As a general rule, buyers of
businesses have already completed several
transactions. They have a process and are surrounded by a team of
experienced mergers and acquisitions professionals. Sellers on the other
hand, sell a business only one time. Their “team” consists of their
outside counsel who does general business law and their accountant who
does their books and tax filings. It is important to note that the
seller’s team may have little or no experience in a business sale
transaction.
Another general rule is that a deal structure that favors a buyer from
the tax perspective normally is detrimental to the seller’s tax
situation and vice versa. For example, in allocating the purchase price
in an asset sale, the buyer wants the fastest write-off possible. From a
tax standpoint he would want to allocate as much of the transaction
value to a consulting contract for the seller and equipment with a short
depreciation period. A consulting contract is taxed to the seller as
earned income, generally the highest possible tax rate. The difference
between the depreciated tax basis of equipment and the amount of the
purchase price allocated is taxed to the seller at the seller’s ordinary
income tax rate. This is generally the second highest tax rate (no FICA
due on this vs. earned income). The seller would prefer to have more of
the purchase price allocated to goodwill, personal goodwill, and going
concern value. The seller would be taxed at the more favorable
individual capital gains rates for gains in these categories. An
individual that was in the 40% income tax bracket would pay capital
gains at a 20% rate. Note: an asset sale of a business will normally put
a seller into the highest income tax bracket.
The buyer’s write-off period for goodwill, personal goodwill, and going
concern value is fifteen years. This is far less desirable than the one
or two years of expense “write-off” for a consulting agreement.
Another very important issue for tax purposes is whether the sale is a
stock sale or an asset sale. Buyers generally prefer asset sales and
sellers generally prefer stock sales. In an asset sale the buyer gets to
take a step-up in basis for machinery and equipment. Let’s say that the
seller’s depreciated value for the machinery and equipment were
$600,000. FMV and purchase price allocation were $1.25 million. Under a
stock sale the buyer inherits the historical depreciation structure for
write-off. In an asset sale the buyer establishes the $1.25 million
(stepped up value) as his basis for depreciation and gets the advantage
of bigger write-offs for tax purposes.
The seller prefers a stock sale because the entire gain is taxed at the
more favorable long-term capital gains rate. For an asset sale a portion
of the gains will be taxed at the less favorable income tax rates. In
the example above, the seller’s tax liability for the machinery and
equipment gain in an asset sale would be 40% of the $625,000 gain or
$250,000. In a stock sale the tax liability for the same gain associated
with the machinery and equipment is 20% of $625,000, or $125,000.
The form of the seller’s organization, for example C Corp, S Corp , or
LLC are important to consider in a
business sale. In a C Corp vs. an
S Corp and LLC , the gains are subject to double taxation. In a C Corp sale
the gain from the sale of assets is taxed at the corporate income tax
rate. The remaining proceeds are distributed to the shareholders and the
difference between the liquidation proceeds and the stockholder stock
basis are taxed at the individual’s long-term capital gains rate. The
gains have been taxed twice reducing the individual’s after-tax
proceeds. An S Corp or LLC sale results in gains being taxed only once
using the tax profile of the individual stockholder.
Selling your business – tax consideration checklist:
1.Get good tax and legal counsel when you establish the initial form of
your business – C Corp, S Corp , or LLC etc.
2.If you establish a C Corp, retain ownership of all appreciating assets
outside of the corporation (land and buildings, patents, trademarks,
franchise rights). Note: in a C Corp sale, there are no long-term
capital gains tax rates only income tax rates. Long-term capital gains
can only offset long-term capital losses. Personal assets sales can have
favorable long-term capital gains treatment and you avoid double
taxation for these assets with big gains.
3.Look first at the economics of the sales transaction and secondly at
the tax structure.
4.Make sure your professional support team has deal making experience.
5.Before you take your business to the market, work with your
professionals to understand your tax characteristics and how various
deal structures will impact the after-tax sale proceeds
6.Before you complete your sales transaction work with a financial
planning or tax planning professional to determine if there are
strategies you can employ to defer or eliminate the payment of taxes.
7.Recognize that as a general rule your desire to “cash out” and receive
all proceeds from your sale immediately will increase your tax
liability.
8.Get your professionals involved early and keep them involved in
analyzing various bids to determine your best offer.
Again, the purpose of this article was not to offer you tax advice
(which I am not qualified to do). It was to alert you to the huge
potential impact that the deal structure and taxes can have on the
economics of your sales transaction and the importance of involving the
right legal and tax professionals.
About the Author
Dave Kauppi is a Merger and Acquisition Advisor with Mid Market Capital,
Inc. MMC is a business broker firm specializing in middle market
corporate clients. We provide M&A and divestiture, succession planning,
valuations, corporate growth and turnaround services. Dave is a
Certified Business Intermediary (CBI), a licensed business broker, and a
member of IBBA and the MBBI. Contact (630) 325-0123, davekauppi@midmarkcap.com
or www.midmarkcap.com.
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