business builder taxes
When the kids show no interest in joining the family business or entrepreneurs decide it is time to move on, it may be time to sell your closely held business.
Experience in our practice and coverage of recent transactions in the business press indicate that we are in the midst of a mergers and acquisitions boomlet.
Other owners are selling, but unless your grapevine is working well or someone is talking out of school, the only thing you hear about the deals is that “terms were not disclosed.”
How are other owners structuring the sale of their closely held businesses? More importantly, what should you be considering?
Tax considerations, at a minimum, should be a neutral factor in a sale transaction, if not a net positive. The right tax strategy may facilitate:
- a single level of tax in a cash sale;
- a tax deferral in a stock swap;
- current or future taxation at advantageous long-term capital gains rates.
Goal one: single tax
An outright sale of stock for cash is intended to provide the sellers long-term capital gains. With an historic low 15 percent capital gains tax rate, coupled with state taxes on the sale, after-tax cash may be 75 percent to 80 percent or more of the sales price. This may be the seller’s best case.
Unfortunately, the seller’s best case may be the buyer’s worst case. A buyer has a strong predisposition from a tax perspective for buying your company’s assets, rather than your stock. Beware: That could derail your tax strategy of paying a single level of tax.
When stock of a company is acquired, any premium paid in excess of the tax cost of the assets, the “goodwill” of the business, is not deductible for tax purposes. A buyer would prefer to buy the assets and goodwill of the company, which would provide depreciation and amortization deductions for tax purposes.
Premium paid in excess of the value of the assets can be amortized for tax purposes over 15 years, providing the buyer a present value tax savings of 15 percent to 20 percent of the cost of the goodwill.
A double tax results when a C corporation sells its assets. The company pays a tax up to 35 percent federal tax plus state tax, and then the shareholders pay tax on the net proceeds they receive for their stock. Combined corporate and shareholder taxes could exceed 60 percent in a worst-case scenario. That is not structuring the transaction to maximize seller’s after-tax cash.
Since an S corporation or a limited liability company is not a taxpayer separate from its owners, the company can sell its assets and distribute the sale proceeds to the owners at a single level of tax. This result may be nearly identical to the 15 percent federal capital gains tax levied on a stock sale.
To avoid the double tax on the sale of assets by a C corporation, transactions directly between the owners and the buyers, bypassing the company, might be considered. The sale of personal goodwill at capital gains rates, or the negotiation of employment, consulting or noncompete payments at ordinary income tax rates, may minimize the overall tax on the transaction when compared to an asset sale.
If the business is a C corporation, achieving a single level of tax may translate into a higher tax rate on employment, consulting or noncompete income or lower overall sales price if the stock buyer is negotiating to recover part or all of the foregone tax benefit for amortizing goodwill, which is only available in an asset purchase.
Goal two: tax deferral
A basic tenet of the tax law is that cash is taxable. To structure a tax deferral, a significant amount of the sales price must be received in stock of the buyer.
There are a couple hurdles for sellers of a closely held business to overcome in this scenario. First, many owners and entrepreneurs do not want to take the investment risk of turning control of their business over to a buyer and having a significant portion of the selling price riding on the buyer’s ability to maintain or increase the profitability of the business. Second, there may be no ready market for the stock received from the buyer in the event the seller wishes to cash out of the business.
If a business is a limited liability company or a partnership, it cannot be a party to a tax-deferred stock swap, so tax deferral in those cases might be achieved with an installment sale. This carries the credit risk of an installment obligation in a cash transaction with the buyers.
If the sellers are willing to take equity back in the sale, proper tax structuring may defer the taxation of that portion of the transaction until the stock received is ultimately sold at capital gains tax rates.
Goal three: capital gains
A single level of tax is an ideal goal of a seller, sweetened by having that single level of tax levied at favorable capital gains tax rates.
When assets are sold, the gain is first taxed as ordinary income up to the amount of depreciation previously deducted for tax purposes. The concept is that if tax deductions for depreciation have offset ordinary income in the past, the later gain on sale of the assets is taxed as ordinary income.
If the fair market value of the assets sold approximates the remaining investment after accumulated tax depreciation, there may be no gain to recapture as ordinary income, and the profit on the asset sale would be taxed as capital gains.
With the 30 percent and 50 percent bonus depreciation rules and enhanced expensing of up to $100,000 of business equipment enacted as economic stimulus in 2002 and 2003, fair market value of assets may exceed the remaining asset cost. Ordinary income rates on asset gains increase the tax cost on an asset sale and reduce the seller’s after-tax cash.
Sellers may view this as a compelling reason to sell stock at capital gains rates, rather than assets subject to depreciation recapture, or to increase the selling price to attain a level of targeted after-tax cash proceeds.
A buyer’s response might be that the sellers enjoyed the tax benefits of the bonus depreciation and expensing deductions to reduce taxable income from business operations, so a tax upon sale at ordinary income rather than capital gains rates is an issue for the sellers that is not negotiable with the buyers.
Whether there is a gain on assets subject to depreciation recapture will be a matter of how the purchase price is properly allocated to the fair market value of the assets. There generally is not a requirement in the tax law that sellers and buyers agreed to the purchase price allocation, although there is a certain appeal to it.
The right tax strategy cannot save a bad deal, but the wrong tax strategy can mess up a good deal. Well-advised sellers are structuring the sale of their closely held businesses to obtain a single level of tax in a cash sale, a tax deferral in a stock swap, and current or future taxation at advantageous long-term capital gains rates.
[contact] Mark Sellner, CPA, is tax principal at accounting firm Larson Allen in Minneapolis and an adjunct professor at the University of Minnesota graduate tax program: 612.376.4580; msellner@larsonallen.com; www.larsonallen.com
