Tax Exit Strategies When Selling Your Business
January 10, 2022
Keeping good books and financial statements can help you to secure a deal when selling your business. A qualified tax professional and advisor can help you perform the due diligence required prior to a successful sale.
If you do not have these items in place, the prospective buyer will notice this early in the formal due diligence process and this could jeopardize the deal from going forward. A later step in the process would be ensuring that you are up to date on all your company filings, which should include not only on income tax filings, but also items such as payroll taxes, sales and use taxes, property taxes etc.
With respect to income taxes, it is critical you file in all states where you have a filing obligation. Perhaps this may involve engaging an accounting firm to conduct a state nexus study. You would be surprised at how many things come up in the due diligence process when it comes to state filings. And if the buyer catches it in the due diligence process because you did not address it on your own, you can expect a hit (sometimes significant) to the purchase price. You are in a much better position going into due diligence where there is a state filing which you incorrectly have not addressed in the past, but when the buyer asks about it you are prepared to answer that it is in the process of being dealt with, for example, with a voluntary disclosure application for past due filings in the state. This process should also involve checking on all state websites and logging into your state account to ensure there are no pending notices. If you are an S corporation, it is imperative that you call the IRS and obtain a copy of your S corporation election approval letter so you have it. I have seen this issue hold up a deal before.
Hopefully, if you had a good attorney and tax accountant at the beginning of your business life cycle, they already walked you through the tax implications of choosing the right type of business entity structure since this becomes most critical when selling your business. If you are a C corporation, selling the assets may involve two layers of taxation often referred to as the dreaded “double taxation.” The first form of taxation is on the entity itself for the gain on sale of assets, with the second level being a distribution to the stockholder taxed as a dividend or a redemption of the stock as a capital gain. However, C corporations may not be all that bad as the owner may be able to take advantage of the qualified small business stock exclusion. This is an opportunity where a shareholder can exclude a capital gain on the sale of their C corporation stock up to the greater of $10,000,000, or ten times their adjusted basis in the stock. However, there are many qualifications to take advantage of this opportunity, including but not limited to, that the stock in question was issued after August 10, 1993, the stock is acquired by the taxpayer directly from the company for money or property, and the tax basis of the total gross assets of the corporation at all times from August 10, 1993, until immediately after the issuance of the stock is less than $50,000,000.
There are certain ways to avoid negative tax consequences upon a sale. The best strategy to avoid double taxation is to sell your C Corporation company stock as opposed to the company’s assets, a scenario where there would only be one level of taxation. However, while a stock sale is almost always more beneficial to the seller (just as it is in the case for S Corporation owners, while for partnerships there is generally no difference between a sale of a partnership interest and partnership assets), the buyer is almost always going to want to structure the deal as an asset sale so they can get a step up in basis of the assets purchased to optimize their future depreciation deductions. This is often where there are some back-and-forth negotiations between the attorneys on the deal, which often leads to adjustments to the purchase price.
Another key item to consider is the gain on sale, and the tax rate on the gain. Many business owners just automatically assume that when they sell their business, the gain on sale is the amount of proceeds they receive less their basis in the company, and that it is a long term-capital gain taxed at the preferential federal tax rate. Neither are necessarily true, or at least completely accurate.
The gain on the sale of your business is not just calculated on the pure economics of the deal dictated by the exchange of cash. A business owner and their accountant must consider any liabilities of the businesses that are being assumed by the buyer, as this would increase the consideration received and therefore the gain on the sale. This will often result in a higher effective tax rate if you were to just compare your after-tax cash in your pocket to the proceeds received on the sale.
Additionally, state taxes aside, which is another whole complicated matter beyond the scope of our discussion here, with respect to federal taxes you may have portions of the gain on an asset sale which may be subject to ordinary tax rates instead of long-term capital gain rates. The items that trigger this ordinary gain are referred to as “hot assets,” which include items such as inventory and accounts receivable (assuming you are a cash basis taxpayer only since an accrual basis taxpayer has already paid the taxes on the receivables). Finally, you may also have fixed assets you are selling as part of the deal that result in depreciation recapture at ordinary tax rates. All of these calculations which dictate the portion of the gain that is taxed at ordinary rates is driven by the purchase price allocation, which is subject to negotiation between the buyer and seller. Normally a valuation company is hired as part of the due diligence process to value all ascertainable fixed assets. This can get tricky because this is yet another component of a sale where there are competing interests. The seller will want as much purchase price as possible allocated to goodwill and intangibles (to avoid ordinary gains), whereas the buyer will want as much purchase price as possible allocated to items such as fixed assets for enhanced depreciation deductions.