Tax considerations for selling a business
June 29, 2017 | Jean Massmann, CPA, Partner
Selling a business? A transaction can be structured in a number of ways and there is usually a significant amount of negotiation that is required to agree on the structure since it has important tax, legal, and business consequences for all parties.
A variety of legal and tax issues must be considered before the sale transaction commences and throughout the process in order to maximize the available tax benefits and minimize risk. These include:
- Preparing the company for the sale.
- Determining whether the sale should be of an equity interest versus an asset sale.
- Using tax mitigation strategies available, including allocation of purchase price, structuring an installment sale, arranging for contingent consideration or an earn-out, or even maintaining an equity position in the company post sale.
To fulfill the above considerations, an important step in any transaction will be identifying a team of advisors. This may include key executives of the company, legal counsel, financial advisors and accountants. The advisor team will want to understand the reasons for deciding to sell a business as well as the purchaser's motivation for purchasing the business in order for the team to advise on the framework for the transaction.
A buyer will want to conduct his or her own due diligence on the company. Self-conducting this investigation before the purchaser conducts its own due diligence provides the seller the opportunity to cure any issues that may delay or adversely affect the sale, or formulate a strategy to negotiate around such issues.
While it may seem that the interests of buyer and seller are always opposed, the desire to complete the transaction usually provides motivation to strike a deal that satisfies everyone. Below we’ve outlined several tax considerations for different sale options and how they can have drastically different tax consequences for the parties involved.
An asset sale may allow the purchaser to obtain a step-up in basis for the depreciable assets acquired equal to the purchase price. To accomplish the greatest immediate income tax benefit, the purchaser will want to allocate a greater portion of the purchase price to the assets that have a shorter useful life, and lower value to assets that have a longer useful life. Additionally, the shorter the useful life, the greater the up-front depreciation deduction, which comparably reduces net taxable income.
For the seller, an asset sale may generate higher taxes for a variety of reasons:
- The nature of the gain related to certain assets sold may be subject to ordinary income tax rate rather than more favorable capital gain rates.
- If the business is taxed as a C corporation, the seller could potentially face double taxation.
- If the corporation is taxed as an S corporation that was formerly a C corporation, and the sale is within the ten year built-in gains tax recognition period, the S corporation’s asset sale could trigger corporate-level built-in gains taxes.
With a stock sale, the purchaser doesn’t generally have the ability to step up the basis in the assets of the corporation being acquired. Furthermore, the depreciable basis of the assets owned by the target corporation will stay the same for the purchaser that becomes the new shareholder. The lower depreciation expense can result in higher future taxes for the purchaser, as compared to an asset sale. In some circumstances, the parties can treat a stock sale as an asset sale for federal tax purposes by making a Section 338(h)(10) election. If this election is made, the purchaser often receives a stepped-up basis in the acquired assets similar to an asset sale.
Sale of Partnership Interest
With a sale of a partnership interest, the rules can vary drastically from a corporate stock sale. The sale of a partnership interest generally gives rise to capital gain or loss. However, under Section 751, capital gain or loss treatment is not available to the extent of the partner’s share of “hot assets” that would generate ordinary income if sold by the partnership. This includes his or her share of the partnership’s unrealized receivables and considerably appreciated inventory. The purchaser will obtain an outside basis in its partnership interest equal to the price paid. This may allow the purchasing partner a depreciable basis in the partnership assets equal to the purchase price or cost.
Contingent consideration and earn-outs
Earn-outs can be particularly attractive when a purchaser and seller need to close the gap between what the seller is asking and what the purchaser is willing to pay. An earn-out will allow a client who is confident (or perhaps overly optimistic) about what his or her business can achieve, to allow such to be truly realized. On the flip side, a purchaser (who is not overpaying up front) may be willing to give the client a piece of the upside potential of the business.
Mitigation of tax consequences
If unable to negotiate the preferred sale structure, a variety of methods are available to potentially reduce or defer the tax consequences of the transactions. Possible negotiations include:
- Allocation of purchase price – provides that if the purchaser and seller agree in writing as to the allocation of the purchase price, the IRS will respect the allocation unless it is not appropriate.
- Installment sales – a disposition of property where at least one payment is to be received after the close of the tax year in which the disposition occurs.
Multiple considerations are relevant in the sale of a business. The structure of the sale, whether as an asset sale or sale of ownership interest defer in the overall tax burden as well as impacting ongoing financial liability or other risks arising post sale, requires careful consideration. Contact us with any questions or to learn more.