Top Ten Tax Considerations for Business Sellers
Selling your business is a complex venture that requires the assistance of plenty of paid professionals, including an accountant, an attorney, and a seasoned business broker. Before you invest in any of their services; however, it is important to understand the major tax considerations involved in selling your business.
Below you’ll find the 10 Most Important Tax considerations for business sellers. You can also check out our eBook, Are You Ready To Sell Your Company? It contains even more details about tax implications when facing a sale, along with other best practices when it comes to priming a company for transition of ownership. And remember, it’s important to review your financials much more frequently than prepping for tax deadlines!
Top Ten Tax Considerations When Selling Your Business
1. What type of legal entity do you use to operate your business?
Is your business a sole proprietorship, a partnership, a limited liability company (LLC), or an S-corporation? These business types are all considered pass-through entities, which means the profits pass through directly to the owners, and they will provide you with maximum flexibility in negotiating the sale of your business. On the flip side, if you conduct your business as a C-corporation, you’ll lose the preferential rates on capital gains, which will now be treated as regular income. While you can convert your business from one entity to another, tax rules are structured to prevent you from improving your after-tax position in such cases.
2. Is it possible to sell a business and not pay taxes on the deal?
Almost all business sales are taxable transactions, although it may be possible to defer taxes under certain conditions. Owners who earned capital gains on the sale of their business can defer taxation on those gains, by investing them in an economically distressed community identified by the federal government as a Qualified Opportunity Zone. Other ways to defer paying taxes on your business include conducting a one-for-one trade of stocks.
3. What are you selling: assets or stock?
When selling a business, transactions are generally structured as the sale of your assets or the sale of stock in your business. Although common wisdom suggests that stock sales are better for sellers and asset sales are better for buyers, there are endless ways to build your bottom line related to either option, which is why it is critical to hire a trusted accountant.
4. Purchase price allocation (asset sale)
If you choose to sell your business based on its assets, the next step is to determine the purchase price allocation. For this step, the IRS requires BOTH buyer and seller to submit a purchase price allocation form. The form requires an estimate of the “fair value” of all assets, and here sellers may try to elevate inventory and equipment values, while buyers will look to keep those values lower. Interestingly, at this point, buyers and sellers are not required to submit the same amount, although, obviously, it is best for both parties to agree on the purchase price allocation before reporting to the IRS.
5. Other possible payments to sellers
C-corporation (or S-corporations subject to certain capital gains tax rules) will generally sell their business via a stock sale. In this instance, buyers are purchasing equity in the business, rather than negotiating the appreciated value of the individual services, goods, and contracts of that business. Here, liability issues tend to inform whether a stock sale is a preferred avenue, as the corporation itself will own all services, goods, inventory, etc., rather than the owner assuming their liability.
6. Deemed asset sale
It is also possible for both parties to create a “deemed asset sale,” in which a stock sale is treated as an asset sale. This is a popular avenue when a buyer may be concerned about the seller’s liabilities. The agreement is also one to be considered if a buyer believes their future tax benefits may outpace tax costs currently facing the seller.
7. Installment sales and escrow
Some buyers may prefer to purchase a business on an installment plan, which will allow them to make payments against the purchase price for years to come. Ostensibly, they will use future net profits from the business to pay off the previous owner. This is a valid payment arrangement and is often utilized for selling a business to family members. It should be carefully considered when selling to an unknown entity, especially one that may not have the ability to manage the business profitably. It is also advisable to consider a life insurance policy for buyers on an installment plan. Additionally, sellers should be aware of IRS Form 537 (2021), which requires that the sellers pay interest on any “installment obligations” in excess of $5 million.
8. Contingent “earnout” payments
To incentivize future performance, a buyer and seller may choose to negotiate a contingent or “earnout” payment, which allows the buyer to purchase the business at a lower rate, but also includes future payments to the seller based upon the buyer meeting certain performance metrics. There are a variety of ways to structure contingent earnouts, but the most common is the binary contingency, in which the buyer pays the seller a fixed amount if a certain goal, such as revenue, is met.
9. State and local tax considerations
In addition to federal income tax, a significant state and local income tax burden may be imposed upon the sale of a business. Taxation by more than one state may also be involved depending on whether the transaction is structured as an asset or a stock transaction. Tax may also be owed in those states if sales, payroll, or earned have occurred in the state.
10. Pre-sale estate planning
If one of your goals is to pass the value of the business to future generations, estate planning should be done as early as possible. Stock values and assets moved into a trust for future generations are valued on the date when the shares are moved, so they are subject to lower tax rates.
Crystal clear? If not, don’t worry! Raincatcher is here to help. Click below to schedule a time to chat with us about your tax concerns, or any others you may have as a business owner today.
And download this book to help you understand tax implications in greater detail. Most importantly, this eBook will help you decide how ready you truly are to sell your business.