By Michael A. Bohinc, CPA
You’ve no doubt heard the expression, “Failure to plan is a plan to fail.” This certainly holds true in the process of selling your business. Planning is imperative; it’s far better to be proactive than reactive.
According to the U.S. Small Business Administration, more than 700,000 businesses change ownership each year. Most of them are small- and mid-sized businesses such as plumbing and HVAC companies. Most are also family-owned businesses.
There are many steps involved in selling a business. Business owners often procrastinate on a plan to sell the business, just like they do with their own estate planning. However, establishing a plan early to sell your business (or establish a succession plan) is one of the crucial first steps. Early planning allows you the greatest amount of flexibility in preparing for the transition of the business.
Taxes, like death, are inevitable. A little bit of advance planning can help both the seller and the buyer. You want to maximize the selling price of the business while minimizing the tax implications of selling the business.
There are two tax considerations for the seller no matter what type of business entity you have:
- How is the income from the sale taxed? As ordinary income or capital gains?
- When is the income taxable?
Let’s look at these two.
First, how is the income taxed? Currently, ordinary income rates top out at 35%. The capital gains rate that most people and transactions fall into is 15%. That’s a sizable difference in rates. Obviously, most sellers would want to have the income reported as capital gains to garner the much more favorable tax rates. The type of entity the company is, and what exactly is being sold, determines the tax treatment of the income.
Next, when is the income taxable? The income is taxable when it’s earned. When the income is earned is determined by how the seller and buyer structure the payments. Remember, there are two parties in the sale of a business: the seller and the buyer. Each party has their own motivations and preferences in the business sale.
There are two types of sales when it comes to selling a business. A sale of the company’s stock, and a sale of the company’s assets. Each type of business entity (sole proprietorship, partnership, C corporation, S corporation) has its own issues when it come to the tax aspect of selling a business.
Let’s take a look at each type of entity:
Sole proprietors and partnerships. A sole proprietorship, by definition, is not an entity. It’s an individual conducting a trade or business in his or her own name. The sale of a sole proprietorship is essentially a sale of the assets that the sole proprietor is using in the business. When the assets are sold, they’ll be classified as capital assets, which results in a capital gain or loss. Sale of inventory items is classified as ordinary income or loss. The income generated from the sale of the assets will flow through into your personal tax return as it does now.
“C” corporations. You can structure the sale either way. If you sell the stock, you’ll pay capital gains tax on any gain (price paid over cost basis of the stock owned) in the sale. You can also sell the assets of the corporation.
However, this is not the preferred method for sellers because it creates a double taxation problem. The “C” corporation sells the assets and pays tax at ordinary income tax rates. Then, when the corporation is liquidated, the shareholders may be taxed again on the distributions. This is a primary reason the seller of a “C” corporation would rather sell the stock of the company. The buyer would prefer to buy the assets of the “C” corporation because he can avoid the assumption of any liabilities (known and unknown) that the corporation might have (i.e., back tax or product liability issues). Also, the buyer can get a step-up in basis on assets such as machinery and equipment. and can then depreciate them over their remaining useful lives.
Both parties must agree on the value applied to each type of asset being sold. This can cause problems, again, because each party has different goals from a tax liability perspective. The buyer wants assets such as inventory to have a much higher value than the land or building. Why? Because inventory is deductible in a current period as a cost of doing business while the building or land must be depreciated over 39 years.
The seller would want the opposite treatment. The seller wants the inventory selling price to be low because it’s taxed at ordinary income rates. The seller wants the real estate selling price allocation to be high because it’s treated as a capital gain and would receive very favorable capital gains tax rates.
“S” Corporations. These are “passthrough” entities, which means everything at the corporate level flows through down to the individual shareholders’ tax returns. These entities avoid the “double- taxation” problem.
You must be careful in an asset sale. There’s a tax trap here. If the seller chooses an asset sale and the company being sold hasn’t always been an “S” corporation, it may be subject to a built-in gains tax. This built-in gains tax (35% flat rate) only applies if the company being sold was a “C” corporation within the last 10 years. This tax was created to prevent a “C” corporation from making an “S” corporation election right before a sale of its assets to avoid the corporate tax.
The only ways to avoid this built-in gains tax is to prove that the asset being sold wasn’t owned by the company at the time of the “S” election, or that the gain is attributable to appreciation after the “S” election was made. If the asset sale is hit by the built-in gain tax, the asset sale is doubletaxed because the gain also flows through to the shareholder’s personal tax return after the “S” corporation has paid the built-in gains tax.
Obviously, this is not a favorable situation for the seller. Also, a portion of any gain realized will be taxed to the seller at ordinary income rates because of the depreciation recapture rules.
Selling a business is full of potential tax traps so it’s important to proceed carefully. The tax implications of selling your company should be assessed as early in the process as possible. As mentioned earlier, the seller and the buyer will have different tax motivations in the company’s sale. There are also a large number of non-tax issues that need to be addressed when selling a company. If you are thinking about selling your company, I would encourage you to discuss it with your CPA and attorney so that you don’t get tripped up navigating through the tax maze.