The tax consequences of selling a business
Many business owners contemplate selling their businesses to start their retirement or to transition into another business. Several issues come to mind when considering selling a business. How much is the business worth? Who will buy it? How much will be left once all the taxes are paid?
What makes selling a business particularly difficult is the fact that business sales are nearly invisible in the market. Look down the block where you live and elsewhere. How many “For Sale” signs do you see? How much would you expect each house to sell for? Typically, people have an excellent idea and knowledge of the information and tax consequences concerning buying and selling houses, cars, furniture, vacation properties, stocks, bonds, etc. However, buying and selling a business is a different story.
Try the same exercise. Look at a business park or office building. How many businesses in the park or building are for sale? What would you expect to pay for them? Chances are when you make this observation, you will not see one business for sale, know the selling price, know how to arrive at a reasonable price or know what the tax consequences of the sale are.
It is critical to be thoroughly aware of the consequences of the sale before beginning the process—the tax aspects of selling a business can be as important as the asking price of the business itself! Among the tax considerations to be familiar with are whether to sell stock or company assets. As a rule, asset sales generally tend to result in more taxes due for the seller, while stock sales will usually result in fewer taxes due.
Many sales of closely held businesses are asset sales. An asset sale, in this context, is a sale of a business by means of selling all or substantially all of the assets of the business. Assets include intellectual property, physical property, inventory, goodwill, real estate, equipment, furniture, fixtures and anything else that would be considered as belonging to the company.
Asset sales, as mentioned above, tend to give rise to higher tax liabilities to the seller than selling the stock of the company does. On the other hand, to the buyer, an asset sale means increased tax benefits because the buyer purchases the assets at a higher basis than what he or she would buy in a stock sale. Due to these tax considerations, it is common practice for the seller to ask for a higher price to compensate for the higher taxes.
When assets of the company are sold, depreciation expenses taken must be recaptured to the extent of depreciation taken or allowed. Depreciation recapture is a somewhat complicated tax concept in which the taxpayer pays ordinary taxes upon the sale of an asset to the extent of which depreciation was taken or allowed. The result is that, instead of paying capital gains at a low tax rate, the taxpayer will typically pay 28 percent to 35 percent tax on the sale of the assets.
Imagine a machine shop that buys equipment for $100,000. During the course of its useful life, depreciation is taken in the amount of $100,000 against it. The equipment (purchased for $100,000) is then sold for $80,000 to a business buyer. At first glance, many would conclude there should be no gain or that any gain should be capital in nature. Unfortunately, there is gain due to depreciation recapture. In this instance, all $80,000 of the purchase price would be subject to depreciation recapture, and it would be subject to ordinary tax at 35 percent, as opposed to the beneficial capital gains rate. The result is that the seller pays an additional $16,000 to $20,000 in taxes while selling the machinery for less than its orginal purchase price.
Away from depreciation recapture, other ordinary gains can arise. When selling inventory or accounts receivable, gains made are subject to ordinary tax (the logic being that the sale of these assets would give rise to ordinary income had they been sold any other way).
For example, say a cash-basis taxpayer, which most of us are, has a drawer full of receivables with a face value of $100,000. Because the taxpayer is a cash-basis taxpayer, the receivables were not previously taxed and are now subject to tax liability when sold. If the receivables are sold with the business, all $100,000 will be subject to ordinary gain to the taxpayer.
Along with depreciation recapture and ordinary gains, capital gains also arise during asset sales. Capital gains are normally taxed at preferential rates. If the company is a C corporation, low capital gains rates do not apply. The C corporation pays capital gains at the same rate as all other income it receives.
With that said, S corporations, limited liability corporations (LLCs) and sole proprietorships will benefit from realizing capital gains as opposed to any other gain. Any amount of money paid for an item beyond its original amount will qualify for capital gain treatment in an S corporation or LLC.
Say a company buys $100,000 worth of equipment, as in the first example. It then deducts $100,000 of depreciation expenses. The company then sells the equipment for $110,000; the result is $100,000 in depreciation recapture (subject to ordinary income tax treatment) and $10,000 of capital gains subject to low taxes.
Since capital gains result in lower taxes, it is best to try to justify all the capital gains possible rather than as depreciation recapture or ordinary income. The concept requires specialized knowledge to justify gains as capital gains as opposed to other gains.
Special Considerations for C Corporations
C corporations have special considerations to ponder. Generally, C corporations are taxed twice. As such, any gain made from an asset sale will be taxed at the corporate level. Once it is taxed, any money distributed to the owner as a dividend is then again taxed at the rate of 15 percent or better. As a result, the owner and company may pay nearly 50 percent in taxes for gains made in an asset sale. It is best to time the sale of the business to close before December 31, 2012. Given the time it takes to sell a business, it is generally best to consider selling soon.
Additionally, C corporations, as mentioned above, do not benefit from preferential tax rates from which other entities benefit. The capital gains of a C corporation are figured in with the ordinary tax rate of the corporation. This can mean that capital gains generally will result in a tax liability of up to 35 percent at the corporate level alone.
Special case law now exists that eliminates the double tax and capital gains burden of the C corporation taxpayer in a business sale. Currently, the tax interpretation allows for personal goodwill to be purchased by a buyer separately from the business transaction. Selling the personal goodwill, to the extent justified, allows the seller to escape a layer of tax to the extent of the personal goodwill sold and take advantage of the lower tax rates of an individual at 15 percent. This is a special, complicated tax issue. Sellers should deal with a specialist knowledgeable in these types of transactions or else the IRS will disallow the personal goodwill.
Stock sales differ completely from asset sales. A stock sale, in this context, occurs when a person or entity sells his or her stock to a third party for value. Stock sales tend to be the best tax scenario for a seller because the gain is primarily capital gain taxed at 15 percent, no matter whether stock in a C or S corporation is sold.
In a stock sale, the seller will look to his or her basis in the entire company as opposed to each individual asset. Each individual asset’s basis is not adjusted in a stock sale. As such, because the asset bases are not adjusted, the buyer does not gain a tax advantage and the seller does not suffer a detriment. Stock sales result in a less complicated and less costly tax scenario for the seller as opposed to asset sales.
The Tax Minimization Analysis
When selling a business, the tax consequences to the buyer are as important as the sale price is to the seller. When you are selling your business, it is extremely important to know what the tax consequences are before entering negotiations.
Once again, asset sales result in higher taxes for the seller and better benefits for the buyer. Stock sales, on the other hand, generally result in fewer taxes for the seller, but fewer tax benefits for the buyer. C corporations face many more unique tax issues that other types of business entities do not.
It is extremely beneficial to have a tax minimization analysis done before trying to sell your business. First of all, the tax minimization analysis shows the tax consequences of an asset sale and a stock sale. From this view, the client gets to see the two extremes. Many are shocked at the effect that one structure has over another on taxes, and consequently cash made, from the sale of the business. This is one benefit of the tax minimization analysis.
Next, an ideal scenario is worked out to provide the client with a complete picture as to what can be done to minimize taxes and maximize the cash into their hands. This provides the client with the primary benefit of the tax minimization analysis, that of knowing a good tax strategy to achieve their goals.
When dealing with a buyer, it is critical that the seller know the tax consequences of an asset and stock sale. It is equally important to know how to minimize taxes. Knowing this will give the parties power in the negotiations right from the get-go.
|Convention Speaker Bart A. Basi, Ph.D., (left) is president of the Center for Financial, Legal & Tax Planning, Inc. Marcus S. Renwick is director of research and publications with the firm, located in Marion, Illinois, and on the Web at www.taxplanning.com.|