For anyone selling a business, tax consequences must be top of mind. Otherwise, the work of a lifetime can be chewed up by federal and state taxes, leaving the former business owner with very unsatisfying scraps. For that reason, the first tax strategy to consider is what professional help will be hired to facilitate the sale. Most businesses will already have a relationship with a CPA or attorney, or both, who provide tax services. When it’s time to sell a business, however, deep experience with the intricacies of tax strategy related to such sales is vital. If the current advisers don’t have it, there’s a big risk in letting them gain it on your dime.
That said, let’s look at things to consider as selling a business and tax laws collide. We will review some of the fundamentals and touch on a few sophisticated techniques for preserving assets, which an experienced expert might help with.
Capital gains and ordinary income
The profit made on the sale of the business can depend to a large degree on whether the seller pays capital gains tax on its assets or ordinary income tax. The Internal Revenue Service looks at the sale of a business as separate sales of its assets. It classifies them as: “capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade.” (There is an exception, however. A corporation can choose to structure a deal as a stock sale, which we will address later.)
For some assets, the capital gains tax applies. This includes machines, equipment, land, buildings and other property held for more than a year. It also includes intangibles, such as goodwill. For some assets, the ordinary income tax applies. This includes inventory, property held less than a year, and accounts receivable. And just to keep things interesting, there are times when both kinds of tax can be charged on an asset. An example is when depreciation deductions taken in the past on machinery and other property are recaptured. Income tax applies to those recaptured deductions and capital gains tax can apply to the remaining gains, if any are realized.
Sellers tend to be in higher tax brackets, so the income tax rate is much higher than the capital gains rate. They want as much of the overall value of the business to go toward things that fall in the “capital gains” category.
Lay the groundwork for selling the business
An owner must perform a great deal of prep work before a sale. Some of it involves shoring up key assets and minimizing taxes.
For example, among the assets a government contractor sells as part of the business are government contracts. It’s not enough for a seller and buyer to come to terms. The Federal Acquisition Regulation (FAR) requires a process called novation. Through novation, the government replaces the original contract with a new one that all three parties agree to. It’s a lengthy process and there is no guarantee that the federal government will approve it.
Minimizing capital gains
To minimize capital gains, a seller wants to establish the highest basis possible for each asset. Thus, he should compile all records on the purchase of each asset, the cost of setting it up, including training costs, and any improvements.
After all, the capital gain is the sale price minus the basis. A high basis means less gain and less tax to pay. This speaks to the importance of good recordkeeping to show all acquisition costs – like taxes, fees, commissions and shipping – and any improvements made to the asset.
Take a detailed inventory
A seller pays the higher ordinary income tax on inventory, so it’s important to perform a thorough inventory for the entire business. The information will shed light on the amount of tax that might be due based on the inventory at the time of sale.
Get a professional valuation
A business owner will be well-served by getting an appraiser to give a valuation of the business that includes the value of each asset. Not only will it help the owner determine a sales price, it also will allow for an estimate of tax liability.
Allocation of assets
The IRS requires buyer and seller to assign a fair market value to each asset from the overall sale price. The Internal Revenue Code also dictates in what order the assets are to be considered. It starts with things whose value is straightforward: cash and general deposit accounts. The sixth category is intangible assets, such as the employees and copyrights. The final category is goodwill. The value of goodwill, which represents things like the company’s brand name and customer base, is defined as the difference between the total sales prices minus the value of the first six categories.
This gives buyer and seller room to negotiate on the value of the assets.
Sellers want as much of the sales price as possible assigned to assets that are taxed as capital, like goodwill. That would mean paying taxes based on the capital gains rate, rather than the higher ordinary income tax rate. They also benefit by limiting allocations to equipment and other depreciable assets. This is where the “recaptured” depreciation, taxed as ordinary income, comes into play.
Buyers benefit from the opposite course. They want to allocate as much of the price as possible to capital assets, particularly those that they can depreciate or amortize quickly.
A business owner with an overall tax strategy for the sale will be in a stronger position to negotiate on allocation.
The structure of the business
The structure of a business up for sale will present challenges and possibilities regarding taxes.
The sale of a partnership, an interest in a partnership, or a limited liability company taxed as a partnership will be met with capital gains taxes. However, as with other types of business, inventory and similar items can result in ordinary income taxes.
The owners of a corporation – the shareholders – can choose to sell it through the sale of stock rather than assets. That way, the owners pay capital gains on the sale of the stock, usually at the lower, long-term rate. A sale of assets brings double taxation for standard corporations: once on the assets themselves and once when shareholders realize dividends from the sale.
S corporations, to which the IRS gives special tax status, avoid double taxation. S corps are pass-through taxation entities. No income tax is paid at the corporate level. Instead, the owners report profits and losses on their personal tax returns and they pay any taxes due. So, with an asset sale, there’s no corporate-level tax to pay. A C corporation can switch to an S corporation and gain the tax advantage, but the timing must be right.
Another advantage for corporations: They can structure a sale as a corporate reorganization and defer taxes. If a corporation finds a buyer whose stock is strong and promising, they can organize a deal in which the seller exchanges its stock for the buyer’s stock. This is called a “tax-free reorganization,” but the tax actually is deferred. The seller isn’t taxed on the value of the stock until it’s sold. The IRS sets a minimum time that the stock must be held, so there’s a risk that its value will decline before it can be sold.
Other tax strategies to consider
The regulations that control “tax-free reorganizations” are intense. Here are a few more options that require the help of experts to pull off.
A business owner can defer capital gains tax on the sale of a business by reinvesting the proceeds in a Qualified Opportunity Zone. All or part of the sale’s proceeds can be placed in a Qualified Opportunity Zone Fund, which invests in economically distressed communities. All or part of the sales proceeds must be made within 180 days of the sale.
A seller can gain some tax benefits by allowing the buyer to stretch out payment for the business and pay in installments. This allows the seller to put off some of the capital gains taxes until payment is received for them. The risks include the possibility of the new owner crashing and burning before the seller gets everything that’s due. Also, ordinary income tax payments can’t be deferred. That means the seller might get hit with a big tax bill while possessing only a portion of the sale proceeds.
Employee Stock Ownership Plan
A corporation can sell the business to employees through an ESOP – an employee stock ownership plan. The owners can defer federal taxes (and possibly state taxes) by rolling over the proceeds into qualified replacement property (QRP), which includes the stocks or bonds of companies operating in the U.S. Upon the death of the owner, the deferred taxes are extinguished and his or her children can receive a stepped-up tax basis on the assets.
Business owners can take advantage of some of the techniques that wealthy individuals use in estate planning.
Charitable remainder trusts (CRT) offer many possibilities. The gain on the sale of assets owned by a CRT is tax exempt, including ownership of a business.
Similar tools are: Grantor retained annuity trusts (GRAT), charitable lead annuity trusts (CLAT), family limited partnerships with recapitalization, and an installment sale to an intentionally defective grantor trust.
The focus of this article has been federal taxes, but business owners must account for state taxes too. The rules can be just as complex as federal tax regulations, and the bills can be life-altering. This is just one more area where the advice of experts is essential
No time for a false step
The sale of a business can be a defining event in the owner’s life. The proper attention to every detail, including taxes, can benefit that owner, his family and his colleagues for many years. At GovCon Wealth, a division of Cope Corrales, expert advisors can help a business owner at this pivotal moment.