Buying or Selling a Business? Understand the Tax Issues before You Sign
As the new year begins, business sales and mergers are proceeding at a steady pace, driven by accelerated private equity activity, business owner retirements and consolidation across various industries. While valuation and deal terms often dominate the buyers’ and sellers’ discussions, the tax consequences of a sale must also be considered. How a transaction is structured—and when payments are received—can determine not only how much tax is owed, but when that tax must be paid.
The First Tax Question: Asset Sale or Stock Sale?
Generally speaking, the sale of a business can be structured in one of two ways:
- An asset sale, where the buyer purchases selected assets of the business—such as equipment, inventory, accounts receivable, intellectual property and goodwill—and assumes only those liabilities specified in the purchase agreement.
- A stock sale, in which the buyer acquires the seller’s ownership interest in the entity itself, assuming both its assets and liabilities. Many buyers will require contractual protections such as indemnity agreements or escrow accounts for the assumed liabilities.
For unincorporated businesses such as sole proprietorships, partnerships and many LLCs, asset sales are far more common. For C corporations and S corporations, however, the parties must negotiate how the transaction will be structured. Their preferences often differ, and the reasons are largely tax-driven.
Tax Consequences Drive Negotiations
From a buyer’s perspective, an asset sale offers a significant advantage: the purchased assets receive a “step-up” in tax basis to fair market value. The buyer can then depreciate or amortize those assets going forward, generating tax deductions and improved cash flow in future years.
An asset sale is often less attractive for sellers, however, since proceeds from the sale of certain assets may be taxed at ordinary income rates rather than capital gains rates. C corporation sellers may also face double taxation on asset sales—once at the corporate level and again when proceeds are distributed to shareholders.
A stock sale generally avoids these issues for sellers. Gain is typically taxed at capital gains rates, and all or a portion of the gain may be excluded if the stock is Qualified Small Business Stock. But buyers lose the benefit of a stepped-up basis, resulting in fewer future deductions. These competing tax concerns often become central negotiating points and can significantly affect the final purchase price. However, special elections are available to treat a stock purchase as an asset acquisition solely for tax reporting.
In the case of an asset sale, the allocation of the purchase price among the assets acquired is a significant negotiating issue, as it impacts the sale proceeds and acquisition costs of the assets.
Installment Sales: Deferring Tax—With Important Limitations
In some instances, an installment sale—where the seller agrees to receive payments over time rather than at closing—can be advantageous. Installment sales are common when the buyer is a related party such as a family member or key employee. Third-party buyers will often structure an acquisition as an installment sale with future payments contingent on the entity reaching certain sales or earnings goals or the sellers remaining as employees.
From the buyer’s perspective, an installment sale can ease immediate financial pressures, eliminate the need to procure outside financing, and incentivize sellers to continue working with the entity. From the seller’s perspective, an installment sale can allow the tax on certain gains to be deferred and recognized gradually as payments are received. There are, however, two critical rules that often catch sellers off guard.
Under the tax code, gains attributable to assets that generate ordinary income, such as inventory and accounts receivable, must be recognized in the year of sale, regardless of whether the seller has actually received sale proceeds allocated to these assets. As a result, sellers may face a significant tax bill before they collect sufficient cash from the buyer.
For example, if the portion of the purchase price allocated to inventory exceeds its tax basis, the resulting gain is taxable immediately, even if the seller has received only a small down payment.
Another rule many sellers are not aware of requires sellers to pay an interest charge on the deferred gains when future installment payments to be received exceed $5 million.
In practice, these issues can affect down payment negotiations, purchase price allocations, liquidity planning and the seller’s overall willingness to accept an installment structure at all. A seller should never agree to an installment sale without careful modeling of the tax impact.
The Crucial Element: Proactive Tax, Legal, and Financial Planning
Although taxes are critical, they obviously are not the only factor to consider. In a stock sale, for example, buyers assume existing and potential liabilities, including legal claims, contract disputes and regulatory exposure. In an asset sale, transferring contracts, licenses, permits or intellectual property can introduce complexity and delay.
These non-tax considerations often intersect with tax planning, reinforcing the need for early planning and coordinated legal, financial and accounting advice. In almost every instance, it is important that buyers and sellers have separate advisors to avoid conflicts of interest. Independent advice also helps ensure that tax consequences, cash flow implications and long-term outcomes are fully understood by both sides.
Ultimately, business owners contemplating a sale should involve their accounting, financial and legal advisors well before negotiations begin. Early and careful planning can make the difference between a successful exit and an expensive lesson learned too late.
Please contact us if you are considering a business sale or acquisition.
