What are the Tax Considerations When Selling Your Business?
By Marty Culhane, J.D., CPA*
Many buyers and sellers of businesses put tax issues on the “back burner” and don’t consider tax consequences until after a deal is struck, including a deal on purchase price. Ignoring tax considerations at the outset of a transaction is a big mistake and can put you in an adverse negotiating position, even if the letter of intent that was signed was “non-binding.” No seller of a business should agree on any aspects of the deal until they meet with a competent tax advisor who can explain, given their specific situation, where they will wind up after the deal closes on an “after-tax” basis. The following points describe ten key tax considerations for sellers of businesses.
1. What Type of Entity Do You Use to Conduct Your Business?
Do you conduct your business through a sole proprietorship, partnership, limited liability company (“LLC”) or S corporation? All of these are considered “pass-through” entities and will provide you with the most flexibility in negotiating a sale of your business. On the other hand, if you conduct your business through a C corporation, your flexibility on selling the business may be limited due to a C corporation’s lack of “pass-through” taxation and the possibility that “double tax” will arise (at the corporate and shareholder level) where a C corporation sells its assets and distributes the proceeds to its owners.
If your business is conducted in one of the pass-through entities described above, you generally will be able to sell assets to a potential buyer and that should be beneficial to you as the seller. Note that in situations where an S corporation used to be a C corporation, some double tax exposure will exist under the “built-in gains tax rules” for ten years after the date the S corporation converted from C corporation status. In addition, even though a C corporation is generally subject to double tax on an asset sale, it is possible that the C corporation has net operating losses or business credit carryovers that may offset the corporate level tax and make an asset sale plausible.
While it is possible to convert from one type of entity to another, the tax rules have generally been structured to prevent you from improving your after-tax position by converting your entity to a different form of entity immediately prior to a potential sale transaction.
2. Is a Tax-Free Deal Possible?
Most sales of businesses are completed in the form of taxable transactions, but it may be possible to complete a transaction on a “tax-free” (actually tax deferred) basis. If you exchange S corporation or C corporation stock for the corporate stock of a buyer, it is possible that exchange can be made on a tax-free basis, assuming the complicated tax-free reorganization provisions of the Internal Revenue Code are met. In order to do a tax-free stock exchange, you need to receive at least 40 or 50 percent buyer stock as part of your total consideration in the transaction, up to 100 percent buyer stock. A tax free asset transfer to a buyer is also possible but that variation usually requires that you receive 100 percent buyer stock in the exchange. To the extent you receive any cash as part of the transaction, it generally will be taxable to you assuming you had a gain in the shares exchanged. One important aspect of a tax-free deal is that the buyer gets no “step-up” in the basis of the seller’s assets (even if the seller had to pay tax on cash received). This makes tax-free transactions somewhat less valuable to the buyer as compared to where a step-up in asset basis is obtained, such as in a taxable asset purchase, but this loss in value may be made up by being able to use buyer stock for all or part of the purchase price, rather than cash.
The tax-free exchange rules generally do not apply to sole proprietorships, partnerships or LLCs. Converting an LLC to a corporation immediately prior to a tax-free reorganization also might be challenged by the IRS.
Another way to roll over a gain on the sale of stock involves selling your corporate stock to an employee stock ownership plan (“ESOP”) which, if structured correctly, allows your stock to be sold with your proceeds reinvested on a pre-tax basis in other qualifying securities. ESOP transactions are complicated, require substantial third party involvement (lenders, trustees, appraisers, etc.) and need to be thoroughly explored in order to consider potential pitfalls that might arise. In addition, certain C corporation stock sales may meet the qualified small business stock “rollover” provisions of Code Section 1045. This provision allows the proceeds of certain taxable stock sales of C corporations to be followed by a reinvestment in another qualified small business stock within sixty (60) days. When a successful rollover is accomplished, tax on the original stock sale can be deferred.
3. Are You Selling Assets or Stock?
Most transactions will be structured as taxable asset or stock transactions, rather than a tax-free transaction. It is important for you to know whether your deal is or can be structured as an asset or stock deal prior to agreeing on the terms of the transaction.
