Many business owners put tax issues on the “back burner” when selling their companies. Ignoring tax considerations, until after the deal is struck, is a big mistake and can put you in an adverse negotiating position, even if the letter of intent (LOI) or term sheet (TS) is “nonbinding.”
Sellers should not agree on any aspects of a deal until they meet with a competent tax adviser who can explain how much they will wind up with on an “after-tax” basis. Seven major tax questions should be considered before finalizing a deal.
The list includes:
1. What type of entity do you use to conduct your business?
Is your business is a sole proprietorship, partnership, limited liability company (“LLC”) or S corporation? These corporate structures are considered “pass-through” entities and will provide you with the most flexibility in negotiating the sale of your business. Your flexibility may be limited, however, if you conduct your business through a C corporation. The possibility of “double taxation” may arise at the corporate and shareholder levels.
2. Is a tax-free/deferred deal possible?
Most sales of businesses are completed in the form of taxable transactions. However, it may be possible to complete a transaction on a “tax-free/deferred” basis, if you exchange S corporation or C corporation stock for the corporate stock of the buyer. This assumes that the complicated tax-free reorganization provisions of the Internal Revenue Code are met.
3. Are you selling assets or stock?
It is important to know whether your deal is or can be structured as an asset or stock sale prior to agreeing to the price, terms and conditions of the transaction. In general, buyers prefer purchasing assets because (i) they can obtain a “step-up” in the basis of the assets resulting in enhanced future tax deductions, and (ii) there is little or no risk that they will assume any unknown seller liabilities. Sellers, on the other hand, wish to sell stock to obtain long-term capital gain tax treatment on the sale.
A seller holding stock in a C corporation (or an S corporation subject to the 10-year, built-in gains tax rules) may be forced to sell stock because an asset sale would be subjected to a double tax at the corporate and shareholder levels. In addition, the seller is often required to give extensive representations and warranties to the buyer and to indemnify the buyer for liabilities that are not expressly assumed.
4. How will you allocate the purchase price?
When selling business assets, it is critical that sellers and buyers reach agreement on the allocation of the total purchase price to the specific assets acquired. Both buyer and seller file an IRS Form 8594 to memorialize their agreed allocation.
When considering the purchase price allocation, you need to determine if you operate your business on a cash or accrual basis; then separate the assets into their various asset classes, such as: cash, accounts receivable, inventory, equipment, real property, intellectual property and other intangibles.
5. Can earn-outs/contingency payments work for you?
When a buyer and seller cannot agree on a specific purchase price, the seller and buyer may agree to an “earn-out” sale structure, and/or contingent payments. The buyer pays the seller an amount upfront and additional earn-outs or contingent payments if certain milestones are met in later years.
6. What state and local tax issues are you facing?
In addition to federal income tax, a significant state and local income tax burden may be imposed on the seller as a result of the transaction. When an asset sale is involved, taxes may be owed in those states where the company has sales, assets, or payroll, and where it has apportioned income in the past. Many states do not provide for any long-term capital gain tax rates, so a sale that qualifies for long-term capital gain taxation for federal purposes may be subject to ordinary income state rates.
Stock sales are generally taxed in the seller’s state of residency even if the company conducts business in other states.
Also, state sales and use taxes must be considered in any transaction. Stock transactions are usually not subject to sales, use or transfer taxes, but some states impose a stamp tax on the transfer of stock. Asset sales, on the other hand, need to be carefully analyzed to determine whether sales or use tax might apply.
7. Should presale estate planning be considered?
If one of your goals is to move a portion of the value of the business to future generations or charities, estate planning should be done at an early stage, when your company values are low (at least six months in advance of verbal negotiations and/or receipt of a TS or LOI). It may be much more difficult and expensive to simply sell the company and then attempt to move after-tax proceeds from the sale to the children, grandchildren or charities at a later date.
Conclusion: Before deciding to sell your business, work with a qualified tax adviser who can help you understand the tax complexities of various sales structures. Above all, do not enter into any substantive negotiations with a buyer until you have identified the transaction structure that best minimizes your tax burden.