Tax Implications of Selling a Business

Tax Implications of Selling a Business

Depending on the circumstances of a business sale, the tax consequences can be severe.  That’s why you must fully understand the tax implications of selling a business before you decide to do so.  There are four major tax aspects of selling a business of which you need to be aware.

1. How is your business legally organized?  Is it a C-Corp, or a pass-through entity (S-Corp, LLC, Partnership or sole proprietorship)?  To a great extent, your answer determines how bad the tax bite might be.
2. How will the business purchase agreement be structured?  As an asset sale or as a stock sale?  Again, your answer can have a significant effect on your tax liability as a result of selling the business.
3. How will the purchase price be allocated for tax purposes?  By IRS regulations, the buyer and seller must agree on an allocation of the purchase price and there are tax consequences to the various choices.
4. How will you be paid?  Will you receive all cash at closing, or are you willing to finance a portion of the purchase price, which might result in some tax savings?

Corporate Entity Tax Implications

If you have a C-Corporation and the transaction is structured as an asset sale, you will be subject to double taxation which will take a very large bite from your business sale proceeds.  It is the worst-case scenario.  To learn more, read these two articles: Newsletter Issue #64 - C-Corporation Tax Implications and C-Corp vs. S-Corp – Tax Consequences When Selling a Business.

There are ways to ameliorate the situation. If you own a C-Corp, you can switch to an S-Corp to save on taxes, but there’s a 10-year built-in-gain rule that might limit the tax benefit of doing so.  To learn more, read: Newsletter Issue #65 - Achieving a Partial C-Corporation Tax Benefit.  Another tax avoidance possibility is allocating a portion of the business value to “personal goodwill.”  It’s a complex undertaking, but can provide a huge tax savings if it is applicable to your situation.  To learn more read: Personal Goodwill When Selling a Business.

The tax implications of selling the assets of a business organized as a pass-through entity are usually more favorable than selling the assets of a C-Corp.  However, when a business has a lot of depreciable assets, the tax consequences can be severe due to depreciation recapture which is taxed at ordinary income tax rates.  To learn more, read: C-Corp vs. S-Corp – Tax Consequences When Selling a Business.

Stock Sale vs. Asset Sale Tax Implications

There are two ways to structure a business purchase agreement.  For most small business sales, the transaction is structured as an asset sale, where the corporate entity is selling its assets, and the proceeds from the sale are deposited into the corporation.  A C-Corp asset sale is subject to double taxation and a pass-through entity asset sale may be subject to depreciation recapture.  On the other hand, a stock sale, whereby the shareholder sells his stock ownership (or his interest in pass-through entities) to the buyer, usually results in taxes being paid at lower capital gain rates.  A stock sale is favorable for the seller, but unfavorable for the buyer.  However, often the buyer’s legitimate concerns about a stock sale trumps the seller’s desire for the tax savings of a stock sale.  To learn more, read: Stock Sale vs. Asset Sale When Selling a Business.

Purchase Price Tax Allocations

For tax purposes, the IRS requires the seller and buyer to use the same allocations of the purchase price of the business to the various assets that are being acquired.  Typical allocations include the value of the tangible assets, the value of a non-compete agreement, the value of the seller’s ongoing consulting with the buyer after the sale closes, and then the remaining balance is attributed to goodwill.

The tangible assets should be valued at fair market value, but that value can be negotiated between the parties as long as the final assigned values are reasonable.  To maximize the depreciation tax benefit, the buyer wants to maximize the value of tangible assets, but the seller wants to minimize that value to avoid depreciation recapture and to maximize the amount attributed to goodwill, which is usually taxed at capital gain rates.

The value of a non-compete agreement is unfavorable for both parties.  The seller is taxed at ordinary rates, while the buyer must amortize the value over 15 years.  Consulting agreements are also taxed at ordinary rates for the seller, but are deductible when paid by the buyer.

Usually, the seller pays capital gain rates on the value of goodwill, but the buyer has to amortize goodwill over 15 years.  To learn more: read: How to Value Goodwill When Selling a Business.

Installment Sales

When the seller finances the acquisition of a business, it’s taxed as an installment sale.  Although complex from a tax standpoint, because you are taxed as the funds are paid by the buyer, you may experience tax savings as a result of being in a lower tax bracket when payments are received in later years.

Disclaimer

The above content is provided for informational purposes only, and should not be construed as tax or legal advice. As it relates to a business sale, tax regulations are very complex.  You should always seek the advice and counsel of an experienced and competent tax professional.

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ATTENTION: Business Owners & Prospective Sellers!

When selling a business, understanding the tax implications of selling your company is extremely important.  Indeed, about 60 of the 90 articles in the
How to Sell a Business Newsletter Series, contain the word “tax.”  Information and recommendations regarding tax considerations are interspersed throughout the newsletter series.  We strongly encourage you to subscribe to the free, bi-weekly email newsletter.

The following newsletter articles primarily address tax issues:

Newsletter Issue #64 - C-Corporation Tax Implications - Explains details of C-Corporation double taxation.

Newsletter Issue #65 - Achieving a Partial C-Corporation Tax Benefit - Explains partial benefits of converting to an S-Corporation.

Newsletter Issue #15 - Can You Afford to Sell Your Business? - Explains the need to consider your net proceeds after taxes.

Newsletter Issue #34 - Preparing to Sell Your Business - Improving Accounting Procedures - Explains how tax minimization policies can be detrimental to your selling price.

Newsletter Issue #72 - Excessive Personal Expenses and Skimming Cash - Explains reasons to eliminate or minimize personal expenses.