It is essential to consider various tax issues before selling a business.
Not doing so can result in a weaker bargaining position and subsequent loss. The following five issues should be considered prior to sale.
1. Personal Income and Capital Gains
There are two basic ways to tax business sales - as personal income or capital gains. Capital gains are taxed at a lower rate than personal income, typically by 10 percent. Various factors affect how the sale, or parts of the sale, are taxed.
2. Type of Business
The type of business affects how the sale can be structured. The basic types of businesses include: sole proprietorships, general or limited partnerships, limited liability companies, and C or S corporations.
Sole proprietors are responsible for all assets and liabilities. Partnerships involve two or more people sharing assets and liabilities, which in limited partnerships may be on unequal terms.
The owners of limited liability companies have less responsibility, while corporations have minimal liabilities. It is possible to change the structure of the business, but not usually just prior to a sale.
In tax terms, C corporations offer the least amount of flexibility on sales. Unlike the other business models, these are not classed as pass through entities and are therefore subject to double taxation, via both the company and the individuals.
This gives significant advantages to selling an S corporation over a C corporation, but it must be registered as such for ten years to gain the full advantage. For proprietorships and partnerships, property is treated as capital gains while other assets are dealt with as personal income.
3. Selling as Assets or Stock
Whether the business is sold as stock or assets can have significant tax consequences, and it is up to the seller to negotiate and determine the terms of the sale. In general, it is preferable to sell a business as stock, as profits will then be treated as capital gains. In contrast, business sold as assets will be partly taxed as ordinary income. If the business is a C corporation, taxed independently of its owners, selling as assets will result in double taxation. Selling as stock also means that the buyer will be responsible for any liabilities that come with the sale.
4. Purchase Price Allocation (PPA)
Purchase price allocation (PPA) is a system of dividing up the sale price into various sections, including both assets and liabilities. The seller and buyer must use the same basic divisions, although there is a little scope for flexibility.
The full sale price is made up of the balance sheet value, the identifiable net assets, along with a write up of assets to obtain a fair market value (FMV) plus a goodwill figure.
How the sale price is divided has several tax implications. Because property and goodwill are taxed as capital gains, and therefore at a more favorable rate, it is in the seller's interest to emphasise these in the allocation.
However, property depreciates over a greater length of time than other assets, such as equipment, which the buyer is likely to want to a greater allocation for. The buyer is then able to write these assets off quickly.
5. Hiring a Tax Advisor
Selling a business can be a complicated process, and as seen above there are several issues that need consideration. In addition, local tax regulations vary from state to state, so it is essential to seek expert advice where necessary.
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