Structuring a business sale and purchase appropriately can help minimize taxes and maximize after-tax proceeds. The 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 ideal for the seller, and vice versa. This article will focus on the purchase and sale of an S-corporation.
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 vary 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 must agree on how that price will be allocated to the assets. The asset allocation can directly affect the buyer and seller’s tax treatments.
Many sellers prefer stock sales to asset sales. 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. A stock sale 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. Instead, many buyers seek to purchase the business in a way where they may recover their cost more quickly through amortization or depreciation. This is typically pursued through an asset sale.
Asset sales typically involve the sale of inventory, fixed assets and goodwill. A buyer should try to allocate as much of the purchase price to shorter life assets such as equipment which is depreciated over five or seven years. Amounts allocated to intangible assets like goodwill are generally amortized over 15 years. A purchase of business assets has a potential to recover a significant portion of a purchase price through tax deductions if structured and allocated properly. For this reason, purchasing a business’s assets vs. stock is a popular option for many buyers.
Ordinary Income & Recapture
As mentioned earlier, the seller generally prefers not to enter into 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. Gain on the sale of fixed assets 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).
Some sales are structured that the seller carries a note from the buyer for repayment over time. Installment sales can work to the seller’s advantage by spreading out payments and recognition of profits, resulting in lower effective tax rates. 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 applied, regardless to any receipt of cash from the sale. The result is the seller 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 in the year the cash is received. Given the preferential capital gain rate, a seller would generally seek allocations to goodwill wherever possible.
This is a high-level look at the tax aspects of buying or selling a business. If you’re considering buying or selling a business, contact Opsahl Dawson for a more in-depth analysis.
Sierra Eckman is a CPA and Shareholder with Opsahl Dawson.