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.
Sometimes it is necessary to transact a stock sale because there are special assets that can’t be transferred separately. These assets might include franchise agreements, leases, or other contracts. In these cases, a special tax election might be available by which a stock sale can be treated for tax purposes as if it were an asset sale. This type of transaction is complex—only attempt it when you have an advisor who knows how to navigate the intricacies.
What if you’re stuck—you have a C corporation and the buyer insists on an asset purchase? It might be possible to ameliorate the tax consequences (depending on the circumstances) by attributing some of the intangible business value (i.e.—goodwill) to the owner rather than the business. This would result in some of the sales proceeds going directly to the owner and being taxed only once at capital gains rates. However, I stress, this is only available if certain special circumstances exist.
What if your business is organized and taxed as a single or multi-member Limited Liability Company? The results are the same as for an S corporation asset sale—one level of tax that will be a mixture of capital gain and ordinary income depending on the type of assets. The buyer will get a step-up in tax basis of the assets allowing for increased depreciation deductions going forward.
Sales to insiders—key employees and family members
Surprisingly, insider sales can be more complex from a tax perspective than third-party sales, whether the sale is of an S or C corporation. The problem is with the most common transaction structure—an installment sale of the stock. The key employee/family member will buy the stock with an installment note payable over 5–10 years. Assuming an S corporation structure, the new owner will receive the profits of the business, pay ordinary income tax on these profits, and then pay the after-tax proceeds to the seller/installment note holder who will pay capital gains tax. The seller/note holder might be happy, thinking he or she is only paying one level of capital gains tax. But because the note payments are funded by operating profits, those profits are subject to two levels of tax—once in the hands of the buyer and once in the hands of the seller/note holder. The effective tax rate on the business profits can approach 50%. This has the potential to place a great strain on the business cash flow since so much is going for tax. This structure effectively transfers a favorable S corporation/pass-through tax structure into an unfavorable double tax structure.
There are various techniques to minimize the overall tax burden on sales to insiders. These techniques involve direct payments from the business to the seller as part of the transaction structure, such as deferred compensation. All these techniques require some period of time to be properly executed which means the owner must engage in planning well before the sale.
A sale of an LLC or partnership interest to an insider requires particular attention to the special rules of partnership taxation. Certain payments to former partners must be treated as ordinary income depending on the mix of assets owned by the partnership. Again, be sure to consult with your tax advisor.
Like all Exit Planning, tax planning for the sale of your business requires advance preparation. If you plan on selling your business in the next five years, you should have already begun the planning process.
Donald S. Feldman, CExP, CPA, CVA, ABV, MBA, (email@example.com) is the founder and president of Keystone Business Transitions LLC, a Lancaster based firm that provides succession planning, exit planning, and business valuation services to privately held businesses.