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SELL_A_BUSINESS_ _DEAL_STRUCTURE_AND_TAXES
| SELL A BUSINESS - DEAL STRUCTURE AND TAXES
The purpose of this article is to demonstrate the importance of
the tax impact in the sale of your business. As an M&A
intermediary and member of the IBBA, International Business
Brokers Association, we recognize our responsibility to
recommend that our clients use attorneys and tax accountants for
independent advice on transactions.
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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