Taxes are already a headache, and just when you think you’ve got a handle on it, they go and change the rules. The recently proposed American Families Plan, put forth by President Joe Biden, calls for substantial tax reform including changes that would eliminate the preferential rates for long-term capital gains for high income individuals, and revert them back to the top ordinary tax bracket.
These changes are not in place yet, but it’s important to be aware of how they may affect you if you are in the process of selling your business. And, regardless of these changes, there are some important questions you should ask before selling your business that may help you minimize your tax liability.
What type of transaction are you considering?
You will need to decide if you are pursuing a stock or an asset sale. These transactions have different pros and cons for potential buyers (as well as impacts on the seller), and understanding that can help you make the right choice for your business. They are also taxed very differently, so be sure to take that into consideration.
A stock sale is just what it sounds like—buying and selling the stocks on the business from the current shareholders. The buyer will purchase equity in the business, taking on all assets and liabilities. With stock sales, the business does not bear the brunt of the taxation, and it instead falls on the individual shareholders who are typically taxed at long-term capital gains rates in addition to any applicable state taxes.
It’s important to note that not all businesses can do stock sales, for example, if it is structured as a sole proprietorship, partnership, or limited liability company. Buyers may not prefer a stock sale, because they will not receive any tax write-offs until they sell their stock to someone else.
With an asset sale, you are selling the specific assets that the business holds and transferring specified liabilities. The assets could include things like accounts receivable, inventory, equipment, etc. Asset sales are attractive to buyers because they have the flexibility to only purchase what they are interested in (and assume the liabilities they are comfortable with) and the tax implications can be more favorable.
An asset sale can give the buyer immediate tax benefits depending on the allocation of the purchase price to the assets (we’ll talk about that in a moment).
What type of entity do you own?
Between C-corporations, S-corporations, LLCs, and partnerships, the tax implications vary widely. Each entity has its own tax provisions, resulting in differing tax liabilities. Understanding your structure is key to minimizing the tax implications on you as the seller and making your business attractive to potential buyers.
For example, let’s look at a C corporation. The owner of a C corporation may prefer to do a stock sale, because if it is structured as an asset sale, the owner could be taxed twice - once when the assets are sold (paying taxes at ordinary income tax rates) and again when the corporation is liquidated as a shareholder who is taxed on the distributions. There are many situations like this where you may be accidentally doubly taxed if you don’t understand the tax implications of your business structure. Consulting with a tax professional is a good idea whenever you are considering selling a business.
What is the purchase price allocation?
If you decide on an asset sale, which is very common, the purchase price allocation has traditionally been a hotly contested part of the transaction. This previously was because of the tax implications that can benefit or harm either party - and both parties are jockeying to get the break! However, with upcoming tax changes, the benefits to either party may soon be minimized.
Let’s say that you are selling a business for $10 million dollars. The purchase price allocation is what you say that money is buying out of the business.
For the buyer, it’s more favorable to allocate a larger portion of that $10 million purchase price to tangible assets like equipment, since the buyer may be able to claim things like 100% bonus depreciation in the first year under newer tax reforms. If the seller has already claimed full depreciation deductions on these assets, they may have to repay that depreciation and have the gain from the sale taxed at the ordinary 37% federal tax rate (which may soon change to a 39.6% rate with the American Families Plan).
For you as the seller, it’s more advantageous to allocate a larger portion of the purchase price to goodwill and intangibles. You may want to assign more of that purchase price to those things due to the fact that they are considered capital assets and only taxed at the 20% federal capital gains rate. It is important to note that if you as the seller has an income greater than $1 million, or a once in a lifetime event that temporarily pushes your income over the $1 million mark (like the sale of a business), that you may be taxed at a capital gains rate of 39.6%, which, means that this is not actually any more advantageous to you. However, if your income is under that $1 million mark, then it still may make sense for your taxes.
What state do you live in?
Many people fixate on federal taxes when it comes time to sell a business, but because tax reform has lowered federal tax rates, state taxes are not to be sneezed at or forgotten about. They can take a sizable chunk out of your business sale and catch you by surprise if you are not careful. Other considerations are any state residency requirements and checking to see if there are any regulations about apportioning goodwill from an asset sale.
Again, it is important to engage a tax professional to help you with selling your business in order to not shoulder an unexpected tax burden at a time when you should be celebrating the successful transfer of your business.
Delta Wealth — Your trusted tax advisors
Here at Delta Wealth Advisors, we’ve built our firm by working with driven and dedicated business owners and executives. We are committed to providing you with financial advisors who will fight for every edge in your finances and will be there to assist you whenever you need help with selling your business. Contact us today to discuss your financial needs.