The process of buying or selling a business is filled with many daunting but effective decisions a business owner can make to impact the profitability and continuity of the business. Structuring these transactions appropriately can help minimize taxes and maximize after-tax proceeds. Getting appropriate and timely input from qualified professionals at an early stage in the process can further these goals and reduce overall stress. Each side of a transaction, i.e., buyer and seller, have differing interests in the tax implications of the deal, and each side will want to structure the deal with the most favorable outcome. What’s most favorable to the buyer often isn’t optimum for the seller, and vice versa. This article will focus on the tax aspects involved in the sale of a pass-through business, particularly as it relates to S corporations.
Stock Versus Asset Sale
Generally, there are two ways a company is sold: through the purchase of a seller’s stock or the company’s assets. The tax consequences and mechanics differ for each transaction. Selling stock is fairly straightforward; the buyer and seller agree on a price and exchange the stock for cash. An asset sale can add additional complexity. A buyer and seller not only have to agree to a price, but they also have to agree on how that price will be allocated to the assets. The asset allocation can directly affect the buyer and seller’s tax treatments.
Consequences of a stock sale are realized at closing. Sellers will recognize a gain to the extent the sales price is higher than their cost basis of the stock. Any gain will be taxed at capital gains rates according to the seller’s holding period. Consideration should also be given for any effect of the Net Investment Income Tax to a seller holding a business interest as an individual or through an estate or trust. This tax could add an additional 3.8 percent tax on top of the otherwise applicable amount. Many sellers prefer stock sales to asset sales; however, this may not produce a favorable outcome from the buyer’s perspective. A purchaser in a stock sale cannot deduct any of the purchase price until they sell the stock, which could be an unacceptable recovery period for a buyer interested in a continuing interest in a business. Instead, many buyers seek to purchase the business in a way where they may recover some of their cost more quickly through amortization, depreciation and other ordinary deductions. This is typically pursued through an asset sale.
Asset sales typically involve the sale of inventory, fixed assets and any intangibles such as patents and trademarks. A buyer should try to allocate as much of the purchase price as feasible to quick cost recovery assets, e.g., inventory and shorter lived fixed asset classes. This could generate more accelerated income tax deductions for the buyer and potentially create some tax savings upfront. A simple example of this in practice can be seen with a purchase price allocation to inventory, which can be deducted as the inventory is sold. Fixed assets are eligible for depreciation through different time frames depending on the asset types. Amounts allocated to intangible assets are amortizable over terms generally not exceeding 15 years. A sale of a business through the sale of its assets has a potential to recuperate a potentially significant proportion of a purchase price through tax deductions if structured and allocated appropriately. For this reason, purchasing a business through a sale of its assets is a popular option for many buyers.
Ordinary Income & Recapture
As mentioned earlier, the seller generally prefers the sale not to be an asset sale due to a portion of the gain potentially being taxed at ordinary rates. Ordinary gains could come about in several different ways. Inventory can generate ordinary gains if the portion of the purchase price allocated to inventory is more than what it cost to make the product. Gain on the sale of fixed assets also could generate ordinary gain income through the recapture of previously claimed depreciation deductions. To the extent a company sells depreciated fixed assets at a gain, that gain will be taxed at ordinary rates up to the amount of accumulated depreciation for the asset(s). For example, a company sells equipment for $10,000 with an adjusted basis of $5,000 ($7,000 original cost, less $2,000 in accumulated depreciation). In this example, $2,000 would be taxed at the taxpayer’s ordinary rates, and $3,000 would be taxed at the capital gains rates. The tax rate on depreciation recapture on real property is capped at 25 percent.
Some sales are structured that the seller carries a note from the buyer for repayment over time or retains an ownership interest pending achievement of certain performance measures. These arrangements are different arrangements referred to as an installment sale. Installment sales can work to the seller’s advantage by spreading out payments and subsequent recognition of profits, possibly resulting in lower effective tax rates. Installment sales could also prove a useful planning tool to navigate the Net Investment Income Tax effect on a business sale. However, there is a potential trap sellers need to be aware of before they enter into an installment agreement. Any gain taxed at ordinary rates, i.e., depreciation recapture and ordinary gain from inventory sale, must be recognized in the year the agreement is executed. This gain recognition is irrespective to any receipt of cash from the sale. The result is the seller could receive a lot less than anticipated in that first year due to taxes owed, or in extreme cases, could owe more in tax than they receive in cash proceeds that first year.
Covenant Not to Compete & Goodwill
A common allocation of any remaining purchase price not allocated to the company’s existing tangible or identified intangible assets involves an allocation to a noncompete clause or goodwill asset class. Money received on a covenant not to compete is taxable as ordinary income to the seller in the receipt year, whereas goodwill is taxed to the seller at capital gains rates. Given the preferential capital gain rate, a seller would generally seek allocations to goodwill wherever possible. The amount allocated to each category is dependent on the facts and circumstances of each particular case as well as the sales contract. For the purchaser, goodwill is classified as a Section 197 intangible asset and is amortized over 15 years starting in the month the agreement was executed.
S Corporations that Were Formerly C Corporations
S corps that were formerly taxed as C corps have some additional considerations in an asset sale, the first of which is the built-in gains tax. S corps that converted from C corps have a five-year waiting period to sell assets that were held when the company was a C corp. If those assets are sold during that period, the seller pays a tax called the built-in gains tax. This taxes the sale at the highest corporate rate (35 percent). There also could be tax consequences if the company has prior earnings from when it was a C corp. Those could be taxed as qualified dividends and at capital gains rates when the sales proceeds are distributed to the selling shareholders. An additional layer of complexity should be taken into account for individual, trust or estate sellers of a business who could be subject to an additional tax through the Net Investment Income Tax.
This is a high-level look at the tax aspects of buying or selling your pass-through entity. If you’re considering buying or selling a business, contact your BKD advisor for a more in-depth analysis.