Selling Your Business? Tax Implications to Consider

So you’ve gotten to the point where you are starting to think about your exit strategy. Most business owners would like to think that there is value in the business they have worked so hard to build and would like to monetize that value. Options you’ve considered include a succession within the family, or to one or more key employees. If that’s the case, various transfer vehicles could be used including an Employee Stock Ownership Plan (ESOP), gifting strategy, or outright sale. It is common for these types of transfers to involve the stock of the entity holding the business. But there may be no key employees or children who present themselves as possible successors, and a third party sale becomes more likely. Hopefully in that case a strategic partner can be found to whom the business has ongoing value – even if you walk out the door.

Once these discussions begin, it’s important to understand what it is you’re selling, because the results can vary dramatically. In general, the buyer would prefer to buy the assets of the business, while the seller would prefer to sell stock. This is especially true if there is built up value inside a taxable corporation. This distinction may not be as important if the entity holding the business is a partnership for tax purposes.

Why is this?

Assume your business is worth $10m and it’s in a taxable corporation. Assume further that the company’s basis in its assets is $2m, the retained earnings are $1.5m, and there is $500k in debt. Your basis in your stock is $200k. If your buyer buys the assets from the corporation for $10m, the corporation will pay tax on an $8m gain, or $3.2m. When you distribute the remaining $6.3m in cash, you have a taxable gain of $6.1m, creating a tax liability of $1.8m for you. Your after-tax cash flow from this $10m deal is $4.3m. Your buyer gets depreciable basis in the assets of $10m and has no exposure to potential liabilities of your corporation. This transaction is good for the buyer and bad for you.

Assume the same facts, but you somehow convince the buyer to buy your stock. If you get $10m for it, you have a taxable gain of $9.8m which will create a tax liability of $3m. You will net $6.8m and will have succeeded in transferring your corporate tax problem to the buyer, along with any potential liabilities of the company. The buyer will not get any step up in depreciable basis in the assets. This transaction is great for you, bad for the buyer.

As a result of this, it’s unlikely your buyer will pay you $10m for the stock. Depending on the circumstances, the stock deal is likely to be completed at a lower value to reflect the fact that they buyer is undertaking whatever liabilities the company has, and gets no opportunity to recover their investment in a stream of tax deductions.

There are also situations where one or both parties are indifferent as to the structure of the deal. Is the buyer a tax-exempt organization? Is there no imbedded tax gain in the target corporation? Does the buyer have substantial loss carry-forwards? Is the business held outside of corporate solution in a partnership or S corporation? So, it’s important to understand the tax motivations on both sides before considering what to sell.

There also may be business and/or legal reasons to prefer a stock deal. These could include the problems associated with re-titling assets or transferring contracts. Congress recognized this and has enacted a tax provision whereby the legal form of a transaction can be separated from its income tax treatment. There is an election available for certain sales of stock through which the transaction is treated as if it was a sale of the company’s assets. This allows the legal form of the sale to be the outright acquisition of stock of a continuing corporation, while at the same time, for tax purposes, a new corporation bought the assets of the old corporation. The result is any gain or loss inside the old company is triggered, followed by a deemed liquidation. The buyer gets their basis adjustment in the assets. This election is part of IRC Section 338.

The purchase or sale of a business presents many complex issues – business, legal, and tax. So consulting with a qualified professional is a necessity.

Article contributed by Paul Steckel, CPA, MKS&H Tax Partner

About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.

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