For Sale: Tax Consequences of Selling a Business

Selling a business has its pros and cons —you’ll probably have more money than you’ve ever had before (unless you’ve sold other businesses), but you’ll be sharing some of your profits with the government.

How much of it you keep and how you structure the sale depends largely on your business entity, so it’s important to consider your exit strategy when you start your business.

Businesses are set up one of three ways: as a sole proprietorship, a partnership/limited liability company (LLC) or a corporation.

When a business is structured as a sole proprietorship or a partnership, the sale of the business will be an asset sale, where the buyer purchases only the assets of the company, not the liabilities or the business in its entirety. Assets included are typically accounts receivable, inventory, fixed assets, customer lists and goodwill.

The income from the sale of the assets is reported on the individual tax return of the sole proprietor or the partner. The allocation of the purchase price to each asset determines how the income will be taxed. For example, the sale of any inventory and covenant not to compete will result in ordinary income. The sale of equipment, real estate and goodwill will result in either capital gain, Section 1231 or ordinary gain income.

The buyer will usually try to get as much of the purchase price as possible allocated to items that would be considered “ordinary gain” to the seller, because the buyer can typically expense those items in the first year of business, instead of capitalizing the assets and depreciating them over time. It’s important for the seller to consult tax and legal advisors when reviewing any letter of intent to ensure a fair allocation of the sale of each asset.

The seller may also try to enter into an installment sale with the buyer for the purchase price of the business. An installment sale is when the seller issues a note to the buyer to have the purchase price paid over an agreedupon number of years. This would allow the seller to defer the tax paid on the sale of the business over the life of the note.

The amount of profit to be recognized in each year would be calculated in the first year and applied to payments received in each subsequent year. The buyer would be required to pay interest on the note, which is reported as interest income to the seller. An installment sale may not be beneficial if tax rates are projected to increase or if the individual expects to be in a higher income tax bracket in future years.

When the buyer and seller cannot agree on a purchase price, they may enter into a contingency sale. The sale price of the business in a contingency sale is based on future facts, such as target sales and earn out. If there’s a cap on the amount a seller can receive, the profit percentage to be recognized each year will be based on the maximum amount the seller can receive. The adjusted basis of the property would be allocated over the length of the agreement. Contingency sales are complex, so it’s recommended that advisors be consulted as early as possible.

If the business is structured as an LLC or a corporation, the sale could either be an asset sale or a stock sale. An asset sale will have the same result as if the LLC or corporation were a sole proprietor or partnership, with the income flowing through to the owner or owners.

In a C corporation, an asset sale would generate the same categories of income as the other entities, but the corporation itself would pay tax on the income and there are no preferential gains rates at the corporate level. The C corporation can determine if the sales proceeds will flow to the shareholders through a distribution for which the corporation will not receive a deduction or, if appropriate, through additional compensation to the employee shareholders. In the C corporation structure it’s important to watch for the double tax on the sale income.

A stock sale of either an LLC (except a single member LLC or a partnership) or any form of corporation would result in capital gain treatment for the seller, just as if he or she had sold shares in a publicly traded company. This type of sale has the greatest tax advantage to the seller, as capital gains tax rates are currently lower than ordinary income rates. However, a stock sale tends to be unappealing to buyers, as they must assume all current debts and potential liabilities, including unforeseen future litigation against the company. The buyer also cannot step up the inside tax basis of the assets.

Understanding how the structure of your business will affect your exit strategy is a key element to an exit plan. Knowing the tax implications of a sale will give you a clearer picture of what the sale means in real after-tax dollars and will provide you with the knowledge needed to negotiate the best deal.

If you plan on selling your business in the future, now is the time to discuss and implement a strategy with a tax advisor.