Taxes and terms in a business sale: It's not all about price

In most business sales, it’s natural for the seller to focus on the price as the defining measure of their company’s market value and their satisfaction with the sale.

However, obsession with the selling price can obscure other important considerations – the terms and structure of the deal, the resulting tax liability, and the net cash received.

“Terms are as important as price,” says Jim Afinowich, managing partner in IBG Business’s Arizona office. “It’s not how much you sell the business for; it’s how much you end up with after tax. And there can be a tremendous difference in tax consequences and how you structure the sale.”

A major role of an M&A advisor is to help the seller keep their eye on that bigger picture, adds IBG managing partner John Johnson (Oklahoma).

“We are always alert to the tax aspects and, during the sale and negotiating process, will work to negotiate a structure that favors the seller. Deal structure can help whittle down the actual taxes through buyer-seller negotiations and cooperation.”

This article offers a very general overview of how understanding the taxes and terms of a business sale can help a seller discern the true value of an offer and, in a competitive bidding scenario, recognize which offer constitutes the best deal.

As you read on, bear in mind that the factors that shape the value of a business sale are deal-specific. Because of the nearly infinite number of variables – the seller and their issues; the buyer and their issues; the company and its issues; and the type, timing, and terms of the transaction – our best objective here is to help you anticipate, from 30,000 feet, some of the factors that can shape a deal’s ultimate value.

PRE-SALE MANEUVERS

At least three tax-related issues should be addressed and resolved before your business is presented to potential buyers.

Estate Taxes. You should ask your estate planning attorney to analyze how selling your business might affect your estate tax liability. This is especially important if your business’s current market value (we can help you with a reliable projection) is considerably higher than it was when you last updated your estate plan.

This is a timely concern. If Congress does not act before the end of 2025, the estate tax exemption will drop from the current $13.6 million per person to just $6.2 million (i.e., $5 million adjusted for inflation since 2017). As a consequence, your seemingly modest estate, which up to this point has not warranted estate tax planning, could become subject to taxation after your death, due to a combination of a lower estate tax exemption and an unexpectedly high selling price for your business.

Gray Dollars. One of our key functions in preparing your business to go on the market is to recast its financial statements to show its true earnings and book value, in a way that buyers expect.

In recasting your financials, we will cleanse them of what Jim Afinowich calls “gray dollars”: personal expenses, or expenses of a dubious business nature (think “condo in Vail”), that you have been running through the company.

“In years past, those gray dollars served a useful purpose by reducing your taxable income,” Jim noted in a recent podcast. “But now you’re in sell mode, and it’s time to pay the piper. If your business is likely to sell for a multiple of four times earnings, each of those gray dollars is going to cost you four dollars in selling price.”

That’s why recasting your financials is so important, and it needs to be completed before the first potential buyer looks at your company.

Double Taxation. If your business is a C corporation, check with your tax professional about the pros and cons of – and your C corp’s eligibility for – electing to be taxed as an S corporation.

An S corp election might allow you to avoid double taxation on the proceeds of an asset sale. However, this strategy requires long-range planning, as gains recognized within five years after the election may be subject to built-in gains (BIG) taxes that would defeat your purpose.

KEY QUESTIONS

After the preliminaries are out of the way, your business is on the market, and you are receiving inquiries and letters of intent from potential buyers, major variables that shape the value of your deal will come into play.

• Will the deal be a stock sale or an asset sale?
• Is it a cash deal, or is the buyer asking you to carry a portion of the purchase price?
• Are you free to move on after the deal closes, or does the buyer want you to remain involved for a while?
• Is any part of the sale price contingent on how the company performs under the new ownership?
• How can you reduce your deal-related tax liability?

STOCK SALE VS. ASSET SALE

Business sales generally fall into one of two categories:

• a stock sale, where the buyer purchases the seller’s interest in, and takes possession of, the legal entity, or
• an asset sale, in which the buyer is purchasing specified assets from that entity.

IBG’s John Johson observes that “small deals are most often asset sales, while larger deals more often involve the sale of equity.”

Each type of sale impacts negotiations, terms, price, and tax consequences.

Asset Sale. As a general rule, buyers prefer to purchase assets (not stock) to avoid unanticipated liabilities of the seller’s entity and, more important, to achieve significant tax advantages.

In an asset sale, each individual asset is assigned a value. The process of purchase price allocation, and the ability to start depreciating each asset in the year of the purchase, holds significant future tax value for the buyer.

“We often see buyers paying more in asset deals,” says IBG’s John Johnson, “due to the value of the step-up in basis for depreciation.”

