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Considerations in Selling Your Business - Part 12: Tax Issues

by Patrick B. Mathis, Shareholder at Mathis, Marifian and Richter, Ltd.

Tax Issues - Part 2

In considering the tax impact of the sale of your business, the structure of the business entity being sold is frequently the initial starting point.

12 iStock 63753849 LARGEFor example, a C corporation for federal tax purposes is subject to tax at the corporate level, and any distributions from the corporation, either as dividends or in the company liquidation following a sale of the company’s assets, will be taxed again at the shareholder level. For instance, if the company’s assets which include inventory, equipment and goodwill are sold for $1,000,000, and the company has a depreciated basis in the assets of $300,000, the $700,000 of gain will be taxed at the corporate level initially. At a 40% federal income tax rate, the tax cost of this sale would be $280,000, consequently leaving $720,000 in the corporation following the payment of this tax.

If the $720,000 were then distributed to the shareholders in a liquidation of the company, that distribution will be treated as taxable capital gain to the shareholders to the extent that the distribution exceeds the shareholders’ basis in their stock. In this case, if the shareholders’ basis was $100,000, and the $620,000 of capital gain were taxed at 20%, this would result in a capital gains tax of $124,000. Thus, after the $1,000,000 sale and the corporate and shareholder level taxes were paid, the shareholder would realize $596,000 of after-tax cash in hand.

On the other hand, if the shareholder sold her stock in the corporation for $1,000,000, and the gain (after considering the $100,000 basis) was $900,000, the tax cost at a 20% capital gain rate would be $180,000 and the shareholder would realize after-tax net cash of $820,000. Consequently the structure of this sale may result in the selling shareholder having a potential swing of $224,000 in net cash after tax.

From the view of the buyer, the purchase of assets worth $1,000,000 in the corporation may expense the cost of the inventory as the inventory is sold, may depreciate the cost of equipment in the year of purchase or over a short depreciation life, and may depreciate the goodwill over a 15 year period. These deductions will serve to offset ordinary income. While the $300,000 of basis in inventory and equipment may be similarly deductible at the time of sale or over a short life for the purchaser of shares of stock, to the extent that the purchaser pays any amount in excess of that basis for the tangible or intangible value of the company’s assets, no deduction may be utilized by the buyer because that cost is “trapped” in the basis of the shares purchased and will only benefit the seller at the time of the sale of those shares.

As a result of this dichotomous tax treatment, negotiations frequently center not only upon the gross price to be paid in the business acquisition, but also the allocation of that price between the multiple potential components of the deal.

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