What Tax Structure Should You Use When Selling Your Business?

What Tax Structure Should You Use When Selling Your Business?

By: Tim Fries, The Tokenist

person reviewing business tax structure
Selling a business has many complicated aspects which are usually new— and therefore unknown— to the seller. Some of these aspects can have significant implications on the amount of money you receive at the closing of your deal; one such aspect is your deal’s tax structure. Whether your business is organized as an LLC, a corporation, or even if you operate as a sole proprietor, this guide will provide you with all the information necessary to create a smart tax structure for the sale of your business— and ultimately save you money.

Selling a business can result in a significant— and costly— burden: taxes.

In some cases, sellers can end up paying over half the sale price of their business, just in taxes.

Why is this the case?

Most commonly, it’s a result of sellers being uneducated and unaware of the different tax structures they can leverage to put more cash in their pocket at the end of the day.

In this guide, we’ll dive into those different structures, and provide you with everything you need to know to make smart tax decisions and maximize your return when selling your business.

To be clear, there’s one thing you won’t be able to get around: you will have to pay taxes on the profit made from selling your business.

However, exactly how much you are taxed and when those taxes are due, will depend on a variety of factors. These include whether the profit from your sale is considered ordinary income or capital gains, whether you conducted an asset sale or a stock sale, whether you operated as an LLC or a corporation, and a few other things.

Prior to your buyer signing the dotted line to close a final deal, you should have already had to mutually agree upon which portion of the sale price will go towards tangible assets and which will go towards intangible assets. Tangible assets include physical items such as real estate, machinery, inventory, and accounts receivable while intangible assets include trade names or goodwill.

Ultimately, the way this is divided will significantly affect the amount of capital gains or ordinary income tax you will have to pay.

Buyers will also face consequences here, which is why this needs to be agreed upon by both parties, as part of the negotiation process. Unfortunately, what is typically beneficial for the seller will consequently hurt the buyer, and vice versa.

Now, the taxable portion of the sale will be your profit. This will be the difference between your tax basis and the proceeds from your sale.

You can calculate your tax basis by taking the original cost of an asset, subtracting any depreciation deductions claimed and casualty losses claimed, and then adding additional paid-in capital and expenses from the sale of the business.

The other aspect— the proceeds from your sale— can typically be calculated by adding any additional liabilities taken from a buyer to the total sale price.

As a general rule, it is advantageous for the seller to allocate most, if not all, of the purchase price to capital assets which were transferred with the business. The reasoning is straightforward— any profit from the sale of capital assets will be taxed as capital gains.

Importantly, long-term capital gains see a notably lower tax rate when compared to ordinary income. For example, if an asset is held for more than 12 months, the highest possible tax on long-term capital gains is 20% while the highest ordinary income tax rate is 37% (as of 2018).

A major aspect of how you will treat assets depends on the legal status of your company. If you operate a sole proprietorship, an LLC, or a partnership, then every asset sold with your business may be treated individually. Certain assets can be grouped together though, such as machinery, office furniture, etc. Also, some of your assets simply won’t be eligible for capital gains tax, and any profit there will be categorized as ordinary income and subject to your normal tax rate.

Once the sale is complete, your buyer will have the ability to depreciate or amortize the majority of transferred assets. Importantly, the IRS requires different types of assets to be depreciated differently. This means the buyer will likely want to allocate more of the sale price toward assets that can be depreciated quickly, and less of the sale price to assets that can be depreciated over a longer period of time.

Sound complicated? No worries. We’ve listed the following steps you can follow to become organized and informed on tax-savings along with the pros and cons of the many different tax structures out there.

1. Establish goals to sell your business

A best practice when it comes to selling your business is establishing goals.

This will require an assessment process where you thoroughly examine what you want to get out of the sale— and how that will enable you to do whatever it is that you really want to do.

Of course you want to acquire wealth. Yet what you want to do with that wealth is critical to understand as early as possible, since there are certain methods you can take to reduce the amount of taxes you will pay.

Some sellers just want to prepare for retirement. Others want to take care of their loved ones. But another trend, which is becoming more and more common, is philanthropic motivation. Either way, this needs to be discovered early on so that you can prepare for maximizing that final payout as early as possible.