In general, buyers prefer purchasing assets because (i) they can obtain a step-up in the basis of the purchased assets resulting in enhanced future tax deductions and (ii) there is little or no risk that they will assume any unknown seller liabilities. On the other hand, sellers often wish to sell stock in order to obtain clear, long-term capital gain treatment on the sale. A seller holding stock in a C corporation (or an S corporation subject to the ten-year, built-in gains tax rules) may, in effect, be forced to sell stock, because an asset sale would be subjected to double tax at the corporate and shareholder level. Note that in a stock sale, the buyer gets no step-up in the basis of the target entity’s assets and, therefore, the buyer presumably will pay the seller less for a stock transaction than an asset deal. In addition, in a stock transaction, the seller will often be required to give extensive representations and warranties to the buyer and normally would be required to indemnify the buyer for liabilities that are not expressly assumed. The length of time such indemnities apply and the amount of any related escrows to secure such claims is a point of negotiation among the parties.
If you are selling your equity interests in a pass-through entity, it may be possible to have such sale be treated as an asset sale even though it appears on its face to be a “stock” sale. Sellers of stock in S corporations can make a Section 338(h)(10) election jointly with a corporate buyer and have the stock sale transaction treated as a deemed asset sale for tax purposes. Such a transaction is treated as an asset sale for all tax purposes and the buyer would get a step-up in the basis of assets acquired even though the buyer technically acquired stock. The seller would be treated as selling the individual assets of the S corporation so some of the gain could be treated as ordinary income. A similar result occurs if interests in an LLC or partnership are transferred to a buyer. In some cases appropriate elections must be made by the LLC or partnership to provide an inside asset basis step-up to the buyer.
4. Allocation of Purchase Price is Critical.
When selling business assets, the federal tax rate on gains can vary from 15% (long-term capital gain) to 35% (ordinary income rates). Sellers and buyers of assets need to reach agreement on the allocation of the total purchase price to the specific assets acquired. Both the buyer and seller file an IRS Form 8594 to memorialize their agreed allocation.
When considering the purchase price allocation, you need to determine if you operate your business on a cash or accrual basis; then separate the assets into their various components, such as: cash, accounts receivable, inventory, equipment, real property, intellectual property and other intangibles. A cash basis seller of accounts receivable will have ordinary income to the full extent of the value of such receivables (but an accrual basis seller will have a full basis in receivables and should not have gain when selling them). Any allocation to inventory in excess of its tax basis will also be subject to ordinary income tax rates. Assets that have been depreciated or amortized in the past may subject the selling owner to “recapture” of past depreciation deductions when the asset is allocated purchase price in excess of its current tax basis but less than or equal to its original cost. Recapture is made at ordinary income tax rates for equipment and at a 25% rate for most real estate. Intellectual property and other intangibles generally qualify for long-term capital gain rates provided that no past depreciation or amortization was taken on such assets by the seller.
The seller should also consider the timing of the buyer’s ability to write off any asset basis, including any that is “stepped-up” as part of the transaction. Buyers generally like to allocate purchase price to shorter-lived assets such as receivables, inventory and equipment. Buyers can write this purchase price off very quickly. On the other hand, land and stock basis cannot be amortized, real property will often be subject to a 39-year write off and intellectual property and other intangibles, such as goodwill, may be written off over a 15-year period. The need to allocate purchase price to the specific assets sold applies to true asset sales as well as sales by S corporations pursuant to a Section 338(h)(10) election and to sales of LLC or partnership interests (where it is necessary to “look-through” the LLC or partnership to the specific assets held by the entity).
5. Other Payments to Sellers; Personal Goodwill.
As noted above, a seller that owns a C corporation (or an S corporation subject to the built-in gains tax rules) will face a double tax situation if assets are sold. In addition, the sale of stock by the seller will result in no basis step-up in assets or other deductible payments to the buyer, since the buyer cannot depreciate or amortize stock basis. This issue is often dealt with by having the buyer pay one amount for the corporate stock and pay other amounts directly to the owners of the corporation for such items as: consulting, a covenant not to compete, interest, property rentals, intellectual property licenses and personal goodwill. In these situations, the buyer will obtain a deduction for the payments which (i) is immediate in the case of bona fide consulting, interest or rental payments and (ii) amortized over 15 years in the case of payments for a non-compete or personal goodwill. Allowing the buyer to make these types of payments typically has a cost to the seller, as compared to if they were merely added to the stock purchase price. When these direct payments are made to the seller by the buyer, the seller will usually have ordinary income taxation, rather than the capital gain rates available on a stock sale, with consulting payments also triggering additional self-employment tax.
