There are many surprises that come up when you are planning your exit from your business. No matter how prepared and how experienced you are, these “surprises” come with the territory. One area, you absolutely do not want to be surprised in, is taxes. Taxes associated with an exit are likely to be significant in size. Luckily, you can often mitigate them a bit if you plan ahead and know what to expect.
With Tax Day rapidly approaching, I’ve had the pleasure of speaking with an experienced professional in this area, Jenna Zhou, more often. I’ve worked with Jenna for many years and she and her team really know their stuff. I’ve asked if she could answer a few questions to get people thinking about this subject before they get too deep into an exit. Jenna’s bio can be found at the bottom of this post after our interview if you are interested in learning more about her professional experience.
Jay Jesse and Jenna Zhou on the Tax Implications of Selling a Business:
Jay: Thanks for taking the time, Jenna. I know this is a very busy time for you. Can you share some general thoughts on what owners should consider when planning an exit?
Jenna: When you plan an exit, it is important to decide whether to structure the business sale transaction as a stock, or an asset sale, for tax purpose. There are different tax implications under these two transaction types.
When selling the stock of a corporation, you change the ownership of the corporation, but the corporation is still in operation. The shareholders of the corporation recognize the gain upon the sale of stock. The corporation itself has no gain or loss from the transaction. The shareholders would likely qualify for the long-term capital gain rates at the federal level. They would also pay state income taxes depending on the states where they reside.
From the buyers’ perspective, the corporation would have a carryover or historical basis recorded in the assets for tax purposes. The buyers would generally not prefer a stock sale because they wouldn’t get the immediate tax deduction for what they pay for the acquisition of the corporation. The buyers would not recover the purchase price they paid for the stock until they sell the stock to a third party later. If the entity type of the selling and buying corporations are C corporations, there are various limitations on the utilization of tax attributes under the current complex tax rules.
An asset sale provides the buyers a tax deduction of the purchased assets over their depreciation and amortization period. The Tax Cuts and Job Acts of 2017 provides an additional first year depreciation deduction (bonus depreciation) and expands the availability of the bonus depreciation to purchased non-original use property. This change has an impact on the merger and acquisition transactions. It increases the incentive for buyers to structure the acquisitions as an asset purchase, rather than a stock acquisition. The buyers would be able to immediately deduct a portion of their purchase price and potentially generate a net operating loss in the acquisition year. The corporate net operating loss generated during the years 2018 – 2020, when the corporate tax rate is 21%, could be carried back five years to the prior years with a higher tax rate of 35%, resulting in additional permanent tax savings to the corporate buyers.
It is also important to evaluate the entity type when you contemplate a sale transaction. The tax implications from the sale can vary widely across C corporations, S corporations and partnerships. Each entity type has an impact on how the gain from the sale could be taxed. C corporations are tax paying entities. S corporations and partnerships are the pass-through entities that are not subject to income tax at their levels but pass their tax attributes to their owners.
During a stock sale, the shareholders of C corporations will pay an additional 3.8% net investment tax on the amount of capital gain from the sale. However, the shareholders of a S corporation who are actively involved in the business may avoid the additional 3.8% net investment tax on the amount of gain from the sale.
The C corporations that sell assets for a gain would be subject to double taxation, first at the corporate level and then again at the shareholder level when the after-tax money is distributed to the shareholders as dividends. However, the shareholders of the S corporations may be taxed only once on the gain from the stock sale if certain conditions are met under the tax rules. Because of the single level taxation, some small businesses choose to elect the S status over the C corporation structure. If the seller is a flow through entity (either an S corporation or a partnership), some of the gain from the sale could be taxed at the ordinary income tax rate due to the depreciation recapture.
Jay: That’s extremely useful information to consider. That difference can be a pretty big number. In the many exits you’ve seen over the years, can you share some surprises that occur in the middle or after the transaction? Perhaps things we can better prepare for?
Jenna: Great question! Both Dean and I have seen this before. I have worked with him in this area for the past ten years.
Selling a business has significant tax implications. The shareholders need to consider collaborating with their tax advisors when they plan the exit in order to avoid the surprises.
First, the sale of a business during an asset sale is not a sale of one asset. When you sell assets within a business, you sell many different assets in the business. Each asset is treated as being sold separately for determining the treatment of gain or loss. The assets will be classified as capital asset, depreciable asset, real property, or inventory. The tax gain or loss on each type of asset is determined separately. The sale of capital assets results in a capital gain or loss. Each capital asset will be further examined to determine if the capital gain or loss is long term or short term. The sale of inventory results in ordinary income or loss.