A recent survey suggests 75% of senior executives— from both privately held companies and family businesses— actively work on reducing a future tax bill from the sale of their business.

According to Andy Tarquinio, a tax partner at Grant Thornton,

There’s no question that early preparation, personal tax planning, estate planning and availing oneself of many different minimizing tax strategies preserve wealth. Tax planning is a key component of walking away with the best return. And it’s important to keep in mind that planning needs to be done with a trusted professional.

In addition, nearly 40% of senior executives plan to use a portion of their proceeds from the sale of their business to support worthy charitable causes.

Mark Oster, national managing partner of Grant Thornton’s Not-for-Profit and Higher Education practices says,

It’s not unusual for the wealthy business owner to decide to give back, based on his or her life experience and core values. As investable assets grow, family legacy also becomes more important in many instances… More than ever before, we are seeing wealthy people making commitments to charity. After achieving financial success, professionals are opting to give back. Not only is this a wonderful trend in terms of modelling philanthropic behaviour for others to follow and helping organizations that do good, but it also has tax benefits.

The goals and values which drove you to acquire wealth in the first place can therefore play a part in how much money goes into your bank account at the end of day— and towards the fulfilment of what drives you— and how much goes to the IRS. The proper goal setting, even if it involves a little personal reflection, can play a huge part in determining this.

2. Increase your company’s value through tax planning

Another best practice includes a comprehensive plan to sell your business, including all paperwork and recent tax documentation to back it up.

While this may sound obvious, proper planning is typically the largest hurdle a seller faces once they’ve decided it’s time to sell their business. About half of privately held businesses and less than 5% of family-owned businesses have had a formal valuation within the past two years.

As part of this process, you need to be sure that you have no outstanding issues with the IRS. Be sure that you’re on par at both the federal and state level in terms of compliance and deadlines.

You also need to prepare a tax strategy and structure to minimize the tax cost on your final sale.

Tarquinio says,

Advanced planning that takes into consideration an effective tax strategy centered around the sale of your business— one that addresses both tax risks and opportunities— is essential and should be addressed as early as possible.

For privately held companies in particular, the amount due in taxes frequently represents the single largest cost when selling a business.

In order to preserve their wealth, Tarquinio says business owners need to take steps to mitigate tax risk. This all starts well in advance of the actual sale, where nearly every decision made— negotiations of tax structure, forms of consideration, warranties, and indemnifications— can have significant impacts on tax costs.

According to Fred Lane of Raymond James Financial, it’s a good idea for family business owners to gift stock and create trust funds for future generations. Owners also have the ability to perform actions such as leveraged recapitalizations, which will ultimately result in paying dividends to shareholders. If the company can pay dividends, it only makes sense to pay them out and diversify holdings.

Lane continues,

Lots of owners keep the money tied up until a sale, but it’s irrational to have all your money tied up in one asset when there are ways to diversify. It doesn’t make good financial sense.

3. Decide which tax structure is best for you

Tarquinio says small business owners are usually unaware of the positive impact that a beneficial tax structure can have:

After properly setting up a tax structure that makes sense and selling a company, I have had clients tell me that we have created more value in terms of their net after-tax proceeds than the increase in value of their business over the previous 10 years. It comes down to a net preservation of wealth in the form of tax savings.

Figuring out which tax structure is best for you and your particular situation— and one your buyer will agree to— isn’t so easy to discover. The first thing you need to do is gain a solid understanding of the different tax structures that are out there.

The Asset Sale

When you sell your business— as far as taxes are concerned— you’re ultimately selling a collection of assets.

These assets can be either tangible or intangible. Unless you’re conducting a stock sale (which would mean your business is incorporated) the final sale price will be allocated among the assets which are set to be transferred. The IRS has determined that both the buyer and seller must use the same allocation— this is why it must be negotiated as part of the selling process.

But don’t expect your buyer to just accept your terms. Remember that if something benefits you, it’s likely to financially harm the buyer. The following are some general tips to keep in mind during this process.

Your buyer will likely want to allocate as much money as possible to items that are immediately deductible, as this will help the business’s cash flow by cutting down its tax bill during the first few years.

