The sale of a business is a complicated process, and the application of federal and state tax law makes it even more so. There are a number of tax structuring elements to consider, ranging from the legal form to specific attributes of the seller and the buyer.
Selecting the tax structure is just as important as setting the price because it dictates the tax cost, which is likely be the most significant cost of the transaction. Ultimately however, the choice of a particular tax structure will depend upon the circumstances unique to the business, its owners and potential buyers. In Step 4 of the Five Steps to Selling Your Business series, the selling group should assess the tax implications arising from a sale and develop appropriate strategies before potential buyers are solicited.
Structure and Type of Consideration
When selling a business, the legal form of the transaction is the starting point for determining the tax treatment. There are two basic legal forms, 1) a sale of assets, and 2) a sale of ownership interests (i.e. stock sale). In addition, the tax law may dictate an outcome that deviates from the “legal” form. For instance, there are certain circumstances where a sale of ownership interests for legal purposes will be treated as a sale of assets for tax.
The seller must also give careful thought to the type of consideration given by the buyer. In lieu of cash, the buyer may ask the seller to take back a note or even offer a form of ownership in the buyer. The type of consideration received by the seller also has tax implications and may result in deferred or minimal taxation. By developing an early understanding of the tax implications from a variety of structuring options, a seller may prepare appropriate negotiating strategies for potential buyers.
As part the selling group’s preparedness, there will be an understanding that the legal form has major tax implications for buyers as well. The seller will understand that a taxable sale of assets allows the buyer to adjust the tax basis of the assets acquired to an amount equal to the purchase price. The adjustment to the basis of the assets is very important when compared to a purchase of stock. A stock purchase usually does not allow for such an adjustment unless certain special elections are made. By quantifying the value of the buyer’s future tax deductions arising from adjustment to the tax basis, the seller may better understand the magnitude of this potential issue to the buying group.
Understanding the tax implications of the selling entity’s tax classification is another important consideration. For instance, a selling entity classified as a C corporation will usually be subject to “double” taxation when a transaction is structured as a sale of assets. The first tier of taxation occurs when the sale of the assets are sold by the corporation. The corporation incurs a tax liability on any gain arising from the sale. The second tier of taxation occurs when the corporation distributes the net proceeds of the sale to the shareholders. Shareholders will incur a tax liability on any gain or income recognized from the distribution.
A seller’s advance knowledge of the implications of a C corporation selling assets may give rise to alternate strategies whereby the shareholder(s) postures to sell stock in lieu of the corporation selling assets. The result of such a strategy is the avoidance of the taxation at the corporate level. Awareness of these implications upfront may aid in qualifying potential buyers who might be open to stock purchases.
Partnerships, limited liability companies or S corporations, on the other hand, are classified as pass-through entities, which mean the gain the on the sale of the assets at the entity level is passed through to the owners. Because the responsibility for federal and state income tax liabilities falls to the owners, entity level taxation (i.e. double taxation) may be reduced or eliminated. Accordingly, there is usually less pressure on owners of pass-through entities to negotiate a sale of ownership interests.
Allocation of the Purchase Price
The allocation of purchase price is another very important aspect of any transaction, and requires careful consideration. This is especially true in circumstances where the purchase price must be attributed to asset classifications as would be the case with a sale of assets, or a sale of interests in an entity (LLC, LP, LLP, etc.) classified as a partnership. Generally, asset sales involve a variety of asset types, each with unique tax considerations. Some asset classes will result in more favorable tax rate treatment than others. For instance, goodwill and other intangible assets may qualify for the more favorable long-term capital gain tax rate, while other business assets may be subject to ordinary or special recapture rates.
Buyers may seek to allocate the purchase price to other items as well. For instance, buyers usually require sellers to enter into non-compete agreements and accordingly, seek an allocation of the purchase price to such arrangements. Sellers should understand tax implications of such allocations on the effective tax rate associated with the sale.
Orphaned Business Operations
In some cases, distinct elements of a business may be excluded, or orphaned, from a sale. For example, certain business units or divisions of the seller are likely to be orphaned because they do not fit with a potential buyer’s business operations. Accordingly, the seller may wish to consider a tax-efficient repositioning of those business units prior to soliciting potential buyers.
Tax structuring is at the heart of any acquisition or disposition. For more information about how your tax considerations during a sale, please contact us.
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