The tax implications of selling your business are huge. There are numerous decisions to be made. The sooner your path is established, the less likely it is that tax issues will derail your sale. In this article, we will provide a high-level overview of these issues and explore potential solutions. In a future series, we will examine each of these decisions in detail, once a month.
Here are the basics of tax planning when selling your business.
Your Business Structure
When you sell your business, the tax impact depends mainly on its structure. If yours is a C corporation, you will be taxed twice. The company will pay corporate income taxes on the sale before it is dissolved. However, the owner will not have immediate access to those funds.
Instead, the business owner (you) will have to withdraw your share of the money from the company and pay individual income taxes on this amount.
An S-corporation structure means you won’t pay double taxes when selling your business. Still, it also means that every single year, your company taxes also impact your tax returns. If you do business in multiple states, you must file taxes in every state.
In this case, it may make sense to reorganize your company before selling. But be aware that if you do, the IRS may take notice. They might investigate if the change occurs too close to the actual sale. This means you need to plan.
Other tax implications depend on how your company is organized. Therefore, be sure to consult with your business broker and a tax professional before making this decision.
Attribution of Goodwill when Selling your Business
This practice was once questionable, but thanks to a court case won in 1998 by Martin Ice Cream, it is now legal. Essentially, this practice allows the buyer to attribute some of the goodwill included in the business’s price to the company itself. The rest is attributed to the owner. Then, they pay the owner that portion of goodwill directly rather than including it in the business purchase transaction.
So what’s the problem? Well, owner goodwill is often tied to relationships with vendors or customers developed over the years, and these are often tied to non-compete clauses. That means if you sign one, the goodwill is considered the property of the company, not the owner. Furthermore, the IRS will not accept any implications to the contrary.
If you are retiring, a non-compete clause may not be an issue. But if you plan to continue in business, particularly in the same industry, you may not be able to use this loophole.
Tax-Free Deals
The dream words for any entrepreneur, the question becomes, are tax-free deals even possible? Well, first, you must understand that being tax-free in this case means being tax-deferred. Additionally, these deals can be pretty complex. They require that you take 40-100% of your proceeds in Buyer stock. Once you sell that stock, unless you roll it immediately into other qualified investments, you will be subject to capital gains taxes of 15% to 35%.
There are rare instances where a tax-free deal can be made to work, but they are indeed rare. Trying to navigate the corporate structure, stocks, and other assets to make a tax-free deal often results in IRS red flags. These are almost a sure sign that the agreement will be flagged for an audit. For the most part, just understand that both the Seller and the Buyer will pay some taxes when it is time to sell your business.
Asset vs. Stock Sale
Most small businesses are sold as assets, but a stock sale or a combination of assets and a stock sale may also be considered. How do you determine this when it is time to sell your business? The best advice is to talk to a professional.
The point is that each has tax implications. The structure of the deal will impact who can depreciate assets. It also affects who pays capital gains on the sale of them, and how these costs affect the final offer from the buyer. Discuss these topics early in the process.
Don’t reach the final stage of the sale process only to have this decision negatively impact the deal.
Allocation of the Purchase Price when Selling your Business
This is another topic that deserves an article of its own. Essentially, when selling assets, you will pay capital gain taxes, either long-term or short-term. Assets such as intellectual property and patents typically qualify for long-term capital gains rates. These are generally lower than those for short-term capital gains.
The kicker comes in when you allocate the percentage of the purchase price to assets. If you are the Seller, you may have to “recapture” some of the depreciation you have deducted for certain assets. If you don’t allocate enough, the Buyer will not be able to depreciate those assets as much in future tax scenarios. This results in higher liability on their part.
Thus, the two parties are at opposite ends of the spectrum regarding this issue. A reasonable compromise that works for both parties needs to be reached.
Tax Implications of Seller Financing
In the case of smaller businesses (those that business brokers usually deal with), if the seller elects to carry some of the financing, they can defer taxes until they receive the payments. Of course, this comes with some risk. If the buyer fails to run the business successfully, they may never receive payment for that portion of the purchase price.
However, if the business is exceptionally large, worth over 5 million, there are some restrictions on how the owner must deal with taxes. Also, remember that certain transactions, such as depreciation recapture and the sale of specific other assets, cannot be legally deferred. Consult with your tax professional and business broker to discuss your specific situation.
Earn-out and Contingency Payments
This is a tricky tax situation because if the Buyer and Seller cannot agree on a price, they can set up earn-out or contingency payments based on certain milestones. However, those are not considered installments in the traditional sense, at least not by the IRS. That means the seller’s tax liability is higher upfront.
Suppose the contingency payments do not come through as expected later. In that case, the Seller cannot retroactively count that capital loss against the original capital gains they paid on the initial sale. They can only offset a limited amount of capital gains they have in that year. That could mean significant losses down the road. However, if all milestones are met, the original payment of capital gains then pays off.
Deciding whether to set up this type of sale will depend heavily on the seller’s confidence in both the buyer and the business itself.
State and Local Taxes
One reason you need a California business broker to sell a business based in California is that the tax laws in California are different from those in other states. Your tax professional and business broker must be based where you live, licensed, and familiar with these unique laws.
Often, these tax laws do not align perfectly with those of the IRS. You may have more state tax liability than you think. This is another area where consulting a professional is vital.
Pre-Sale Estate Planning
If one of your goals is to leave some of the proceeds from the sale of your business to future generations, transferring that equity to a trust long before the company sells is a more effective way to set up those accounts. It is preferable to avoid trying to move after-tax gains into those trusts following a sale.
This is another area where planning can help you avoid being flagged by the IRS and even penalized. A financial planner or tax professional, familiar with estate law in your state and at the federal level, is the best way to protect yourself and your assets.
Does all this sound quite complicated? It is. Selling a business can be like adding another job to your busy schedule. That’s why your first call should be to Rogerson Business Services when it is time to market your business in California.
We’d be happy to help you initiate the process and maximize the benefits of your business sale. Contact us today!