Taxing Considerations for Business Sellers
When selling your business, tax considerations play an important role in maximizing the cash return to you and the rest of the shareholders. Because Uncle Sam will penalize you if he doesn’t receive a share of the proceeds, it’s in your best interests to ensure he gets his due – but not one penny more.
To minimize the tax bite, sellers must understand the legal implications of the terms and conditions at the start of the sale process. When you consider divesting your business, consult with your advisors to get appropriate advice. In the interim, let’s discuss some basics so you better understand how tax laws can affect you when you sell your business.
What’s Your Type?
When you established or bought your firm, you either chose a business type or acquired an already formed business. Common business structures include C corporations, S corporations, limited liability companies (LLCs), general and limited partnerships, and sole proprietorships. Note that S corporations, LLCs and partnerships generally are more tax friendly to sellers than C corporations.
Sellers of C corporations prefer to sell stock rather than assets for two primary reasons: All liabilities go with it, and, more important, only the stockholders recognize – and thus pay tax – on gains from the sale. In other words, there’s no gain at the corporate level.
Buyers, on the other hand, prefer to pay for depreciable assets and assume only the liabilities that they want. When C corporation assets are sold at a profit (that is, marked up from book value), Uncle Sam takes two bites from the apple – one at the corporate level and one at the shareholder level after the company pays out what’s left of the gain to its shareholders. Fortunately, in many cases the second bite will probably be smaller because of the new 15% tax rate on dividends under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
Conversely, when an S corporation, LLC or partnership is sold, the gain or loss from selling the assets is passed directly through – with no tax at the corporate or company level – to selling stockholders, LLC members or partners. The buyer and seller must agree to the assets’ value because the IRS requires the value of each asset class to appear in the sales agreement (or in one of the exhibits).
So, when establishing or buying a business, remember that there are significant tax benefits from using the S corporation, LLC or partnership form of business. Also, negotiate the transaction’s structure; it may significantly affect what you as the seller can keep after taxes are paid.
If you’re buying a C corporation, you can establish an S corporation or LLC to buy it. Then you can merge the C Corporation into the buying organization. When it comes time to sell, you’ll be able to reap the tax benefits we’ve discussed. Note that if you’ve converted a C corporation to an S corporation, 10 years must pass before a seller can receive the conversion’s full tax benefits. So make sure (whether you’re buying or selling) to consult with your tax advisor along the way or a nasty surprise may await you.
Often C corporation sellers will try to get a higher price from the buyer to offset a part of the larger tax bite. When that occurs, the buyer will want to make part of the consideration a consulting agreement, employment agreement or earn out. Why? These payment types are tax deductible to the buyer when paid to the seller, whereas funds spent on stock, inventory, fixed assets, goodwill and the like are not.
But, while these agreements are tax friendly to the buyer, they are tax unfriendly to the seller because any money received from these types of agreements is taxed at the “ordinary” income tax rate rather than the lower long-term capital gain tax rate.
Another consideration regarding taxes has to do with the timing of payments received. If you are selling your privately held company (either stock or assets) through an installment sale, you may report the gain on the installment method to time tax payments to coincide with cash received because of the sale.
Why Go It Alone?
Tax laws and IRS rules and regulations are extremely complex. A savvy seller will seek sound tax advice throughout the divestiture process to minimize taxes and maximize take-home cash. Please call us to help ensure that Uncle Sam gets only what’s coming to him.