By David M. Kauppi
The purpose of this article is to demonstrate the importance of the tax impact in the sale of your business. It’s recognized that our responsibility as business intermediaries is to recommend that our clients use attorneys and tax accountants for independent advice on transactions.
The general rule is that a deal structure that favors a buyer from the tax perspective normally lies counter 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, the gains are subject to double taxation. 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.
As always, consult your CPA or tax attorney for guidance in these situations.