Understanding the Tax Implications of a Business Sale
Bill Kenedy, Lutz Consulting and M&A Shareholder
October 22, 2019
Most business sale transactions are structured as ‘asset sales.’ This is where the buyer sets up a new entity that acquires the assets of the selling business. How a business is structured can have significant tax implications to a seller. In addition, how the company allocates its purchase price amongst its assets in the transaction will also affect its tax level. In this blog, we cover a few of the most significant issues we have seen surprise business owners.
C-Corps vs. S-Corps Taxation
Because C Corporations are legally considered a separate tax-paying entity, they are subject to a double layer of taxation when selling assets. A C-Corporation will first pay tax at the applicable corporate rate on the gain associated with the sale of assets being sold by the corporation. The shareholders will then pay taxes at capital gains rates when the remaining cash is distributed out of the corporation to the extent these proceeds exceed their basis in the corporate stock. One way C-Corps can avoid this double taxation is by doing a stock sale versus an asset sale. When a C-Corporation owner sells their stock, they only pay capital gains tax on the difference between the sale price and their basis in the stock.
In contrast, S-Corps are pass-through entities which are not subject to tax but rather pass their tax attributes out to their owners. As a result, S-Corporations only pay taxes once, at the shareholder level, when selling their assets. Because of the single taxation, many small businesses choose to utilize the S-Corporation structure over a C-Corporation.
The amount of proceeds allocated to equipment (any property besides real estate), that has been depreciated for tax purposes, are taxed at ordinary rates, to the extent the asset was depreciated.
You purchased a machine in 2016 for $10,000 and, over three years, deducted $7,000 of depreciation. Three years later, in 2019, you sell this machine for $8,000. This means that the basis on the machine at the time of the sale would be $3,000 ($10,000 - $7,000 = $3,000). The gain on the sale would be $5,000 ($8,000 of proceeds less $3,000 of basis). All $5,000 of the gain would be taxed at ordinary rates since the $5,000 does not exceed the amount of depreciation deducted on the machine. If your gain is greater than the depreciation deducted for the piece of equipment, there is potential for a portion of the gain to be taxed at the lower capital gains rate.
Many times, in our initial meetings with business owners considering a sale, they assume the asset sale price would be considered a 100% capital gain. However, this is often not the case, and it can have a material impact on the net proceeds the business owner receives after paying taxes. Aside from the example above for depreciated equipment, another example that can result in an owner paying taxes at ordinary rates we often see is a company utilizing the ‘cash-basis’ method. Using this method means a portion of the sale proceeds is allocated to Accounts Receivable.
For example, as discussed above in an asset sale, the sale price will be allocated to the various assets being purchased as a part of the sale. A portion of the sale proceeds will be allocated to accounts receivable. If the business has been utilizing the cash-basis method, it has not recognized income associated with these receivables. So, 100% of the proceeds allocated to these receivables would be taxed at ordinary income rates.
Both the sale structure (asset vs. stock sale) and how the proceeds are allocated amongst the assets, can have a material impact on the amount of taxes associated with the business sale. We recommend that, after gaining an understanding of the value of your business, you also take the time to determine the potential tax implications. Doing this will help you prepare your financial plan and consider if adjustments to the sale structure might result in a tax benefit on the sale. If you have any questions or need help determining the tax implications on your business sale, please feel free to contact us for assistance.
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