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Tax Issues
Selling a business will impact on your tax liability, and buying a business will impact on the buyer's tax liability. The impact is controllable to some degree. Some of the items that will impact taxes and the ways they can be controlled are outlined below.
Capital Gains Treatment
Capital Gains, especially long term capital gains, are taxed at a significantly lower rate than other income, so the seller wants to take as much of the gain in the form of capital gains as possible. How much of the sale price is classified as capital gains depends on how the sale price is allocated for tax purposes, which is discussed below.
Another tax impact of a business sale that can be partially controlled by a seller is the time in which money is actually received. That is, if you receive the entire amount this year, the tax on the gain is due with this year's taxes (due next April 15 or before in some cases). However, if you are taking the money over a period of time that extends beyond the current year, you are essentially deferring some of your tax liability into future years.
Allocation of Sale
The sale needs to be allocated for tax purposes. That is, so much of the sale price is allocated for equipment, so much for inventory, employment or consulting contracts, and so much for goodwill. The buyer and seller must both use the same allocation.
The tax implications of the allocation are of critical importance. Some parts of the sale price can be treated as business expense, and other parts cannot. For example, many tangible assets such as vehicle and computers can be depreciated quickly and so the buyer will want to assign a high value to them so that the taxes they will pay are reduced for the first few years after the sale. Sellers, however, will pay taxes at ordinary income rates on any value assigned to tangible assets over book value (depreciation recapture). Sellers would rather have a higher value assigned to goodwill, which is taxed at capital gains rates. Goodwill is a section 197 intangible, which can be amortized by the buyer over 15 years using the straight line method. IRS publication 535 lists section 197 intangibles:
The following assets are section 197 intangibles and must be amortized over 180 months:
- Goodwill;
- Going concern value;
- Workforce in place;
- Business books and records, operating systems, or any other information base, including lists or other information concerning current or prospective customers;
- A patent, copyright, formula, process, design, pattern, know-how, format, or similar item
- A customer-based intangible;
- A supplier-based intangible;
- A license, permit, or other right granted by a governmental unit or agency (including issuances and renewals);
- A covenant not to compete entered into in connection with the acquisition of an interest in a trade or business; and
- Any franchise, trademark, or trade name.
Equipment and other tangible assets (not including inventory) can be depreciated using current IRS accelerated depreciation schedules.
Stock Versus Asset Sale
A small corporation can be sold either through the sale of its stock or the sale of its assets. Buyers usually insist on buying on an asset sale basis. This is discussed in more detail in section XIII. Structuring the transaction as a stock sale may allow you to change a lot of income from ordinary income into capital gains.
If you sell your C-corporation on an asset sale basis and the sales price exceeds your capital investment (cost minus depreciation as taken on tax returns) into the company, you can essentially be taxed twice. That is, the corporation will be taxed on the capital gain, and the stockholders will be taxed on their share of the gain individually when the proceeds of the sale are distributed (through a liquidation). This is an issue that you should discuss with your accountant before offering the corporation for sale. There may or may not be a way of avoiding some of the double taxation. However, you can at least know what to expect, and your accountant can calculate the tax consequences under a stock or asset sale scenario. Once tax consequences are considered, it is possible that you will discover a stock sale offer may be worth more than a higher asset sale offer.
This double taxation issue does not apply to an S-corporation unless the corporation was first established as a C-corporation and later elected S Corporation status. An S-corporation that changed its status may be subject to a capital gain tax if it were to be sold on a stock sale basis. Your accountant will be able to find out if a stock sale will result in a corporate capital gain tax for your S-corporation.
Consult Your Accountant
In any case, the tax consequences need to be clearly understood by you as you are going into the sales process. For this reason, it is absolutely essential that you consult your CPA before the sale, when an offer is made, and especially before closing the sale. Only your accountant, who has the whole picture of your own personal and business financial and tax situation has the information and skill to appropriately advise you.