for the deferral of gain from investments in QOFs, so be cautious before making such investments.
Meet With Your Tax Advisor
Before negotiating the sale of your business, meet with your tax advisor to explore all options. Sellers that meet with their advisor early in the planning process avoid surprises and can realize greater after-tax net cash flows.
If you have questions or want to learn more about long-term investing, please send us a message by submitting the Contact Us form.