For many business owners, the sale of their business is a once in a lifetime event, perhaps the culmination of years of hard work to grow the value of the business. In many cases, the business represents the owner’s principal asset to fund a comfortable retirement. Even if retirement is not the motivation, selling business owners are always focused on retaining as much of the proceeds from the sale of their business as possible. Unfortunately, business owners have to share part of their good fortune (and the results of their hard work) with Uncle Sam in the form of taxes. Thus, smart business owners focus on structuring the sale of their business in the most tax-efficient way possible.
The taxation of the sale of a business depends upon both (i) the type of entity through which the business operates and (ii) whether the owners sell their equity in the business or the company sells its assets. If the company is operated as a C corporation, then a sale of equity is usually more tax efficient because only the shareholders pay tax and at the lower capital gain rates (maximum 20%), but an asset sale would result in both a corporate-level tax (at 21%) as well as a shareholder level tax on the amount left over after the corporation pays taxes. If the Company is an S corporation, which passes-through corporate income to its shareholders, then tax is paid only at the shareholder level. However, a sale of S corporation equity would only trigger capital gain, whereas an asset sale could trigger capital gain, ordinary income (taxed at up to 37%) and depreciation recapture (taxed at 25%) depending upon the types of assets sold by the company. If the business is an LLC or other entity taxed as a partnership, then the tax treatment is similar to that of an S corporation, but even a sale of assets could trigger some ordinary income if the business has appreciated inventory or accounts receivable.
Buyers of businesses typically prefer to purchase assets of a business because that allows the buyer to take depreciation deductions based on the purchase price. This is particularly attractive with the availability of 100% bonus depreciation deduction for a limited time under the 2017 tax law. Even if the buyers are willing to buy the equity of a company, they may want the sellers to agree to elect to deem the transaction an asset sale for tax purposes (such as with a “338(h)(10) election”).
In certain cases, it may be more beneficial to agree to an asset sale (or deemed asset sale) and negotiate a higher purchase price to account for the tax benefits being made available to the buyers. For that reason, business owners should consider having a financial projection prepared that models the potential tax treatment of each type of sale transaction. If the sale of a business is taxed as an asset sale, then the sellers also should negotiate the allocation of the purchase price among the assets of the business. Since different types of assets are taxed differently, the allocation could affect the overall tax paid on the transaction, making the financial projection process even more important.
These are only some of the many tax issues business owners need to address when considering the sale of their business. Consulting with a tax advisor experienced in business sales can have a significant impact on the amount that sellers must share with the government. As the saying goes, “It is not how much you make, it is how much you keep.”