The purpose of this article is to demonstrate
importance of tax impact in sale of your business. As an M&A intermediary and member of IBBA, International Business Brokers Association, we recognize our responsibility to recommend that our clients use attorneys and tax accountants for independent advice on transactions.As a general rule, buyers of businesses have already completed several transactions. They have a process and are surrounded by a team of experienced mergers and acquisitions professionals. Sellers on other hand, sell a business only one time. Their “team” consists of their outside counsel who does general business law and their accountant who does their books and tax filings. It is important to note that seller’s team may have little or no experience in a business sale transaction.
Another general rule is that a deal structure that favors a buyer from tax perspective normally is detrimental to seller’s tax situation and vice versa. For example, in allocating purchase price in an asset sale, buyer wants fastest write-off possible. From a tax standpoint he would want to allocate as much of transaction value to a consulting contract for seller and equipment with a short depreciation period. A consulting contract is taxed to seller as earned income, generally highest possible tax rate. The difference between depreciated tax basis of equipment and amount of purchase price allocated is taxed to seller at seller’s ordinary income tax rate. This is generally second highest tax rate (no FICA due on this vs. earned income). The seller would prefer to have more of purchase price allocated to goodwill, personal goodwill, and going concern value. The seller would be taxed at more favorable individual capital gains rates for gains in these categories. An individual that was in 40% income tax bracket would pay capital gains at a 20% rate. Note: an asset sale of a business will normally put a seller into highest income tax bracket.
The buyer’s write-off period for goodwill, personal goodwill, and going concern value is fifteen years. This is far less desirable than one or two years of expense “write-off” for a consulting agreement.
Another very important issue for tax purposes is whether sale is a stock sale or an asset sale. Buyers generally prefer asset sales and sellers generally prefer stock sales. In an asset sale buyer gets to take a step-up in basis for machinery and equipment. Let’s say that seller’s depreciated value for machinery and equipment were $600,000. FMV and purchase price allocation were $1.25 million. Under a stock sale buyer inherits historical depreciation structure for write-off. In an asset sale buyer establishes $1.25 million (stepped up value) as his basis for depreciation and gets advantage of bigger write-offs for tax purposes.
The seller prefers a stock sale because entire gain is taxed at more favorable long-term capital gains rate. For an asset sale a portion of gains will be taxed at less favorable income tax rates. In example above, seller’s tax liability for machinery and equipment gain in an asset sale would be 40% of $625,000 gain or $250,000. In a stock sale tax liability for same gain associated with machinery and equipment is 20% of $625,000, or $125,000.