One significant distinction is the sale of so-called “personal goodwill” which is taxable as a long-term capital gain to the seller (and amortized over 15 years by the buyer). It is often a difficult question to determine whether a seller truly has personal goodwill or whether all of the goodwill related to the business resides in the entity used to conduct the business. Sellers who take a position that they are selling personal goodwill or that are providing a direct covenant not to compete to a buyer, should anticipate that the IRS might challenge such payments and attempt to treat them as if they were made directly to the corporate entity and then distributed to the seller on a “double tax” basis. Care should be taken to value any personal goodwill and establish its existence under the applicable case law.
6. Installment Sales (Seller Financing) and Escrows.
If a buyer is allowed to pay the purchase price over some extended time period, such as five years, the seller may be able to defer the overall gain on the transaction until payments are actually received by the seller (along with applicable interest). However, no deferral is allowed with respect to any portion of the transaction that represents depreciation recapture (described in Section 4 above) or gain on ordinary income type items such as accounts receivable or inventory.
A seller who provides seller financing is of course at risk for the buyer not operating the business successfully and the possible non-payment of the installment note. In addition, if the deferred portion of the sale price exceeds $5 million, the IRS has established rules that require the seller to make interest payments that essentially negate the benefit of the installment sale tax deferral. Sellers who make an installment sale are permitted to “elect out” of the installment sale method and pay all the tax related to the transaction up front. This may be desirable in some situations, especially if the seller believes capital gain rates will increase significantly in the years when payments are to be made.
Buyers may also establish escrow amounts where a portion of the purchase price is put into escrow and paid to the seller at a later date after it is clear that the seller’s representations and warranties in the transaction agreements were not violated. Such escrows can be structured to provide the seller with installment sale treatment so that the seller does not pay tax on the escrowed amount until the escrow “breaks” and the proceeds of the escrow are paid to the seller.
7. Earnout/Contingent Payments.
When a buyer and seller cannot agree on a specific purchase price, it is sometimes provided that an up-front payment will be made and additional earnout or contingent payments will be made to the seller if certain milestones are met in later years by the business that was sold. Even where the original transaction qualified for long-term capital gain treatment, a portion of any contingent payments will be treated as imputed interest and taxable to the seller as ordinary income. This amount increases each year from the date of the original transaction closing. So a contingent payment that is made five years after the transaction closes could have a significant amount of imputed interest, depending on prevailing interest rates.
Recipients of contingent payments are entitled to use the installment sale method (or elect out of it). One pitfall with the installment sale method is that special rules apply to “spread” a seller’s tax basis out to later years when contingent payments are involved in a transaction. By moving basis to later years, a seller’s up front taxation is increased and there is a risk that the basis pushed to later years may be wasted. If the applicable milestones are not met and contingent payments are not paid, this could leave the seller with significant “wasted basis” and a capital loss in a later year when contingent payments were expected but never materialize. This capital loss cannot be carried back to offset the prior capital gains recognized on the transaction in earlier years, it can only be used to offset current and future capital gains or $3,000 of ordinary income each year, with an unlimited carryover. Sellers who agree to contingent or earnout payments should carefully analyze the installment sale rules and anticipate the possibility of having wasted basis in later years. In some cases, an “election out” of installment sale treatment may be advisable.
8. Outstanding Stock Options.
If the selling entity has outstanding stock options, they will need to be considered as part of the overall tax analysis. In an asset transaction, the options generally remain outstanding unless the transaction is structured as a deemed asset sale and the outstanding interests in the entity are sold to the buyer. Where stock or the interests in an entity are sold, the seller will need to consider what happens to the outstanding options. It is possible for the buyer to assume the options and perhaps replace them with options in a buyer entity. Another alternative is to cash out the options for the difference between their value and their exercise price. These type of “cash out” payments are considered ordinary wage income, reported on a W-2 with payroll and income tax withholding, and will create an expense deduction on the selling entity’s final tax return, even where the options are exercised prior to the deal being closed (although the exercise of a qualified incentive stock option prior to selling the stock to a buyer may avoid payroll and withholding tax on the ordinary income of the optionee).
