Considerations in Selling Your Business - Part 11: Tax Issues
- Created: Sunday, 30 October 2016 00:00
by Patrick B. Mathis, Shareholder at Mathis, Marifian and Richter, Ltd.
Tax Issues - Part 1
The tax cost to the seller resulting from the sale of a business can be greatly affected by the structure of the sale. Similarly, the structuring can significantly impact the tax benefits to the buyer in a business acquisition.
The allocation of payments between the buyer and seller is a critical element in determining the tax treatment of those payments for both parties. For example, the sale of stock in a corporation is treated as the sale of a capital asset subject to capital gains income tax rates. Assuming the sale qualifies for long term capital gain treatment, the tax rate may be up to 20% to the seller. The gain on the sale of stock is calculated as the difference between the sale price and the seller’s basis in those shares.
If the same payment was taxed at ordinary income tax rates, without the benefit of basis, the rate may be up to 39% on the total payment. For example, if a shareholder sells all of his stock in the business for $1,000,000, with a cost basis of $200,000, the tax cost would be $160,000 (at a 20% rate, without considering state tax rates), resulting in the seller realizing $840,000 of after-tax cash in hand after the sale and tax cost. On the other hand, if that $1,000,000 were treated as payment on an employment contract of the seller and taxed at ordinary income rates of 39%, the cost could be $390,000, resulting in after-tax cash in hand to the Seller of only $610,000.
Buyers also seek to structure the allocation of the purchase price to maximize tax benefits, usually in the form of deductions which may be claimed as early as possible following the purchase. In the above example, the cost of purchasing shares of stock becomes the buyer’s basis in those shares and will offset the gain on a later sale of that stock to a third party. However, the cost of those shares is generally non-deductible to the buyer and simply “sits” as a basis in the shares until a later sale. On the other hand, payments to the seller for an employment contract will be fully deductible in the year paid and consequently offset income of the buyer’s business as the payments are made, yielding tax benefits at ordinary income rates, rather than the lower capital gain rates which would result from a sale of shares.
In approaching a potential sale, the seller (and buyer) should be particularly aware of the potential impact of variations in structuring the sale transaction. Before entering the marketplace or discussions with potential buyers, a seller should carefully analyze the value of the business, its assets and liabilities, the potential allocation of the gross sales price to different components of the business, including employment contracts and covenants not to compete, and the anticipated tax cost of varying allocations. This will allow the seller (or buyer) to begin those discussions with an outline of an optimal structure and after-tax cash yield for that party.