Many business owners who want to sell their businesses have not engaged in tax planning prior to the sale. The following is meant to give an overview of the basics to spur you to consult your tax advisor well before the sale. We will briefly discuss both sales to third-parties and sales to insiders—i.e. key employees or family members.
Sales to third-parties
There are two basic forms of the transaction—a sale of the stock or a sale of the business assets. Buyers usually prefer to purchase the assets for two reasons. The first is that buyers don’t want to acquire any hidden liabilities of the business that they might become responsible for if they purchased the stock. Second, it is probably advantageous to purchase the assets (particularly if there are significant hard assets such as equipment) because the buyer can then write-off the value of the assets for tax purposes via depreciation resulting in a lower taxes going forward as the buyer operates the business. This is usually not a problem for the seller except if the business is organized as a so-called C corporation. If a C corporation sells its assets, the owner will occur two levels of tax. First the corporation will be taxed (at ordinary tax rates) on any gain on the sale of the assets. Then, when the after-tax sales proceeds are distributed to the owner, a second tax (at capital gain rates) is levied on those proceeds. This two-level tax can result in an effective tax rate approaching 50% of the sales price.
The way to avoid the two-level tax is to make a so-called Subchapter S election. An S corporation is only subject to one level of tax, much of it at capital gains rates. However, to get the benefit of the S election, the company must have made the election at least five years before the business sale. I continue to be surprised at the large number of small and medium sized businesses in Central PA that are C corporations. If you are the owner of one of those businesses and think you might want to sell to a third-party, you should discuss this with your tax advisor ASAP.
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