The process of selling a business is filled with many decisions a business owner makes to ensure the best after tax profit once the sale is finished. Structuring the transaction properly can help minimize taxes and maximize after-tax profits.

Getting effective and timely input from qualified professionals early in the process can reduce stress and ensure success. Knowledgeable providers like the CSuiteXchange offer the best management level advice on sophisticated transactions. What’s most favorable to a buyer often isn’t optimum for the seller, and vice versa. Thus, it is to your benefit as a seller to think clearly about how you ultimately be impacted, but also to know what “hot buttons” may drive decisions for the Seller as well.

This article will focus on the tax aspects involved in the sale of a pass-through type of business, like the typical LLC, and particularly as it relates to S corporations.

Stock Versus Asset Sale

Primarily, there are two ways a company may be sold: through the stock of the company or via the company’s assets. Selling stock can be simple, but isn’t always; the buyer and seller agree on the price of the stock and exchange it for cash or other consideration. In an asset sale, the buyer and seller agree on price, and then also have to agree on how that price will be allocated to the various assets. The asset allocation will likely affect both the buyer and seller’s tax outcome.

Consequences of a stock sale are realized by the seller at closing. Any gain will be taxed to the seller at capital gains rates according to the seller’s holding period – long term or short term. The nuances of calculating the gain can be challenging and generally require an experienced tax specialist to determine the amount properly. The buyer will have to work with his own tax professionals to determine what his basis on the newly acquired stock will be.

Asset sales may involve the sale of inventory, fixed assets, receivables, intellectual property and often most important, goodwill. Fixed assets may be eligible for depreciation or amortization depending on the asset types. The sale of a business via asset sale has the potential for significant, early tax deductions for a buyer. Along with the flexibility of choosing which assets will be included or excluded, the potential tax benefits makes asset purchases very popular with buyers.

Installment Sales

Many sales are structured so that the seller carries a note from the buyer as part of the consideration in the sale, or may retain an ownership interest in the company that will often be transferred to the buyer at a future date based on the achievement of metrics agreed upon by the parties. Installment sales can work to the seller’s advantage when payments are spread out over a period of years and taxes can sometimes be deferred into those later years instead of coming due at the closing on the business.

But be careful! There is a potential pitfall for unwary sellers – they need to be aware that any gains taxed at ordinary income tax rates, including recapture of past depreciation expense, is recognized in the year the agreement is executed and taxable at the time of sale. This tax liability accrues to the seller irrespective of whether there is any cash exchanged at the time of sale. Thus, a seller could receive a much smaller than anticipated after tax receipt, even a negative amount, in the year of the sale of the business.

Covenant Not to Compete & Goodwill

In most asset sales, there is some allocation of purchase price to goodwill and often to an agreement not to compete as well. The non-compete allocation is taxed as ordinary income, while goodwill is taxed as a capital gain. Sellers then, prefer that as much as possible gets allocated to goodwill, unless the amount allocated to the non-compete results in a negative interpretation of the non-compete language to the seller, but this is unlikely.  Buyers allocate goodwill under section 197 of the Internal Revenue Code,

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 Landmark Advisors to assist you today.