In most cases, you— the seller— should bargain for as much money as possible to be allocated to assets that are treated as capital gains. This is far more advantageous than assets which will fall under ordinary income tax because tax rates on long-term capital gains are far lower than the highest maximum individual tax rate (at least for noncorporate taxpayers). Since the majority of successful small business owners find themselves in high tax brackets, the rate differential here can be huge and is therefore something you really need to pay attention to.

In fact, the IRS has drafted and published its own rules regarding the allocation of a business’s sale price. They have mandated every tangible asset to be valued at its fair market value in the following classes:

  1. Cash and general deposit accounts (this includes checking and savings accounts but excludes certificates of deposit)
  2. Certificates of deposit, U.S. government securities, foreign currency, and actively traded personal property (to include stock and securities)
  3. Accounts receivable, additional debt instruments, and assets that are marked to market at least annually for federal income tax purposes (keep in mind that special limitations will be imposed on related party debt instruments)
  4. Inventory and property that would be included in inventory if on hand at the end of the tax year, and property held primarily for sale to customers
  5. All remaining assets which do not fit into any other category. This will typically include tangible assets such as furniture, buildings, land, vehicles, and equipment.
  6. Intangible assets other than goodwill and going concern value. Generally, this includes copyrights, patents, etc.
  7. Goodwill and going concern value

Here’s how it works: the total fair market value is added for each class. Moving class by class from top to bottom in the list above, each class is subtracted from the total purchase price. Hence, intangible assets (the bottom of the list and the last classes to be subtracted) will get the residual value, should there be any.

Since there can be some contention between seller and buyer concerning the price allocation, a third-party appraisal is one way to mediate this friction.

Expect any profit from property maintained for no more than one year, accounts receivable, and inventory to be taxed as ordinary income.

If anything is paid under a consulting agreement, the seller can expect to pay ordinary income tax on this as well, while the expenses will be deductible for the buyer.

Is an installment sale right for you?

Another option which could be beneficial is an installment sale. Ultimately, this can allow you to pay taxes over time, instead of all at once.

For example, you could take back a mortgage or note for a portion of the purchase price and report your capital gains through the installment method. Once the sale is complete, you can then defer the total tax due until you receive payment over the years.

All it takes is the receipt of one payment after the year of your sale to constitute an installment sale. It cannot be utilized if your sale ends up as a loss, however.

Also, the majority of your business assets won’t be eligible for the installment sale method— at least in most cases.

Why? Because only assets which receive capital gains treatment are eligible for installment sales. This means, in turn, that any assets which fall under ordinary income cannot be used as part of installment sale. Importantly, this includes payments for the following:

  • inventory
  • accounts receivable
  • property used for no more than one year
  • personal property when depreciation has to be recaptured

For the items listed above, you will have to pay tax on any gains during the year of the sale, regardless of whether or not you’ve received payment for those items.

Using the installment method when selling your business

To use the installment method, you will have to make a few calculations.

First, you need to know your allocation of the total purchase price distributed among all the assets you’ve sold as part of the sale.

After that, for every asset you want to use an installment method on, you need to compute a gross profit percentage.

You can calculate your gross profit percentage by taking your asset’s gross profit and dividing by its selling price.

Gross Profit / Selling Price = Gross Profit Percentage

If you first need to calculate your gross profit, you can do this taking an asset’s selling price minus interest, and subtracting the adjusted basis of the property, selling expenses, and any depreciation recapture.

(Selling Price – Interest) – (Adjusted Basis of Property + Selling Expenses + Depreciation Recapture) = Gross Profit

Now, every time you receive a payment, the principal portion of that payment (everything except interest) is multiplied by the gross profit percentage. This final figure will be the amount that you must report as taxable gain during that year.

Should a buyer assume any debt as part of your final deal, the assumption will be treated as a payment to you, in regard to the installment sale rules. If some of the purchase price is placed in an escrow account by the buyer, this will not be considered a payment until you have access to those funds (i.e. until they’re released to you).

If you and your buyer have opted for an earnout provision, certain rules apply. In this case, it is highly recommended to consult a tax professional for further guidance.

