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Selling your business is a major milestone—exciting but also complex, bringing with it a host of important questions: What type of sale is the right fit for you and your business? What are some ways to maximize your net proceeds? How can you avoid unexpected tax liabilities?
For business owners, achieving the most tax-efficient transaction requires careful consideration of how to structure the sale, manage capital gains, minimize the tax burden, and allocate the purchase price. You must decide which type of sale suits your business best and which tax strategy will create the optimal outcome.
In choosing the optimal type of sale for your business, you need to determine how the business should be structured post-transaction. By planning strategically, you can enhance your after-tax proceeds and ensure a smoother transition. Your options for selling the business depend on the type of buyer and may include the following:
Seller financing/installment sale. Receiving payments over time instead of as a lump sum can have beneficial tax implications. An installment sale allows you to spread out capital gains tax liability over several years, potentially lowering your overall tax burden.
Other factors can impact your tax burden too, such as:
When selling your business, the tax considerations are multifaceted and complex. Having an idea of the different tax-impacting elements of the agreement prior to closing the sale can help you plan appropriately and avoid headaches down the road.
Capital gains tax is a critical consideration when selling your business, as it applies to the profit made from the overall sale of assets or stock. If you’ve owned the business for more than a year, you qualify for the long-term capital gains tax rate—0%, 15%, or 20%, depending on your taxable income—which is typically lower than the short-term rate. The structure of the sale, however, determines whether some portion of the proceeds may be taxed at ordinary income tax rates, which are based on your business income, the organizational structure of your business (i.e., S corporation, C corporation, partnership, sole proprietorship, limited liability corporation), and, as mentioned, the terms of any employment and consulting agreements.
As stated above, the structure of your business sale significantly impacts your tax implications. The tax treatment of an asset sale, in which you sell individual assets and liabilities of your business while remaining the legal owner of the entity, can be complicated, as different assets are taxed at different rates. Tangible assets (such as equipment and inventory) may be subject to ordinary income tax rates due to depreciation recapture, which occurs when the sale price exceeds the asset’s depreciated value, thus increasing your tax liability. Intangible assets like goodwill, on the other hand, are generally taxed at capital gains rates.
Buyers usually prefer an asset sale because they can step up the basis of the assets to their fair market value, which provides better depreciation and amortization benefits. As a seller, however, you’re more likely to face higher tax rates due to the combination of ordinary income and capital gains taxes, although it’s worth remembering that the buyer’s advantage can be a lever in negotiating the overall purchase price.
In a stock sale, you sell your ownership shares in the company, transferring all assets and liabilities to the buyer. Stock sales are usually more favorable for the seller due to lower capital gains taxes (if the shares have been held for more than a year, as mentioned earlier) and because you can avoid depreciation recapture of individual assets. But buyers may hesitate over the need to assume all existing liabilities and to forgo the opportunity for higher tangible asset depreciation benefits. (For a detailed comparison of asset sales versus stock sales, refer to our guide on structuring the sale of your business.)
Based on your organizational structure, certain options offer greater influence over the outcome of your tax position in a sale. These options may allow you to treat the sale as a stock sale for legal purposes, while treating it as an asset sale for tax purposes – specifically, the F reorganization and Section 338 (h)(10) elections.
If applicable to your circumstances, choosing an F reorganization or a Section 338(h)(10) election can optimize tax outcomes for both buyer and seller. An F reorganization involves a tax-free restructuring of the seller’s S corporation or other business, which allows you to perform a tax-deferred equity rollover (explained above) while the buyer treats the transaction as an asset purchase for tax purposes. A Section 338(h)(10) election also treats the sale of stock as a sale of assets for tax purposes, providing potential tax benefits for both buyer and seller, but typically does not allow for a deferral of an equity rollover investment by the seller. (For more details, read our article on choosing an F Reorganization or a Section 338(h)(10) election.)
Buyers and sellers have different viewpoints on how to allocate the purchase price. The purchase price allocation dictates the tax treatment of the proceeds from the sale of your business and is reported on federal tax form 8594, which both parties must file with their tax returns for the year in which the sale occurred. On this form, the assets fall into different classes as determined by the IRS: Class 1, 2, and 3 assets are valued at face value. Class 4 assets (inventory) are valued at cost. Class 5 (fixed assets and tangible property) is where negotiation between buyer and seller will most likely occur, as these reflect fair market value and are subject to depreciation recapture. Class 6 assets are intangibles aside from goodwill, such as permits or a trained workforce. And class 7 is where goodwill is recorded along with whatever is left of the purchase price after all other asset classes are accounted for.
Often the largest of intangible assets, goodwill is typically taxed at the capital gains rate: buyers in an asset sale can amortize this amount over 15 years, delivering a potentially significant tax benefit from their perspective. Buyers will seek a higher value assigned to tangible assets such as property and equipment, as these provide them with a step-up in basis and depreciation benefits. Meanwhile, sellers like you prefer that a low value is assigned to tangible property because it is taxed at ordinary income rates and depreciation recapture applies.
Start by reviewing the options described above, but be sure to consult your tax advisor. Engaging with experienced M&A professionals is crucial to successfully navigating tax-related issues during the sale of your business. At PCE, we specialize in providing comprehensive M&A and ESOP advisory services, ensuring that you receive tailored advice for your unique situation. Our team of experts is here to guide you through every step of the process, from evaluating your options to executing the sale. Reach out to us to explore your alternatives and make informed decisions about your business sale.
Investment Banking
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nicolek@pcecompanies.com
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dcooper@pcecompanies.com
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407-621-2199 (fax)