Basic tax consequences to consider in the Sale of your Business
We will start this month’s blog with a familiar disclaimer: before making any decisions, you should consult a tax accountant familiar with your contemplated business sale. That said, here are some common tax issues which deserve your consideration in the early stages of selling or thinking about selling your business:
If you are a ‘C’ corporation, you will be subject to the dreaded double taxation unless you sell your business as a stock sale instead of the more buyer preferred asset sale. Stock sales have both liability and security regulation issues so they are not desirable from the standpoint of most buyers. If the sale of your business is not contemplated in the near future, consider changing your ‘C’ corporation to a more tax friendly ‘S’ corporation.
Federal law requires that the buyer and seller spread the purchase price of the business over the same asset categories using the same valuations. This is controlled by the IRS with the mandatory filing of IRS form 8594. The caveat here is that buyers generally like to assign a high value to the fixed assets being purchased so that future depreciation write-offs will be significant which translates to lower taxes paid. From the sell side, writing up the assets being sold can result in a depreciation recapture which can often surprise the seller with ordinary income instead of the more desirable (i.e. lower taxes) capital gains.
Sellers should avoid placing fixed asset values on the form 8594 greater than book value to avoid the depreciation recapture trap. Unfortunately, both buyer and seller must agree to this, and as such, values assigned on the form 8594 can be an area of potential disagreement. Seller notes are not taxed until payments are received which has the benefit of pushing taxes out to future years. The principal is generally taxed at the favorable capital gains rate while the interest is taxed as ordinary income.
Often buyers assign part of the sales price to a consulting agreement as it pushes such payments from the buyer into future periods and allows for a tax deduction for such payments in the period in which they are made. From the sell side, consulting payments are taxed as ordinary income vs. the generally more favorable capital gains rate if the amount of the consulting agreement had been included in the sale price.
Earn-outs which often are represented by the buyer as part of the purchase price are in fact a contingency payment, which if made to the seller will be taxed as ordinary income. Earn-outs then have a double whammy: (1) the payment is contingent on certain benchmarks being achieved (i.e. these are not sure things); and (2) if paid they are taxed as ordinary income.
There are obviously many tax issues to be considered as you move forward on the possible sale of your business. We suggest you start reviewing these tax matters with your tax advisors early in the sale process..
Contributed by Michael Greengard, Praxis Business Brokers.