Business succession (part I)

Key Tax Implications in Selling Your Business

By Todd M. Williams, CPA, CVA, ABI - October 2021

We are big believers in long-term planning. And in that vein, succession planning is an integral part of business planning, perhaps even when you start your company.

How are you going to monetize the value in that business when you’re ready: to fund your retirement, or pass along that value to your heirs, or even start a new business?

A big piece of that puzzle is tax strategy. There’s danger in not knowing what you don’t know, and you don’t want to get blindsided by unforeseen tax issues when you have so much on the line. So, while short-term tax issues will feel more urgent as you’re starting and running your business, it’s essential to keep the long-term tax issues in mind as well.

Here are a few relevant thought-starters for those who plan to monetize their business with a third-party sale:

What’s best for the seller may not be best for the buyer and vice versa:
As a seller, you will have several levers to pull in fashioning a transaction that’s optimal for you. But the buyer will have their own priorities, and there will be choices and tradeoffs to be made in hammering out a final deal. For example, it’s advantageous to a buyer to acquire “assets” that qualify for immediate depreciation, but for the seller, those proceeds would be taxed at a higher rate as ordinary income rather than capital gains. Start the process from an educational perspective, understanding where your differences lie and then using that knowledge in your negotiation. Ultimately, you will have to work together to optimize the tax impacts of the deal to suit both of you.
Tax consequences for both seller and buyer: Most small businesses sales are structured as assets sales, even though a stock sale may be more advantageous to the seller. The seller’s federal tax liability could be twice as high on an asset sale (taxed as ordinary income) compared to a stock sale (taxed as capital gains). And the federal rate for ordinary income may even be going up soon. Knowing your potential tax liability for different deal structures can help you recoup as much as possible in the sales price. Conversely, if the seller can reduce their tax liability with a favorable deal structure, that savings could be passed on to the buyer.
You may want to negotiate the deal in pieces: The buyer and seller will have to agree on how much of the money is going to each element of the sale – e.g., equipment, real estate, product inventory, customer data, goodwill, etc. This is a key step in the negotiation process as each piece of the business may be treated differently from a tax perspective. Be ready to work through each part of the business, understanding that there will be choices and tradeoffs in balancing all the competing demands.
Your corporate election may have big tax implications: Are you a C corp., S corp., or an LLC? The biggest issue here is the possibility of double taxation. The C corp. will pay taxes on the proceeds from the sale (as revenue), and then the shareholder will pay tax on the distribution of that money as a capital gain. On the other hand, the S corp. and LLC qualify as “pass-through” entities, where the entity pays no tax and the revenue from the sale is passed through directly to the shareholder as income. But don’t try to switch elections right before a sale because the IRS doesn’t let sellers’ game the system; if you sell within five years of a new corporate election, you’ll still get taxed according to the previous rates.
Installment sale or lump sum?: From a tax perspective, it can be in the seller’s interest to stretch out sales payments. A major consideration here would be the seller’s capital gains bracket: i.e., how close are you to breaking through into the next higher bracket? You may be able to structure installment payments to control your capital gains rate exposure. The hitch is that optimizing installment payments for tax purposes may stretch out payments longer than the seller is comfortable, in effect, holding a note guaranteed by the buyer. The silver lining may be that, as we counsel sellers all the time, the seller will likely want you to stay in the business for a year or two to shepherd the transaction to completion – i.e., teach them all the systems, help with customer retention, etc. So, maintaining a leadership role in the business in that interim period may help cushion any payment risk.
Don’t ignore state taxes: Your tax liability can be material changes as you move from a federal to a state tax regime. Some federal deductions and exemptions are not available at the state level. For example, some states make no distinction between capital gains and ordinary income, a big potential variable in high-tax states. Some states graduate their capital gains rates, like Arkansas, where an initial tranche of capital gains is exempt from state tax. And some states, like Ohio, have deductions for business income that other states don’t have. As stated above: don’t be in a position of not knowing what you don’t know. Even though state tax rates are lower than federal rates, they can still be material and highly variable.

Ultimately, the theme here is education and planning. Selling a business takes forethought; it’s not something to rush into at the last minute when you’re ready to pack up and hit the golf course. And in the context of a business sale, tax planning is essential, ideally something you want to start on years before your exit from the company.

So, if you’re starting to see the glow of new opportunities on the horizon, even if they are far away, we can help you get started on that education and planning process sooner rather than later.

Todd M. Williams, CPA, CVA, ABI

Trainer, Wright & Paterno

A proud member of The Concord Custom Wealth Group