Minimizing Negative Tax Implications When Selling a Business – Post #30

In our Building a Sellable Business series, you’ve publicized your intent to sell your business. You’ve given your sales presentation and received a buyer’s Letter of Intent to purchase your business. As you determine how you will get paid upon the sale of your company, you’re getting into the financial terms of negotiations now. Friends, you must know that if money is changing hands, taxes follow. Sellers who understand that the purchase price is only the beginning of sales negotiations soon find themselves trying to figure out how to minimize negative tax implications when selling a business.

Podcast Time Index for “When Should a Business Owner Start Social Security?”

01:08 – When Should a Business Owner Start Social Security?

02:23 – The Three Ages of Social Security

02:33 – Full Retirement Age

03:48 – Early vs. Delayed Benefit

06:09 – Taxation of Early Benefit

08:09 – Claiming on Your Spouse’s Early

10:03 – The Key Thing to Consider

12:09 – What is the Latest You Can Take it?

13:01 – Why is it Such a Big Deal?

14:23 – A Case Study for the Analytically-Minded

18:24 – So When Should You Start Collecting Social Security?

19:29 – When Should you Take Social Security at 70?

20:41 – Wrap Up

Overnight, many sellers become “armchair, Google tax experts” ready to take on the most knowledgeable tax planners… or so they think. If you research the Internet for tax advice, you will learn a lot of information. However, that information may be completely inapplicable to you and your business sale. When you’re dealing with taxes and sales negotiations related to a purchase agreement, be smart. Utilize the team you’ve (or should have) built. Let the professionals identify ways you can minimize negative tax implications when selling your business.

Any time you’re dealing with taxes, talk to your Certified Public Accountant and your CERTIFIED FINANCIAL PLANNER™. What I have to say is not tax advice. Your particular circumstances will differ from mine and from my clients’, so you need your own CPA and CFP^®. By working together, they can offer you the best tax advice based on your unique situation. So lean on them, and just use my post as a discussion starter.

The Tax See-Saw Effect

During negotiations, sellers’ and buyers’ attorneys are making changes to the language of sale. Any time buyers or sellers make pertinent financial changes to the purchase agreement, one will face tax consequences and the other will receive tax benefits. Changes in the purchase price, payouts through employment contracts, cash sales versus stock sales, earnouts versus promissory notes, or combinations thereof directly affect tax liabilities each party will face. As your teams work to clarify the language of the sale, you will see a see-saw effect in tax credits and dues. Rather than giving some and taking some, you will win some and lose some. The more taxes the buyer pays, the less you pay or vice-versa. There is no win-win. One party will “win” the battle to minimize taxes while the other will “lose.”

Typically, the IRS taxes earnings from the sale of intangible assets (i.e. goodwill) and certain tangible assets (i.e. Company Stock) at a Long-Term Capital Gains rate of 15% – 20%. On the other hand, the IRS typically taxes earnings from the sale of tangible, hard assets like equipment and accounts receivable at a higher Ordinary Income rate of 25% – 40% (the actual percentage rates sellers pay depends on their income bracket.)

In a business sale, then, sellers hope to increase the percentage buyers pay for assets which generate the lowest tax rates and decrease the percentage they pay for assets which generate higher tax rates. Buyers hope to do the exact opposite to take advantage of depreciation and/or amortization on hard assets. Thus, buyers try to minimize their own immediate and future tax liabilities.

As you can see, buyers’ and sellers’ goals directly oppose one another. The see-saw cannot reach a level plane. It must tip up toward one party and down toward another.

The Type of Sale Affects Your Tax Implications

Essentially, you can sell your company’s assets or its stock ownership. But no matter how you sell your business, you will have to pay taxes. Ultimately, your goal should be to minimize your tax implications when selling a business.

The Asset Sale

In an asset sale, the seller retains possession of the legal entity but nothing more. Essentially, you are selling the “stuff” you own and manage but not your company’s name or its liabilities. Sometimes, you retain your cash on hand, too.

Generally, self-employed medical professionals participate in asset sales because the small business operates under the proprietor’s name. If these dentists, chiropractors, physical therapists, optometrists, or the like practice as “Jane Smith Clinic,” then the buyer will purchase Jane’s assets but not the business’s identifying name.

Using the tax see-saw effect we discussed earlier, an asset sale can place the seller in the “losing” position. Let’s say that furniture, equipment, and patient bases make up the majority of the sellable assets. As mentioned earlier, earnings from the sale of those assets usually fall within the Ordinary Income Tax rates of 25% – 40%. Self-generated goodwill (the value of the company not attached to a tangible asset) makes up a very small percentage of assets within the purchase price. Likely, earnings from the sale of that asset will fall within the Long-Term Capital Gains Tax rates of 15% – 20%.

