Tax Considerations when Selling a Business [Transcript]
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[Plan Your Future Today]
[Mark Patrick, CPA]
[Patrick & Robinson, CPAs]
When you’re selling a business, it’s not just the gross amount of the sale that’s important. It’s the amount that you have after taxes. Today we’re going to talk about the exit tax on the sale of your business. There are numerous variables to consider in the tax ability of your business. We’re going to talk about each one of those. Each sale is unique. In fact, there’s probably as many different bottom lines as there are different sales. How you structure it is important. The details will materially affect what your net income is going to be. Include a tax advisor and your team of experts, because you need to have that person to get the best bottom line after tax benefit.
First of all, let’s do some definitions. Tax basis is an extremely complicated subject. It’s evolved over many years of tax law, and you need to understand that to know what your net tax cost is going to be. Fundamentally, you start with the sales price, the closing cost that you paid when you bought it, the additional investments you’ve made with it along the way, less depreciation, amortization, any liabilities that are assumed by the buyer, any funds that you’ve withdrawn from the business, it’s adjusted for inherited or gifted amounts over the years, and any suspended losses due to your lack of basis or at risk money, and then it’s adjusted for any settlement of company debts. Simple, right? You can see why you need to have an expert to help you through this process.
Goodwill. That’s not the place you take your junk at the end of the year to get a tax deduction. Goodwill is the amount that someone pays you for assets over and above what you have actually got in value. If you sold a $500,000 business and had 300,000 of hard assets, you have $200,000 of Goodwill. It’s an intangible asset to represent the extra amount paid over and above the hard assets.
Net assets is the difference between the agreed amount that the seller’s basis is, that is, what you have in it, and the liabilities that are assumed by the buyer. If you sold a car for $10,000, with a $5,000 loan on it, it has a net asset value of $5,000.
Then the net taxable income is the difference between the sales price, less the costs that are incurred at the closing, less the asset basis that we’ve just talked about.
Then you have to decide, are you selling the assets or the entity? That’s an important concept to know, and you’re going to have a discussion between the buyer and yourself over what’s best for each of you. When you sell the assets, you determine the value of each and every asset that is being sold, not collectively. The ordinary income comes about for gains on inventory, accounts receivable, those type of normal business assets; the ordinary income on the recapture of depreciation, which we’ll talk about a little bit later; the capital gain income is the excess amount over those amounts. You’re going to have a combination of ordinary and capital gain income in the sale.
When you sell the entity, you’re releasing the entire business. You really don’t care what the individual assets are worth. You’re selling the stock or the LLC value that you have in the entity. Generally, that’s all going to be capital gains, which is a better tax rate for you. The assets of the business will retain their basis to the new owner because they’re buying the entity. They’re not buying the individual assets. They will have to deal with those when they sell those individual assets later.
When you sell the assets, first of all, if you’re a sole proprietor, that’s the only choice you have. You don’t have an entity if there’s nothing around it, such as an LLC or corporation. You’re actually selling the individual assets. A partnership has gains on the individual assets and that flows through to the partners. An LLC with no election to do otherwise would also flow through. It’s either going to be a Schedule C, sole proprietor, or it’s going to be a partnership and it will flow through to the individual members. The gain on each individual asset class will be gains flowing through to the owners.
The LLC with an S election is treated as an S corporation. Logically, that would be the case. You’ve not changed the entity, but you changed the tax status to an S corporation. Everything would flow through in an asset sale.
An LLC electing to be a C corporation would also be taxed like a C corporation, and all of the gains will be taxed inside of the entity and you would retain the actual corporation because you sold the assets out of it.
The S corporation with an asset sale has gains on individual assets and those flow through to you. The C corporation, as I said before, is going to be taxed inside the corporation, and then you still hold the corporation to deal with the gain later on when you sell it.
An LLC or corporation can be sold as an entity, creating a capital gain to the owner. You’re selling the actual ownership of the entity. The same treatment would be whether it’s a C or an S corporation, because you’re selling the actual stock, also with the LLC.
The basis of individual assets are assumed by the buyer when they’re buying the entity, because they do not get sold individually. They are sold collectively.
In addition, you may have other agreements that you have to deal with. You may have a covenant not to compete. That’s likely to be the case because they don’t want you opening up shop across the street after you’ve sold. Consulting agreement, that would be taxed as ordinary income. A personal service contract, that also is taxed as ordinary income. But the sale of personal goodwill, which is often the case, because you have value for your selling that and not competing with them, so that would be treated as a capital gain item.
The allocation of the purchase price in an asset sale is a very careful calculation. You and the buyer have to make an agreement on that. Different classes of assets are taxed at different rates. As I mentioned before, inventory and accounts receivable would be sold at a gain at ordinary rates because it would have been ordinary had you turned those in the case yourself when you sold them. Different types assets are treated differently for tax deductions to the buyer. For example, if they are buying your capital assets, such as your fixed assets, trucks, cars, desks, computers, those would be taxed. It would be deducted to them over a depreciable basis over several years. The same is true with the goodwill we talked about before. It is amortized, and you deduct that over time as a buyer. The negotiation for the asset allocation between all of these different items is very important because you’re going to have a different tax effect, and they’re going to have a different tax effect.
The timing of the payments is also important. Are you going to sell this all at once? Ar they going to go get an SBA loan and pay you a lump sum? Are you going to hold part of the, or even all of the sales price over time and collect it over time as well? You would be paying the tax as you collect the money over the several years.If you hold the paper. That may be an advantage to you if you want to collect the money, don’t need the money, and have some interest benefit or to defer the tax by collecting it over time. It does not affect the buyer’s ability to deduct anything, because they’re going to have the full title in possession to be able to take their deductions accordingly. It spreads the proceeds over multiple years, keeping you in a lower tax bracket hopefully. If you sold it for a million dollars in one year versus 200,000 over five years, you could see that you would be in a significantly different tax benefit tax bracket.
