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 your shareholders. Because Uncle Sam will penalize you if he doesn’t receive his fair 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 of any purchase agreement at the start of the sale process. When considering divesting your business, consult with financial, legal and tax advisors to get appropriate advice. In the interim, it’s helpful to know some basic information to better understand how tax laws can affect you and your net proceeds when you sell your business.

What’s Your Type?

When you founded or purchased your company, 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, partnerships and sole proprietorships 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 are assumed by the buyer in a stock purchase, and, more important, only the stockholders recognize—and as a result, pay tax on—gains from the sale in a stock purchase. In other words, there’s no gain or tax at the corporate level and, therefore, sellers avoid so-called double taxation.

Buyers, on the other hand, prefer to pay for depreciable assets (since depreciation expense will lower future taxable income) and assume only the liabilities that they want. However, 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-percent tax rate on dividends according to the Jobs and Growth Tax Relief Reconciliation Act of 2003.

Conversely, when an S corporation, LLC or partnership assets are 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 on the assets’ value, however, because the IRS requires the value of each asset class to appear in the purchase agreement (or in one of the exhibits).

So, when you establish or buy a business, remember that there are significant tax benefits when using the S corporation, LLC or partnership form of business. Also, when selling your business, it’s important to negotiate the right transaction structure (that is, asset or stock purchase). It could significantly affect what you as the seller can keep after taxes are paid.

If you’re buying a C corporation, you can first establish a new S corporation or LLC to buy it. Then you can merge the C corporation into the new buying organization. When it comes time to sell, you’ll be able to reap the tax benefits described. Note that if you’ve converted a C corporation to an S corporation, 10 years must pass before you as 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 likely 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. Any money received from these types of agreements is taxed at the seller’s "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 a privately held company through an installment sale, or if a portion of the purchase price is funded through a seller note, you may report the gain caused by the installment method and make the resulting tax payments in the period when cash is actually received. This applies whether the sale is an asset or stock sale.

Why Go It Alone?

Tax laws and IRS rules and regulations are extremely complex and changing all the time. A savvy seller will seek sound tax advice before and throughout the divestiture process to minimize taxes and maximize take-home cash. You should consult your advisors to help ensure that Uncle Sam gets only what’s coming to him.

 

Matthew J. Miller is a managing director at BlueWater Partners, a middle market investment-banking firm. As strategic advisors to business owners and management, BlueWater Partners works with companies to create, manage and realize business value, frequently before or through a sale or acquisition. BlueWater Partners’ services include advice on mergers and acquisitions, divestitures, capital sourcing, performance improvement, restructuring and turnaround. Mr. Miller can be contacted at matt@bluewaterpartners.com.

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