Note that some options may not be vested (exercisable) at the time of a deal, but a change in control of the issuing company may “accelerate” vesting. If this happens, be careful of the 20% excise tax that is applied under Internal Revenue Code Section 280G to “parachute” payments (which includes the value of accelerated vesting of options) made to certain sellers when a change of control in a business occurs. Where Code Section 280G could apply, a vote of the selling shareholders may negate its application for certain private companies.
9. State and Local Tax Issues.
In addition to federal income tax, a significant state and local income tax burden may be imposed on the seller as a result of the transaction. Different states may be involved depending on whether the transaction is structured as an asset or a stock transaction. When an asset sale or a deemed asset sale is involved, tax may be owing in those states where the company has assets, sales or payroll and where it has apportioned income in the past. Many states do not provide for any long-term capital gain tax rate benefits, so an asset sale gain that qualifies for long-term capital gain taxation for federal purposes may be subject to ordinary state rates. Stock sales are generally taxed in the state of residence of the selling owner even if the company conducts its business in another state. Thus, an owner who has established a bona fide residence in a state without income tax may be able to sell stock without incurring any state tax. A stock sale that is treated as a deemed asset sale, however, may be “looked through” by the states where the company conducts its business and state taxes may be assessed in those states, but some taxpayers have made successful challenges to such positions in certain states.
State sales and use taxes must also be considered in any transaction. Stock transactions are usually not subject to sales, use or transfer taxes, but some states impose a stamp tax and may attempt to levy their stamp tax on the transfer of stock. Asset sales, on the other hand, need to be carefully analyzed to determine whether sales or use tax might apply. Most states tax the transfer of tangible personal property from a seller to a buyer except that, when an entire business is sold, there is often an “isolated or occasional” or “casual” sale exemption for business assets that are not regularly sold in the seller’s business. The isolated or occasional sale exemption rules do not typically apply to the transfer of motor vehicles that require retitling as a result of the sale transaction, so tax will likely be owed on motor vehicle transfers. In addition, typically there is a resale exemption available for inventory that is purchased by a buyer so sales and use tax won’t be owing on inventory. Transfers of real estate will usually require real estate transfer (or deed) tax and this type of transfer tax also applies in some states when stock of an entity holding real estate is sold, even if the actual real estate is not transferred.
Some states require pre-sale notifications to be made to the state regarding a potential transaction, with the buyer at risk for the seller’s unpaid sales or use tax (and unpaid employee state wage withholding) if a tax clearance certificate is not obtained prior to the transaction closing. A buyer who ignores the pre-sale notification rules could wind up paying the purchase price twice — once to the seller and once to the state for the seller’s unpaid taxes.
10. Pre-Sale Estate Planning.
If one of your goals is to move a portion of the value of the business to future generations, estate planning should be done at an early stage in order to move any interests in the selling entity for the benefit of the children or grandchildren when values are low. If equity is moved into trusts for the children or grandchildren at an early stage, those trusts will receive the benefits of the sales proceeds when an asset or stock sale is completed. On the other hand, it may be much more difficult and expensive to simply sell the company and then attempt to move after-tax proceeds from the sale to the children or grandchildren at a later date. A number of other estate planning techniques can also be implemented, especially if they are put in place well before any deal is contemplated. Transactions such as a so-called “defective grantor trust” provide an excellent way to move substantial transaction value to future generations on a tax-effective basis if they are established early enough to avoid IRS scrutiny.
Before you decide to sell your business or enter into any substantive negotiations with a buyer, be sure you have reviewed with a qualified tax advisor the myriad tax considerations involved. Only after you have considered the transaction structuring options in light of your particular business structure and financial situation can you engage in meaningful negotiations with a buyer.
Copyright Oppenheimer Wolff & Donnelly LLP. Marty Culhane is an attorney and tax partner with the Minneapolis office of the Oppenheimer law firm and a CPA (inactive) with over twenty-five years of experience working with clients buying or selling businesses and related corporate transactions.