However, the IRS requires if you have an installment sale to charge interest. Right now, the tables are very low, so that’s not really a significant thing, but they do want you to charge interest so the seller would have interest income, the buyer would have interest expense. If that’s not stated in the contract, you have to go to the applicable federal rate tables to determine what those rates would be and calculate that in the contract.
The payments can also be over a fixed term, such as the 200,000 over five years, or it can be variable, such as based on performance. It might be 20% of the net profit or 10% of the gross income. They would have a floating payment over those period of years and you would calculate your gain accordingly, as you collected the funds.
That also shifts some of the risks to the buyer… to the seller, I’m sorry, to the seller because they have to stay engaged to make sure that the sales and the profits stay up during the terms of the sale. Remember to include all other sources of income on your personal return when you calculate this. For example, you may have other salary, you may have investment income or retirement income, social security inherited property that’s generating income. Keep that in mind when you’re calculating what your income tax is going to be, because it’s a collection of all of those sources of income as to what your tax will be.
Consequently, the timing is very over a number of years, as well as in what year you may have other income. I’ve often said that when you get to the decade in which you turn 60, there’s a lot of decisions to be made about taking your retirement, your social security benefits, and selling your business to know when’s the best time for tax purposes to get that income.
Let’s take an example here. Let’s suppose you sold the business for $1 million. It consists of $50,000 in cash, $25,000 in inventory, 25,000 in prepaid expenses, 400,000 of depreciable assets, less $200,000 of already depreciated amounts, 25,000 of accounts payable, and 50,000 balance of a line of credit, which they will assume.
You have net assets there of 225,000. Trust me, I’ve done the math. That’s what it comes out to be. Your corporation has a $10,000 initial investment that you put into the business. Your basis in the corporation is $10,000, but it has $225,000 in net assets.
Here we have a sale of a million dollars, less the broker commission of 10%, which is not unusual of a hundred thousand, closing cost of about 25,000, so the net proceeds the actual cash on the table is 875, less the net assets from the previous screen of 225,000, so there’s a net taxable income of 650,000. You’re going to have a recapture tax on the depreciation that we talked about, 200,000 at 39.6… I’m sorry, of 100,000 would be 396, $39,600. Then there’s a 20% tax on the remaining 550, take the hundred thousand off of the 650, and that would, at 20% on 550, would be $110,000. The total tax is 1496.
All right, plan B. Here we’re going to sell the stock. We’re going to get a million dollars for the stock. Again, a hundred thousand dollars commission, 25,000 in closing costs, and the net proceeds is 875. Same number. Shareholder’s basis is $10,000. That’s what you invested in it. Your gain then is 865. The capital gain on 20% is 173,000. 25,000 or so more in tax this way versus the other. Sometimes it works one way, sometimes it works the other. Your numbers will determine what your situation is.
Let’s review those same numbers again. We have $50,000 in cash, 25,000 of inventory, 25,000 prepaid expenses. 300,000. This is how we’re allocating the purchase price. 300,000 to depreciable assets, 675 of goodwill, less 25,000 of accounts payable assumed, and 50,000 credit line of credit assumed. That’s how we allocate the million dollars to the buyer. The buyer now has $300,000 of depreciable assets to start over calculating their depreciation and 675,000 of Goodwill to be able to take amortization. If they bought the stock, they would only have a million dollars worth of capital gain property as an investment and no current tax benefit. This way they would start taking actual amortization, depreciation on that balance right away. The million dollar stock purchase is not nearly as attractive to the buyer as it is to the seller. You have to look at the variables between the two.
If it’s an installment sale, going back to the $650,000 gain, a hundred thousand is the recapture of depreciation. You have longterm capital gain of 550. Year one, you receive $130,000, which is one-fifth of the total. The tax due is 25,000 on the hundred thousand, 25% we’re assuming because it’s in a lower bracket than it would have been at the 39.6 lower income. $4,500 on the $30,000 not recaptured. The recapture has to be declared in the first year as ordinary income. You have 25,000 on a hundred thousand as ordinary, and you have 15% on 30,000 at 4,500. That’s the first year. Thereafter, it’s all capital gain. You follow on through. You’ve got year two of 195, year three, 195, all the way through. Your tax is $117,000 versus the 173 or 149 that we talked in the previous slides. You can see spreading it out over time, if your other income is limited, lowers your tax as well. You do have the risk of waiting for your money, I recognize that, but it’s something to consider.
In conclusion, it does matter whether you sell your assets or you sell your entity. It’s a very important decision. It’s one of the big points of negotiation between the buyer and the seller. Are you a sole proprietor, an LLC, partnership, S corporation, or C corporation? That matters as to how you’re going to be taxed and when. Are there side agreements, such as the noncompete or personal service contract that would be taxed at ordinary income? Or perhaps there’s goodwill. That would be a capital gain. How does that fit into it? Allocate the assets sold to the buyer or the seller’s advantage? Big point of negotiation you have to work out between the two of you. Do you collect the proceeds as a lump sum or over several years? That’s important because you’re going to have less tax usually if you wait over time, but you take the risk of the loss of collection as well. In certain times, you have changes in tax law, which you may have planned to do it one way, and then tax laws change others in future years, and you may not be as attractive in deferring that. Do you have other material income to consider as well? Interest, dividends, salaries, retirement, those kinds of things.
Engage a solid tax advisor in this process because they could be well worth your savings of tax.
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