Second, after the individual assets have been classified and analyzed, the next step is allocating the sale price to each class of asset sold. Both the sellers and the buyers will use a residual method to allocate the consideration to each business asset transferred. This is the method to determine the gain or loss from the sale of each asset and how much of the purchase price is allocated to goodwill and other intangible property. This allocation determines the amount of capital gain or ordinary income which the sellers will pay taxes on. It will impact the tax consequences for the buyers and sellers. The sellers would want to allocate the purchase price as much as possible to the capital asset to save on taxes. However, this may not be ideal for the buyers. It is common for the sellers and buyers to negotiate the allocation of purchase price.
As discussed early, not all gain from the sale of assets is a capital gain. This gets further complicated when the business has utilized a cash basis accounting for tax return purposes. The sale price is allocated to various assets transferred during the sale. A portion of the sale price will be allocated to accounts receivable. For cash-basis taxpayers, they have not recognized income related to the accounts receivable. Therefore, all proceeds allocated to the account receivables would be treated as ordinary income for tax.
Many owners structure the sale of a business as an installment sale and receive payments after the year of sale. The sellers cannot apply installment sale reporting for the sale of inventory or account receivables. For these items, the seller will pay tax on the gain during the year of sale, even if they have not received payments for them.
Last, it is common for the shareholders to continue to provide consulting services after the sale of the business. The amount they receive under a consulting agreement for the post transaction period is generally not part of the purchase price. Therefore, the amount is ordinary income to the shareholders.
Jay: That makes a lot of sense. One thing that particularly resonates with me is really knowing how different conditions will impact you before negotiations. Often, I’ve seen a good plan get accidentally turned on its head when structure gets changed during negotiation. You may not realize it until after you have agreed to the point. Knowing what is favorable and unfavorable to you, ahead of time, will help you when you are having those conversations.
I get lots of questions from people who are considering their schedule for exits about changes in tax laws, and if they should consider them when determining that schedule. What’s coming down the pike? How should owners contemplating a near term exit start thinking about potential tax law changes?
Jenna: There are personal, professional, financial, and tax considerations when you determine whether to sell a business. During the past five years, the tax rules have constantly changed. In addition, some of the tax law changes are retroactive.
The implementation of the proposed tax changes under the Biden Administration may have some negative tax implications on the net proceeds from potential mergers and acquisition transactions. This may impact the owners as they consider the timing of the exit. The tax rate on long-term capital gains may increase from 20% to 39.6% for the taxpayers whose earnings are over $1 million. The corporate income tax may increase from 21% to 28%.
Considering the competing priorities the Biden Administration faces, it is possible that the tax law changes may not take effect until 2022. This may leave 2021 as the ideal year for these types of deals if the sellers are concerned about the potential rising tax liabilities. One strategy to mitigate the impact of the proposed changes is to use installment sale to manage annual income levels and keep them under $1 million as much as possible.
Our discussion of the tax implications is a broad overview. Each sale’s details could be different and would have a different tax result. It is best that you collaborate with your advisors when you plan an exit.
Jay: Thanks so much Jenna. I know this is such a complex set of topics and trying to hit the nuances in an article like this is impossible. I think you did a great job giving people a taste for how they should be thinking, while also helping them understand that getting expert advice is critical and worth every penny. Good luck with the rest of tax season!
More Information on Jenna Zhou and Dean Smith
Jenna enjoys helping her clients with their corporate tax issues, including reducing worldwide effective tax rates, navigating puzzles in the income tax provisions for financial statements, and mergers and acquisition related tax matters. The results are tax savings and peace of mind for the clients. Jenna specializes in advising clients on their consulting and tax compliance needs. Her diverse client base includes public companies, private equity-owned entities, and family owned businesses. To learn more about Jenna, or to contact her, visit her LinkedIn profile or at the Plante Moran website.
Dean brings 30 years of tax and accounting experience to his corporate clients. He is a leader in the corporate tax and transaction advisory services at Plante Moran. Dean provides value by not only answering the questions, but also digging deeper to uncover all potential impacts on the clients’ business and to provide solutions for underlying issues. Dean makes the technical side of the tax issue easier to understand and, as a result, often serves as the client’s de facto tax department. To learn more about Dean, or to contact him, visit his LinkedIn profile or at the Plante Moran website.