Important Tax Considerations When You Sell Your Business: An Overview (Part I)

Selling your business may seem like a natural progression for your company and the possibility of early retirement may look closer than ever, but without careful planning and execution and thorough consideration of the tax impact of sale, eventual financial outcome may end up being much smaller than anticipated.

You can structure sale of your business in two primary ways: 1) sale of the stock or interest in the company or 2) sale of underlying assets. Depending on the structure chosen, special elections made and type of underlying assets, composition of gain as ordinary vs capital may differ significantly and so may the tax liability.

Now let’s consider tax consequences of selling your business under two different scenarios. Under the first scenario, you are the owner of a closely held C corporation. Under the second scenario, you are the owner of a pass-through entity, an S corporation or a partnership.

C corporation – sale of assets

A C corporation is a taxable entity and upon sale of its assets will be taxed on the gain. Both ordinary income and capital gains are taxed at the same tax rate, so allocation of gain among different types of assets does not result in tax savings for the seller. When the C corporation distributes cash proceeds to you as a shareholder, you are taxed again on that income but at a lower capital gain tax rate. As a result, sale of assets by the C corporation normally results in double taxation.

C corporation – sale of stock

Another option for sale of a business structured as a C corporation is sale of stock. It results in one level of taxation for you as the seller and gain is taxed at a preferential capital gain rate. In addition, if you are an owner of qualified small business stock which was held for more than five years, you may qualify for 50, 75 or 100 percent gain exclusion depending on the year stock was issued and total amount of gain. For qualified small business stock issued after September 27, 2010, at least up to $10 million of gain can be fully excluded from federal tax, including Alternative Minimum Tax (AMT).

However, it is important to note that this broad overview applies to federal gain only as state conformity often varies and needs to be addressed separately. For example, California no longer allows gain exclusion on sale of qualified small business stock sold on or after January 1, 2013.

It is also worth noting that depending on the buyer’s market for your company and your competitive edge, a buyer would usually prefer buying assets vs buying stock as it allows the buyer to step up basis in the acquired assets and also to take higher depreciation. Therefore, selling stock, although advantageous for you as the seller, may be less attractive for the buyer, so some concessions may be required.

Tax free reorganization

Finally, there is an option of structuring the sale as a tax-free reorganization that will allow you to defer tax due on sale where you receive the buyer’s stock in exchange for stock of your own company. There are extensive requirements to be met for reorganization transactions, but if done right, you will defer gain and be taxed upon the sale of purchaser’s stock down the road. There are certain time limitations as to how soon the purchaser’s stock can be sold. Careful consideration has to be given to all factors involved.

Please stay tuned for the upcoming discussion on sale of business by an S corporation.