In this particular case, the seller could pay the higher ordinary income tax rates on the majority of his earnings from the sale. So if you’re selling assets for $1,000,000, you could pay upwards of $400,000 in federal taxes. That number doesn’t even account for state and local taxes you’ll owe! (Of course, this is a hypothetical situation. The exact details of your specific situation could vary greatly.)

On the other hand, with a little tax planning, you could tip your see-saw the other way. You could reallocate your asset mix to be mostly self-generated goodwill with some “stuff” thrown into the sale. Potentially, this particular seller could pay Long-Term Capital Gains Tax rates for that majority goodwill asset at 15% – 20%.  Then, he could pay higher tax rates on the minority earnings from the sale of his “stuff.” In this case, the seller of the company would actually win the see-saw negotiations because he virtually receives the tax rate of a stock sale (see below).

The Stock Sale

In a stock sale, the buyer purchases the sellers’, or shareholders’, ownership stock in the company. The buyer assumes ownership of the entity, the name, the assets, and all of the liabilities. Don’t miss that… you just sold your liabilities!!! (THIS IS HUGE. Don’t miss post #32 that will address this very issue!)

As I mentioned above, Company Stock is often taxed at a Long-Term Capital Gains rate of 15% – 20% rather than at the Ordinary Income rate of 25% – 40%. Depending on the sales price and the seller’s income bracket, sellers might even get away with paying zero taxes on this type of sale.

The Predetermined Sale

However, not all sellers can participate in a stock sale, and some cannot tweak their tax liability percentages. If you’ve been reading this series, you know that I often tell you that the choices you make at the beginning of your business, affects your sale at the end. Your entity choice is a case in point.

Your company only has stock ownership (or membership interest in the case of an LLC) to sell if you operate as a C Corporation, an S Corporation, or an LLC. If you operate as a sole proprietor or general partnership, you have no ownership/membership interest to sell. Thus, you will sell your assets and pay tax liabilities on those earnings based on your asset percentages.

Similarly, if you operate your company as a C Corporation, that entity choice predetermined your tax liabilities years before you ever get to the business sale. The government taxes C Corporations AND C Corp shareholders yearly in what we call a double taxation liability. That same double taxation status applies to the company’s sale as well. Your company will pay taxes on its sales earnings, AND shareholders will pay taxes on the same earnings.

Pre-Planning Can Minimize the Negative Tax Implications

So long before you ever sell your company, decisions you make can affect the taxes you pay on your sales earnings. Therefore, you should employ a good CERTIFIED FINANCIAL PLANNER™ and a good Certified Public Accountant years before you get to the business sale. Pick ones who deal with business and tax planning. Quite possibly, they can save you thousands or millions of dollars in taxes.

Charitable Intent

Many times, depending on your age or your over-arching goals, a little bit of charitable planning as it relates to your business sale could save you lots of money. A sale I was working on when I wrote the blog post Achieving Charitable Desires While Increasing Your Net Gain provides a great example of this.

Particular clients of mine stood to gross about $10,000,000 upon the sale of their company. Before the sale took place, the owners told those of us on their exit team that they wanted to give $1,000,000 of their proceeds to a religious charity. First, we verified that the organization fell under the IRS’s qualified charity rules and regulations. Then, we looked at the clients’ tax implications.

Originally, the clients hoped to donate the money after they sold the business. So we ran an analysis based on that scenario. If they sold the business for $10 million, paid their taxes, and donated the money after the fact, they would walk away with approximately $7,270,000 net cash. Since $1 million would go to charity, we determined that they would lose around $2.8 million of their $10 million deal.

Alternatively, we did an analysis based on a pre-gift scenario. If the owners gave the money to charity before the sale ever took place, they would net approximately $7,500,000 cash. Friends, that is over $200,000 more in the owners’ pockets!

Small Adjustments

You might also look at making slight adjustments as you’re planning to sell your business. Timing can make a difference here. If your tax liabilities will be $1 million and you close the sale in December, you will owe that money by April 15. However, you could delay the closing by one month. Then, you would not owe that $1 million until the following April. What if you took that $1 million you owe the government and invested it in a low-risk CD or savings account for those 15 months? You’d make money off of the government’s money.

Small changes in buyer allocation percentages can also make a difference in your tax liabilities. If you increase the percentage allocated to goodwill and decrease the percentage allocated to hard assets, you could minimize your tax liabilities.

Those charitable contributions or small adjustments are just a taste of how tax planning can help you. Tax planning with a CFP^® and a CPA years before you sell your business can potentially save you hundreds of thousands of dollars. So, friends, don’t wait until you cash-out of your business to look at your tax implications. Look now. Then, keep as much of your earnings as possible when you sell years down the road.

Next article we will be discussing the business’s purchase agreement and the ways that it will protect you AND the buyer.