The tax planning required for selling or buying a business can be a daunting task with abundant risk and reward. One of the key steps to completing a successful exchange for both parties is planning for income taxes. Proper planning will minimize risk and maximize financial compensation by avoiding pitfalls and capitalizing on opportunities that otherwise may not have been discovered in time to act. One of the most common decisions to make is whether to structure the sale as an asset sale or a stock sale. If an asset sale, how will the proceeds be allocated among the business’s assets? Another common and essential planning goal is to determine the after-tax gain for the seller or after-tax cost for the buyer.
Calculation of after-tax gain (seller) and after-tax cost (buyer)
The net proceeds after taxes or cost after taxes is a critical driver in the decision-making process and negotiations and can be materially different from gain or loss before considering tax. For the seller, the net proceeds after tax will determine the capital available for financial investing, retirement, paying a debt, or other goals. For the buyer, the net cost after taxes will decide their actual borrowing or capital requirements, the viability of the business, and a host of other considerations. Tax planning is essential to having peace of mind when agreeing to the terms of a business sale, which can be achieved by significantly reducing the risk of unplanned tax consequences that could have changed the decision-making and planning process if considered during negotiations.
A stock sale is an option for businesses taxed as C corporations or S corporations. In a stock sale, calculate taxable gain by the sale proceeds less stock Basis. The Basis for a C corporation is what was paid for the stock initially. The Basis for an S corporation is more complicated but is typically tracked yearly on a Basis Schedule that is attached to each shareholder’s K1. Any gains from a stock sale will be capital gains, which has preferential rates compared to the higher income tax brackets in the current tax code. The top capital gains rate is currently 20%, compared to the top income tax rate of 39.6%. In a stock sale, the buyer does not get a step up in Basis for the depreciable assets. For this reason, a stock sale often favors the seller.
For small businesses, an asset sale is more common than a stock sale and is more complicated for tax purposes. In an asset sale, allocate the sale proceeds among the business assets. The buyer and seller agree to the asset allocation in the purchase agreement contract, and the asset allocation is reported on IRS form 8594 by the buyer and seller. The IRS can use form 8594 to match the asset allocation reported by both parties if it doesn’t agree that there is a risk of an IRS examination. In a review, the IRS typically honors the asset allocation per the purchase agreement contract. In certain sales, the asset allocation can dramatically change the tax liability for the seller or tax benefit for the buyer. Often, an asset allocation that helps the buyer will hurt the seller and vice-versa. However, this is not true in all situations. If the terms of a sale are close to being agreed upon, but the negotiations stall, an option is to look for ways the asset allocation can be changed to benefit both parties. Even once an agreement is made, one or both parties may want an intermediary to look at the deal and see if changes in the allocation can benefit one side without hurting the other.
Common Asset Allocation Categories
Inventory – Proceeds allocated to inventory will be the buyer’s initial inventory cost. Higher inventory cost is typically better for the buyer. The cost of goods sold will be less when selling the inventory, lowering their taxable net income. Proceeds allocated to stock, for the seller, are treated the same as if they sold the stock to a customer in the ordinary course of business. Any gain or loss is regular income and affects their taxable net income in the year of the sale.
Goodwill – Goodwill is amortized 15 years on a straight-line basis by the buyer. Fifteen years is a significant cost recovery period; thus, the buyer typically wants goodwill to be lower if not considered in the allocation. Goodwill is taxable to the seller as capital gains, which is usually beneficial.
1245 Property (personal property – equipment, furniture) – 1245 property recapture is taxed as ordinary income to the seller. Recapture is the gain applied to the previous depreciation of an asset. The IRS assesses taxes at capital gain rates for any allocation over the recapture. The buyer can depreciate the value allocated to each asset, based on depreciation rules. Generally, the higher the amount allocated to 1245 assets is more beneficial to the buyer than the seller. There are instances where a shift in this category can benefit one party without being a detriment to the other. You can capture opportunities if both parties agree to try and identify them. An intermediary can be used for this if the buyer and seller don’t want to share additional financial information.
1250 Property (real property – buildings) – 1250 property follows the same general guidelines as 1245 property. The main difference is that the depreciation life is much longer for the buyer (27.5 or 39 years).
Current assets and current liabilities – This category would typically be allocated based on a balance sheet balance and will not have a significant impact on the buyer or seller directly. There may be an indirect impact due to another category receiving less of a valuation which could be potentially beneficial or detrimental for the buyer, seller, or both. This category is often immaterial.
Selling or buying a business presents a host of challenges. It can be tempting to mostly ignore the tax ramifications after being bogged down in dealing with other decisions that need immediate attention, and often in a narrow time frame. Every business sale has at least three parties involved in negotiations: the buyer, the seller, and the IRS. It’s in the best interest of the buyer and seller not to ignore the existence of potential tax pitfalls and non-negotiable opportunities after the completed exchange. If you need more information on the tax ramifications of buying or selling a business, please contact Abacus CPAs, LLC at 417-823-7171 or www.abacuscpas.com. Better Guidance. Smarter Decisions.