Four Tax Considerations Before Selling a Business
February 01, 2020
Updated as of February 21, 2022
With most tax rates at historic lows, owners of middle-market companies thinking of selling their businesses are still poised to save significant tax liabilities. Even with the changes brought on by the COVID-19 pandemic, business sale transactions are still receiving significant interest. Though it is unlikely that the current 21% corporate tax rate and 20% federal long-term capital gains rates to individuals will change as the midterm elections approach, lawmakers have historically not been shy to apply retroactive changes to tax law, further increasing the risk of higher taxes for business owners. Before proceeding with any business sale, it is important to review the main tax impacts based on the entity being sold and the transaction structure. Here are the basic primary considerations of a sale of a business in the current tax environment.
1. Sale Type
At the outset, it’s important to decide whether the transaction will be a stock or an asset sale. Wide tax differences can exist between these two transaction types, making this the first and most important consideration of selling your business.
With a stock sale (assuming an S or C corp), the transaction and any potential gain does not run through the business. It is instead recorded at the shareholder level and taxed once (presumably at L/T capital gains rates for individuals, plus their resident state tax rate).
To a buyer, a stock sale is usually not the preferred option since its basis in the company purchase is frozen in time. In other words, the buyer cannot enjoy any immediate tax write-offs after the purchase until they subsequently sell their stock to a third party.
By contrast, an asset sale provides the buyer with tax write-offs over time, or in some cases in its entirety in the year of sale depending on the allocation of the purchase price to the assets. As a result of enjoying immediate tax benefits, buyers typically prefer asset sale structures.
2. Entity Type
Tax implications also vary across C corporations, S corporations, and partnerships. Each entity carries its own specialty tax provisions that can impact a gain from a sale and the subsequent tax liabilities.
As one of many scenarios, C corporations selling assets for a gain would be subject to double taxation – once at the corporate level and then again once the after-tax proceeds are distributed to the shareholders and taxed as dividends. If the selling party was a pass-through entity (S corp or partnership), a common problem occurs whereby some of the asset gains are taxed at ordinary rates (up to a 37% top rate) and some at long-term capital gains rates. The ordinary rate gain portion can come from a common tax kink called depreciation recapture to offset the depreciation expense benefits enjoyed by the prior owner at the same ordinary tax benefit.
Partnerships, meanwhile, have no concept of selling stock. Furthermore, even if the intent is to buy a partnership interest (or say partnership units), tax statutes dictate the sale must be treated as an underlying sale of the partnership assets to the owners. Sometimes, this situation has been mistaken for a pure capital gain sale on equity units similar to corporate stock, so care should be taken. In reality, selling a partnership leads to ordinary income treatment on the gain in several specific areas.
3. Purchase Price Allocation
With asset sales, the purchase price allocation can be the most heavily negotiated aspect of the transaction between the parties. This is particularly true for equipment-intensive industries. In these sales, the ordinary income tax aspect looms large which can lead to adverse tax results to the seller.
As an example, a buyer may seek to purchase manufacturing equipment with an allocated $10 million purchase price. The benefit to the buyer is that they receive a step up in the basis of the equipment, and even further, can claim 100% bonus depreciation in the first year for tax purposes under newer tax reform rules. However, the seller may have already claimed full depreciation deductions on the equipment and be left with little or no tax basis. As such, the gain to the seller on the equipment would lead to depreciation recapture and taxed at the ordinary 37% federal rate.
By contrast, since goodwill and customer-based intangibles are considered capital assets for tax purposes, the gain on such would be taxed at the more favorable 20% federal capital gains rate. This example fosters a seller bias to allocate more of the purchase price toward intangibles and less toward ordinary assets such as the equipment example above.
4. State Considerations
Finally, it’s crucial to review state tax implications, or to consider tax saving opportunities.
When selling a business, federal taxes often command the lion’s share of attention. However, with tax reform having lowered federal tax rates, state taxes now occupy a far bigger piece of the tax pie chart. A couple notable matters that arise at the state level are how to apportion any goodwill from an asset sale among multiple states, and the residency of the seller in the sale year.
On the latter point, a business owner in a high taxed state with a buyer on “stand by” to purchase their business may be tempted to move their primary residence to a state with no income taxes once the deal is struck (such as Florida or Nevada). However, state residency requirements are stringent and tax audits on them are rigorous. A taxpayer seeking to move would not only need to be living in the new state for most of the tax year, but would also need to take actions that entrench them into the new state’s economy – such as changing voter registration, obtaining a driver’s license, or joining local organizations that require live attendance.
In all cases of a business sale, a tax professional should be engaged to help consult on the many tax details and particulars. Selling a successful business should be a happy event, so do not let a surprise tax bite down the road ruin the moment.