Structuring the Sale of a Company for Tax Purposes
by Alan J. Smith November 22, 2003
It's no secret that an owner of a company wants to get as high a sales price as possible when the business is sold. Often times what is misunderstood is the after tax impact on the way the business is being transferred, the type of entity form involved and the tax aspects, and tax implications of an asset based sale or a stock sale.
What is the best end result for the seller? It's getting the best price and terms (financial) along with achieving the non-financial goals of the business owner. Best terms include how a business transfer is structured for tax purposes. Saving taxes should play a large part in the overall considerations when selling a company.
As an example, assume a C Corporation in an asset sale has assets with a zero tax basis worth $1,000,000 and the company is debt free. The shareholders basis in their stock is also assumed to be zero. Upon sale, the Company would realize a $1,000,000 gain; at the 35% marginal rate for corporations, it would pay $350,000 in Federal income tax. The remaining $650,000 is distributed to the shareholders who would pay Federal capital gains tax at 20% or $130,000. On the $1 million sale, the shareholders end up with after-tax proceeds of $520,000- a 48% tax bite! However, had the shareholders sold their stock, there would only be one tax of $200,000, with $800,000 in after-tax proceeds to the shareholders. Obviously, stock sales involving C corporations are often more favorable to sellers when there are built-in gains.
As a general rule, sellers should seek favorable tax rates and deferred gain recognition. Contrasting that, buyers should be seeking early tax deductions for what they pay. Sellers of C corporations insisting on a stock sale may have to discount the price to compensate the loss of deductions for buyers. Correspondingly, buyers who insist on an asset purchase will likely pay a premium to sellers of C corporations because of the double tax sellers will pay. In such a situation, the seller can seek ways to allocate the purchase price around a C corporation, and as an example, employ the use of non-compete agreements and employment/consulting agreements. Sellers avoid the double tax, and buyers get a least a 15 year write off (e.g. non-compete agreement). Income from non-compete agreements, and employment/consulting agreements, are ordinary in the hands of the individual seller- again taxed at higher ordinary income tax rates.
Another area that is often overlooked is how goodwill is treated. Goodwill is normally considered a capital asset attached to the business enterprise. However, if the goodwill is deemed "personal" to the business owner and not attached to the business enterprise, the tax results are significantly different for the seller. The buyer still gets a 15-year write-off (same as a non-compete agreement), but the seller gets taxed at a lower capital gains rate. The buyer is in a no worse position; the seller pays tax at capital gains rates- about one-half ordinary income taxes! Personal Goodwill offers three significant tax-saving benefits for sellers in business transactions:
- Price allocation away from C corps (avoids the double tax)
- Price allocation away from accrual basis tax entities to cash basis owners (availability of the installment sale method)
- Goodwill allocation to individuals (lower capital gains rates)
Each company will have its own unique facts and circumstances. Every seller will have various ways to minimize tax obligations that will involve employing strategies to insure that result. This is a critical task that should not be underestimated as there are many tax law changes and their resultant ramifications that continue to offer challenge and opportunity. Based on the particular situation, every seller should insure they are seeking competent tax and valuation advice that will maximize the most positive financial result in the end. Care should be taken to explore all the available options and avenues that are available.
Alan J. Smith is President of Bay Pacific Group, Inc. (BPG), a San Francisco based merger and acquisition firm that negotiates sales of privately held companies with $5 to $150 million in revenue. Alan can be reached at 415-420-1696 or e-mailed at firstname.lastname@example.org.
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