Tax Considerations for Selling a Business

What type of corporate entity matters:

• S corporation or other pass-thru structure such as an LLC
• The main difference is the C corporation pays income tax at the corporate level while at S corporations the income tax is paid by the individual shareholders.

What type of sale matters:

• Stock or asset sale
  • Stock sales – the buyer purchases the shares of the company and thus owns the legal entity. 
  • Asset sale – the buyer purchases all the assets of the company but not the legal entity.

C- Corporation:

• Because the entity is taxed on its income and then the individual shareholder is taxed on dividends, an asset sale of a C corporation results in a very high tax bill. Combined federal rates will easily exceed 40%.
• Therefore, owners of C corporations need to have stock sales where a majority of the taxes will be capital gains at 20% federal for active owners. Note there are variations of stock deals where the transaction is taxed as an asset deal.  But these are still far better than a straight-up asset sale. 

S-Corporations and other pass-thru entities:

• In many cases the tax bill on an S corporation sale will be lower than in a stock deal vs an asset deal, however, the difference is usually not so dramatic that it affects the likelihood of a completed deal.

Taxes in an asset deal – C corporation:

• Assets on the books such as inventory, AR and net book value of fixed assets have zero tax.
• Most other assets will be taxed at the corporate federal tax rate of 21%.
• To obtain the proceeds, the shareholders will have to declare a dividend which will be taxed at 20% for each individual.
• Thus, a minimum combined 41% tax rate for a majority of the purchase price.
• In some cases, there is the possibility of assigning some value to personal goodwill which eliminates double taxation on that part.  However, this is often not available to middle market owners and if so, requires a separate detailed discussion.
• State corporate income taxes also apply and can be up to 11.5% although most are much lower.  Rates are also subject to change as Pennsylvania’s tax is on a declining schedule through 2031 to 4.99%. North Carolina – 2.5%, New York – 7.25%
• An asset sale of C corporation should be avoided.

Taxes in an asset deal – S corporation or pass-thru:

• The key here is the purchase price allocation.  This is negotiated and determines both the seller’s tax bill and the buyer’s annual depreciation and amortization write-offs.
• Basic components:

• As you can see the ideal tax structure for a seller is to reduce gains on fixed assets and minimize the non-compete allocation.  The fixed asset allocation is usually the most heavily negotiated part.  Non-competes are usually easily agreed to at a reasonably low number.
• In many cases, especially for businesses with low fixed assets, the tax bill on an asset sale can approach that of a stock sale.

Taxes on a stock sale:

• If it is a stock sale and treated as a stock sale, then the shareholders pay capital gains tax on the value received over their basis.  You will need to obtain your basis from your accountant, but a quick rule of thumb would be the equity value of the company.
• Only two components:

• Pretty simple and low tax rate but….
• Buyers don’t like this because they cannot depreciate assets or amortize the balance of the purchase price thus, they get no tax deductions going forward. 
• Therefore, in many cases, buyers will ask for a 338(h)(10) or an F reorganization which allows them to purchase the shares but have the parties treat it as an asset sale for tax purposes. 
• Whether you have a C or an S corporation the treatment is the same as the tax calculation noted above for asset deals with an S corporation.  This is because it is still a stock deal.

State taxes on asset deals:

• Many states tax capital gains the same as ordinary income.
  • Examples:
    • New York – up to 10.9%
    • California – up to 13%
    • Pennsylvania – 3.07%
    • North Carolina  – 4.99%. 

Conclusion

The tension between stock and asset deals is more common at the smaller end of the market with deals under $10 million in value.  As deals become larger, the companies become more complicated and only stock deals make sense from a practical standpoint. There are many exceptions for a variety of reasons, but the key takeaway here should be to have a basic understanding of the workings of tax regulations in the sale of your business and consult with competent tax experts.