Stock Sale. While buyers like to buy assets, sellers tend to prefer a stock sale. This is especially true in the case of C corporations, which, as we mentioned above, face the problem of double taxation. If a C corp sells its assets, with the seller retaining the stock, the proceeds will be taxed twice: first when the corporation files its tax return(s), and again when the shareholders file theirs.

In contrast, in a stock sale, the proceeds go directly to the shareholders, who report the gain only on their individual tax returns.

The conflicting objectives of buyer and seller make asset allocation an important part of negotiations, with the result that a buyer might give a little on price or terms in order to get a more favorable allocation, while the seller might give on the latter to enhance the former.

ALL CASH VS. SELLER FINANCING

As we mention in a related article, most business sales involve some form of seller financing. The higher the selling price, the greater the likelihood of a seller carryback, with the financed amount paid in installments.

In an installment sale, the buyer takes immediate ownership, but payments are made over multiple years. The good news for the seller: Your tax payments are spread out over the installment period.

Your willingness to offer seller financing can result in a higher price, to (a) reward you for waiting for some of your money and (b) reduce your loss in the event the buyer fails to make all of their payments.

Put another way, in any transaction that’s not all cash, you should discount the expected value of any non-cash consideration.

STAYING ON AFTER THE SALE

The buyer may want you to remain on board for an agreed period, to facilitate the ownership transition, shorten the buyer’s learning curve, and transition key relationships with suppliers and customers.

This arrangement can be beneficial to you, as well:

• Your willingness to stick around can justify a higher selling price.
• While consideration for transitional consulting/employment for a reasonable period post-sale is often baked into the purchase price, longer-term employment can warrant additional compensation.
• You might want to continue your involvement in the business if you are carrying back a portion of the selling price and you want to protect your investment, or if a portion of the selling price is contingent on future profits. (See our discussion of “earnouts,” next.)

POST-CLOSING PERFORMANCE

One of the roadblocks that commonly arises in structuring a business sale stems from differing viewpoints of value. As we discuss in another article, when an impasse occurs, an “earnout” can bridge the value gap between buyer and seller. Earnouts involve a certain future dollar amount that the buyer agrees to pay to the seller based on the business’s performance after the transaction is completed.

Earnouts can be structured in a number of ways and based on a variety of financial benchmarks, such as revenues, gross profits, or net income. An earnout agreement also has tax questions that need to be answered, mainly: Will the money that the earnout generates for the seller be treated as part of the purchase price or as ordinary income?

Using a conditional seller note can keep the value as a capital gain for the seller, whereas calling it an “earnout” will typically turn those payments into ordinary income and allow the buyer to deduct the payment as a current expense.

TAX-PLANNING THE SALE

To recap, how your sale will be taxed depends on a combination of the structure of your business, what is being sold, and the terms of the sale. We will wrap up this article with a primer on the taxing of a sale and how some types of sellers can reduce their tax bill.

Capital Gains Basics. A business sale usually triggers a long-term capital gain for the seller. An oversimplified example: You started your business seven years ago with a $200,000 investment. You sell it now for $15.2 million, producing a long-term capital gain of $15 million that will be taxed (as the proceeds are received) at the federal capital gains rate of 20%, or $3 million.

As straightforward as that appears, things can get complicated when the aforementioned issues of double taxation arise. That’s not a threat if the seller is an LLC, S corp, or other pass-through entity, but, again, it’s a major threat if the seller is a C corp.

The effective attribution of personal goodwill can provide some welcome relief.

Personal Goodwill. The cost of double taxation can be reduced by how the terms of the deal address the company’s intangible assets or “goodwill.” What is good for the seller is usually bad for the buyer, and vice versa, but not always, and the treatment of personal goodwill is one of the exceptions.

Let’s tweak our $15.2 million sale example to add two facts:

• The seller is a C corporation.
• The parties agree that the company’s tangible assets are worth $9 million, leaving the remaining $6.2 million to be classified as personal goodwill.

If that goodwill had been attributed to the corporation along with all of the other assets, it would be taxed at 20% to the corporation and then, as we mentioned earlier, taxed again to the shareholders after they receive their shares of the proceeds.

But because the buyer and seller agreed that the seller’s reputation, expertise, relationships, and other items of personal goodwill would be segregated from the corporation’s assets and attributed to the seller personally, the $6.2 million in personal goodwill is paid directly to the seller, bypassing the corporation and avoiding double taxation on that portion of the price. (See our popular article, “Martin Ice Cream and the Sale of Personal Goodwill.”)

CONTACT US

With a track record of more than 1,100 successful closings, at an 86% closing rate (three times the M&A industry average), IBG Business is well-equipped to help you explore the successful sale of your mid-market business.

To start the process of selling your company for top dollar, to the best-fit buyer, contact any member of the IBG Fox & Fin team of M&A professionals.