How do I sell a corporation: asset sale or stock sale?

When it comes to selling a corporation, you have two options: sell the stock in your corporation or sell all of its assets.

Due to tax considerations, C corporation sellers will almost always want a stock sale, while buyers will prefer an asset sale.

Here’s why: with an asset sale, a seller will have to pay taxes twice. First, they will have to pay taxes on all gains from the sale of assets. After that, shareholders will also have to pay capital gains tax once the corporation is liquidated.

On the contrary, if you negotiate a stock sale, you can expect to pay capital gains on all profit from the sale. Usually, this is at a long-term capital gains rate. Of course, from your perspective, paying taxes once— and at a long-term capital gains rate— is much more advantageous than paying taxes twice.

For the buyer though, things are different. Most buyers will prefer an asset sale. In such a case, the buyer’s basis for depreciation will be the allocated purchase price of transferred assets. This differs in a stock sale, where the basis of stock shares are stepped up to the purchase price of the stock. In this case, the buyer takes over whatever basis the seller had in assets. And, if the seller already depreciated some of those assets down to zero, the buyer can’t claim any depreciation deductions on them. In the end, buyers will generally prefer asset sales.

Another important note: when comparing the two, the lowest overall amount of taxes to be paid— when both the buyer’s and seller’s taxes are combined— is usually a stock sale.

One way a seller can leverage this potential advantage is by adjusting the purchase price to account for any future tax burdens faced by the buyer. In this case— theoretically at least— both parties can walk away at the end of the deal with more cash in their pockets and less going to the IRS.

Can the second tax be delayed when selling a C corporation?

Yes, there is a possibility for this: switching to an S corporation.

Under the S corporation, there’s usually just one tax to shareholders for both asset and stock sales. If this is the route you want to take, the sooner you make the transition, the better— even if you plan to sell years down the road. Once you become an S corporation, you will most likely be able to eliminate the double taxation on any appreciation seen after your transition.

If you do end up transitioning to an S corporation, it is highly recommended to get professional tax help as well as an appraisal at the time of your switch.

Tax-free reorganizations explained

There is one way that, if eligible, your business can defer tax altogether when selling a business.

For starters, your business must be incorporated, and you must be selling out to a larger corporation. That’s just the easy part, however. The IRS has many additional rules for these types of transactions.

If you’re eligible, you will be able to structure your sale as a corporate reorganization, where you ultimately accept the purchasing corporation’s stock in exchange for the stock of your business.

You will have to pay taxes eventually however, just not at the time of the reorganization. Whenever you decide to sell your stock, that’s when you can expect to pay taxes. Also, if you receive other property or tax, you will likely have to recognize taxable gain.

Keep in mind that this type of reorganization won’t always be in your best interest. The buyer’s stock must qualify as a good investment. You might have to undergo certain holding periods where you can’t sell the stock, which could last up to two years. A lot can happen to the value of a stock in 24 months.

That’s why, if you’re considering this route, it is strongly recommended to seek legal counsel from an experienced attorney in this potentially messy area.

Final Thoughts: Tax Structure Checklist When Selling a Business

In conclusion, the following points provide some key points to keep in mind while preparing to sell your business:

  • Understand that many decisions which are negotiated between you and a buyer will have significant implications on the tax structure of your deal— this means they can determine a significant portion of the funds you actually receive from your sale.
  • Tax structures need to be understood before you put your business on the market. You need to know your best option and plan accordingly to make that option attractive to buyers.
  • Consult with expert legal and tax professionals who are experienced with your particular situation.
  • Make sure all of your business’s tax requirements are complete and have no outstanding issues.
  • Buyers will generally push for an asset sale, while sellers will find an equity sale more attractive.
  • Recognize that, in general, cashing out immediately and receiving all funds from the sale will only increase your tax liability.
  • Think about resale estate and gift tax planning which would transfer wealth to future generations. If you choose this option, complete all preparations as early as possible, before any serious discussions form with potential buyers.

ABOUT AUTHOR

Tim FriesTim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim is also the co-founder of Protective Technologies Capital (protechcap.com)

 

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