Tax Implications of Selling a Business
When determining whether or not you want to structure a purchase or sale as an asset sale or a stock sale will depend on the answers to a few different questions.
Depending on the circumstances of a business sale, the tax consequences can be severe whether or not you structure the business sale as an asset sale or a stock sale. That’s why you should 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. Business Entity:
How is your business legally organized? Is it a C-Corp, or a pass-through entity (S-Corp, limited liability company (LLC), Partnership, or sole proprietorship)? To a great extent, your answer determines how bad the tax bite might be.
2. Asset Sale or Stock Sale:
How will the business purchase agreement be structured? As an asset sale or as a stock sale? Asset sales and stock sales have wildly different consequences on your after-tax proceeds. In a stock purchase, the seller will typically pay capital gains tax on the proceeds. On an asset purchase, the seller pays ordinary income taxes on a PORTION of the sale, depending on how the asset sale purchase price is allocated, more on this later.
3. If It's An Asset Deal:
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.
In asset sales, this is usually outlined in the sale and purchase agreement usually it's called purchase price allocation or PPA in industry jargon. In a stock sale, generally speaking, purchase price allocations are redundant in a sale and purchase agreement (SPA) because the buyer in a stock purchase agreement is effectively buying one asset, which is the entity's stock. Whereas, in an asset sale the buyer is purchasing individual assets (each with their own tax implications) and therefore needs to break out those individual assets.
4. When Will The Seller Receive Their Money?
Will you receive all cash at closing, or are you willing to finance a portion of the purchase price? This may mean some tax savings particularly in an asset sale and less so in a stock sale since in stock sales typically a seller will just pay capital gains. While in asset sales there is more flexibility in allocations and therefore tax consequences.
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 strategies to avoid or at least mitigate the tax bite. 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.
There is one other way out for C-Corps which is worth considering. Although it is only applicable to stock sales for C-Corps (so the buyer must agree to a stock sale.) This is in reference to section 1202 of the IRS code. From a 10,000 foot view here are some of the benefits:
- The gain exclusion is available for stock issued after Aug. 10, 1993, and applies to the greater of $10 million or 10 times the aggregate adjusted basis of the stock at the time of the issuance.
- So if you have an initial basis of 1.5 mm in the business you can exclude 10x 1.5mm = 15mm of the stock sale price.
You have to be a "qualified business" to qualify for 1202 gain exclusion. This goes beyond the scope of this article, for now, just know that it's available but can only be applied to stock sales of a C-Corp.
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 as a seller faces double taxation in a C-corp sale. 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, largely because buyers prefer asset sales, where the corporate entity is selling its assets, and the proceeds from the sale are deposited into a new company.
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.
Generally speaking, sellers prefer stock sales, and buyers favor asset sales. However, often the buyer’s legitimate concerns about a stock sale outweigh the seller’s preference for 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 income tax rates for the seller, but are deductible when paid by the buyer.
Usually, the seller pays capital gain rates on the value of goodwill which is effectively a bucket for intangible assets, but the buyer has to amortize goodwill over 15 years. To learn more read: How to Value Goodwill When Selling a Business.
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.
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.
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.