Structuring the Sale
Universal Advisor, 2004 Issue No. 3

Tax considerations play an important role in maximizing the cash return from the sale of a business. To minimize the tax impact, sellers must understand and consider — at the start of the sale process — the tax rules that will ultimately impact the amount of cash they will realize from the transaction.

This section provides some basic information that should help the seller understand some key concepts that, if left unaddressed, could significantly increase the tax liability associated with the transaction. Common business structures include regular or “C” Corporations, S Corporations, limited liability companies (LLCs), general and limited partnerships, and sole proprietorships. Note that S Corporations, LLCs, and partnerships generally are more tax friendly to sellers than C Corporations.

Shareholders of C Corporations typically would prefer to sell their stock to a prospective buyer rather than have the buyer acquire the assets of the corporation. In the case of a stock sale, the corporate entity remains intact, which means that all corporate liabilities remain with the corporation. More importantly, the seller experiences only one level of tax, which is at the favorable capital gain rate of 15%. An asset sale by the corporation results in two levels of tax. The first tax is to the corporation on the gain from the sale of assets. The shareholders pay the second tax when the corporation is liquidated, and the after-tax sales proceeds are distributed to the shareholders.

Conversely, buyers typically prefer an asset acquisition since they can pick and choose only the liabilities they wish to assume and, thus, are protected from undisclosed or contingent liabilities. In addition, the buyer of corporate assets will allocate the purchase price to the acquired assets which, in many instances, will result in a significant “step-up” in the basis of the assets acquired. This basis step-up will result in increased depreciation and amortization deductions, which will reduce the buyer’s overall tax liability and will effectively reduce the cost of the acquisition. The buyer also has the opportunity to select the type of business entity in which to place the assets as well as select new accounting methods, accounting periods, and employee benefit plans.

When an asset sale is unavoidable, the seller has some ability to lessen the impact of the double tax. For example, allocating a portion of the purchase price to personal goodwill, covenants not to compete, and consulting services to be performed by the seller may help to reduce the double tax. Every situation is unique; therefore, careful tax planning is critical in each business sale transaction.

In contrast to C Corporations, double tax is generally avoided when an S Corporation, LLC, or partnership sells its assets. Since there’s no tax at the entity level, the gain from the sale of assets is “passed through” to the individual entity owners where the tax is paid. While this “pass through” tax regime is far more favorable than the double taxation regime of C Corporations, the gain from an asset sale may be subject to a mix of the capital gain tax rate of 15% and ordinary tax rates (as high as 35%). The tax rate depends on the nature and character of the assets sold. Finally, as with the sale of C Corporation assets, purchase price allocation among the assets sold can be an important minimization tool.

Tax laws and IRS rules and regulations are extremely complex. As a result, it’s important to seek competent tax advice at the onset of the negotiations for the sale of any business entity.