Tax Considerations When Selling Your Business

Selling your business can leave you facing a hefty tax bill, but with planning it is possible to minimize or defer some taxes.

There are four basic reasons for selling your business: retirement, disaster, great price, or forced liquidation. No matter the reason, you may face a significant tax bill. This could end up being more than half of the selling price, leaving you less to put in your pocket after all taxes are paid.

On any sale of a capital asset, including business property or your entire business, you have to pay income tax on your capital gains. Ordinarily the gains are taxed in the year of the sale. With current law, long-term capital gains are taxed at a significantly lower rate than ordinary income. If you have held the asset for longer than 12 months, the maximum tax on long-term capital gains is 20 percent (and if you are in the 15 percent tax bracket, the maximum rate is 10 percent).

The taxable amount is your profit, which is the difference between your tax basis and your proceeds from the sale. Tax basis is your original cost for the asset minus depreciation deductions claimed, minus any casualty losses claimed, and plus any additional paid-in capital and selling expenses. Your proceeds from the sale generally means the total sales price, plus any additional liabilities the buyer takes over from you.

If the business is a sole proprietorship, a partnership, or an LLC, each of the assets sold with the business is treated separately. So, the formula described above must be applied separately to each and every asset in the sale (you can lump some of the smaller items together). Certain assets are not eligible for capital gain treatment; any gains you receive on that property are treated as ordinary income and taxed at your normal rate, which can be as high as 38.6 percent in 2003. The problem becomes one of allocation. If you negotiate a total price for the business, you and the buyer must agree as to what portion of the purchase price applies to each individual asset. The allocation will determine the amount of capital or ordinary income tax you must pay on the sale.

The buyer of the business is going to want to allocate more of the price toward assets that can be depreciated quickly, and less of the price to ones that must be depreciated over 15 years or even longer (such as buildings) or not at all (such as land).

That is the simple version, but there are a number of qualifications to the rules and issues that present planning opportunities for sellers (and buyers) of businesses.

Ordinary income vs. capital gains: Gains on some of the assets being transferred may have to be taxed at ordinary income tax rates, rather than at the 20 percent maximum long-term capital gains tax rate.
* Installment sales: If you defer receipt of the purchase price to later years with an installment sale, you may be able to postpone paying tax on your gains until you receive them.
* Double taxation of corporations: For business organized as corporations, the structure of the deal as an asset or stock sale can have very different tax results.
* Tax-free reorganizations: Where one corporation is buying another, you may be able to structure the sale as a tax-free merger.

Tax-Free Reorganizations

If your business is incorporated and you are selling out to a larger corporation, it may be possible to defer any tax due on the sale. How? By structuring the sale as a corporate reorganization, and accepting the purchaser's stock in exchange for your own business's stock. If you manage to comply with the IRS's extensive rules for these types of transactions, you won't be taxed on the value of the stock you receive, until you sell it at some point down the road. If you receive other property or tax in addition, however, you'll have to recognize taxable gain to the extent of this "boot."

This type of deal is only advantageous if you are selling out to a buyer whose stock is a good investment. Remember, you'll be exchanging a nondiversified investment over which you had control (your own company) for a nondiversified investment over which you may have little or no control. Under Federal tax laws, you generally can't go out and immediately sell the buyer's stock; you may be required to hold it for as long as two years, or you will lose the tax-free status of the transaction. In two years, almost anything can happen to the value of the stock.

If your buyer proposes structuring the deal as a merger or corporate reorganization, our advice is that you seek the advice of an attorney with extensive experience in this very complicated area.

Structuring a Tax-Free Deal

Many mergers and acquisitions today are driven by the desire to consolidate. In these cases, a company grows, or is created, by acquiring smaller fragmented companies. This movement toward consolidating "mom and pop" businesses into larger organizations raises the issue of tax-free reorganizations as an acquisition structure.

Internal Revenue Code Sections 368(a)(1)A, B, and C - often referred to as the "Alphabet Sections" - govern the tax treatment of these transactions. Similar to "pooling of interests" accounting, the underlying concept in a tax-free deal is the continuity of ownership interests.

Type A Reorganizations

A Type A transaction allows the selling parties to receive substantial cash or other "boot." In a Type A deal, the law isn't as concerned about the type of consideration; the main requirement is continuity of ownership, which generally is met if at least 50% of the target's stock is acquired with the buyer's stock. In practice, deals have been done with less than 50% and the courts have upheld them. Any cash received in the transaction is taxable.

Type B Reorganizations

A Type B reorganization involves an exchange of some or all of the buyer's voting stock for voting stock representing control (at least 80%) of the target. Aside from being tax~ free, this type of deal may avoid a hostile management (only the shareholders need be negotiated with), doesn't have to comply with awkward or costly state merger statutes, and doesn't require the acquisition of substantially all the target's assets (as does a Type C transaction) -

The biggest disadvantage of a Type B transaction is that the consideration must consist solely of voting stock. In many middle-market transactions, however, the shareholders are interested in receiving at least some if not all of the purchase price in cash.

A Type B reorganization may be useful in transactions where several organizing companies start an industry consolidation play with themselves as founders. In these cases, the founders' objective is eventual stock appreciation as opposed to immediate cash. Another potential technique for 'achieving the same outcome might be a series of Section 351 transactions in which each organizer contributes assets to a newly formed corporation in exchange for stock.

Type C Reorganizations

In a Type C deal a company acquires "substantially all" of the target's assets in exchange solely for voting stock. But in determining whether the exchange is solely for stock, the buyer's assumption of the seller's liabilities is disregarded.

In addition, if the buyer uses voting stock to acquire at least 80% of the market value of the seller's assets, then the buyer may use other forms of consideration in addition to voting stock. The catch, however, is that if consideration in addition ,to voting stock is used, any liabilities assumed by the buyer must be considered in applying the 80% test.

The law doesn't specifically define "substantially all," but IRS advance rulings generally follow a standard of 70% of gross assets and 90% of net assets.