Taxes—The Key to Keeping More In The Sale of Your Business
Being Ready vs. Being Prepared
By David DuWaldt, Managing Director
Los Angeles Office, Corporate Finance Associates
"How much is my business worth" is a question we often hear from owners considering the sale of their business. But a better question might be, "How much will I get to keep after my business is sold"? One of the keys to unlocking the answer to this question involves taxes and how large a check you write to Uncle Sam will ultimately be determined by the structure of the transaction. However, structuring a transaction so that the seller and buyer are both afforded tax benefits is not quite as simple as it sounds.
With every sale of a business enterprise there will be tax implications. The structure of a sales transaction and the underlying facts and circumstances will determine the tax results. The scope of this article is limited to federal income taxation, including the tax imposed on capital gains. There are several other tax issues that need to be addressed in a business sale including estate, gift, state and local taxes.
Asset Versus Stock Sale
Absent other issues such as the transfer of permits, licenses, leases, and certain intellectual property rights, which might only be accomplished through a stock sale transaction, buyers will generally be motivated to purchase assets rather than stock of a corporation. Many assets, including goodwill, can be amortized, depreciated or subject to depletion, which can prove to be advantageous to a buyer when comparing such a structure to the purchase of corporate stock. Except for the tax election provided under IRC Section 338(h)(10), which basically treats a stock purchase as an asset acquisition, a buyer cannot amortize or depreciate corporate stock.
From the selling shareholder's point of view, a stock sale is advantageous since it will be treated as a capital asset for tax reporting and, as long as the stock was held for at least a year, the resulting gain will receive the more favorable long-term capital gain tax treatment. With respect to an asset sale, if a C corporation is the seller, there is essentially a double taxation effect to the shareholders – taxable gain on the sale of assets by the C corporation followed by a capital gain resulting from the distribution of net assets to the stockholders upon liquidation of the corporation. Although the tax basis in the stock of the C corporation is subtracted in determining the capital gain to the shareholders, quite often the tax basis in the stock is fairly low relative to the net assets received upon liquidation of the corporation.
Since the Tax Reform Act of 1986, many privately held corporations have made the S election in order to be treated as a Small Business Corporation. As long as the S election has been in place for a long enough period of time and avoids the built-in gains tax described under IRC Section 1374, an asset sale will not result in federal double taxation since the tax basis in the stock to the shareholder is increased by the pass through gain from the sale of assets. Therefore, in closing down the selling S corporation, the subsequent liquidating distribution to the shareholders will be offset, in large part, by their increased tax basis in the stock. In addition, if one of the assets sold by the S corporation is goodwill, the resulting gain from such sale will be passed through to the shareholders and receive the more favorable long-term capital gain tax treatment. By comparison, a C corporation selling goodwill does not receive the lower capital gain tax treatment at the corporate tax level as does an individual taxpayer.
So if the seller is a C corporation instead of an S corporation, will shareholders face substantial tax upon sale unless they lower their selling price, sell stock and be subject to capital gains tax? Not necessarily. There are other transaction structures one might consider to reduce taxes, particularly if the seller is a C corporation.
ESOP Rollover
An ESOP, or Employee Stock Ownership Plan, is a special type of a qualified employee benefit plan (a defined contribution plan as opposed to a defined benefit plan) and can emulate either a money purchase pension plan or a profit sharing plan. An ESOP is similar to a stock bonus plan except that it can use the credit of the company (sponsor) and borrow funds from outside sources. In other words, it can set up a financially leveraged transaction to buy stock from shareholders of the sponsor.
Now for the substantial tax benefit – pursuant to IRC Section 1042, if certain requirements are met, including the requirement that the stock sold to the ESOP must be from a domestic C corporation, the gain upon sale of stock of the C corporation can be deferred or rolled over into qualifying replacement property ("QRP") within twelve months. The QRP is generally domestic equities and bonds, including those of publicly traded companies. It is important to note that QRP does not include mutual funds, municipal bonds, or U.S. Treasury obligations. Essentially, the gain on sale of stock to the ESOP reduces the tax basis in the QRP and sets up the tax deferral. With the lower tax basis in the QRP, a subsequent sale of the QRP can result in capital gains tax.
Qualified Small Business Stock Rollover
Pursuant to tax legislation in 1997, IRC Section 1045 provides for the rollover of gain from the sale of qualified small business stock. The stock sold must be from a C corporation, among other requirements, and in order to defer the gain from the stock sale, other qualifying small business stock must be acquired within 60 days.
This stock must have been originally issued after August 10, 1993; not have more than $50 million in gross assets at any time on or after the issue date; and at its original issue was acquired in exchange for money, property other than stock, or compensation for services provided. The corporation cannot redeem more than 5% of the outstanding stock and at least 80% of the assets of the corporation must be used in the active conduct of a qualified trade or business.
Qualified Small Business Stock Exclusion
When it originally became law back in 1993, IRC Section 1202 provided for an exclusion of 50% of the gain from the sale of qualified small business stock. Among others, two of the requirements for this favorable tax treatment are that the stock must be held for at least five years and the stock must be from a C corporation. In 2009, new legislation increased the exclusion of gain to 75% for small business stock acquired between February 17, 2009 and December 31, 2010. The Small Business Jobs Act of 2010 moved the gain exclusion up to 100%, with certain limitations, for stock acquired by December 31, 2010. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, that became law on December 17, 2010, extended the time period of one year for acquiring qualified small business stock. Therefore, stock will need to be acquired by December 31, 2011. Another nice feature of the law change in 2010 is that the excluded gain will not be treated as a tax preference item for computing the Alternative Minimum Tax.
Charitable Remainder Trust Strategy
If properly structured, a shareholder can avoid capital gains tax entirely by using a charitable remainder trust strategy. The trust is established and a trustee named. The shareholder conveys the stock to the trust and the trustee will sell the stock tax free pursuant to IRC Section 664(c)(1). The trust will invest in assets and pay the shareholder income for the remainder of the shareholder's life. Upon the death of shareholder, the residual assets of the trust are transferred to the charitable organization designated by the shareholder. In addition to converting the asset into an income stream, the shareholder can derive a charitable contribution tax deduction in the year that the stock is conveyed to the trust. The measure of the contribution deduction involves a present value computation since the shareholder is essentially giving a future interest in the business away. It is important to keep in mind that the trust is irrevocable which means that the shareholder cannot take the stock back from the trust after the transfer. Also bear in mind that the Internal Revenue Service frowns on preplanned stock sales so the transaction is a bit delicate. This type of strategy is generally designed for those who wish to give assets to a charity and may not have beneficiaries in place to inherit their estate.
Reorganization Tax Strategies
The area of reorganizations under the tax code can be basically broken down into two groups – acquisitive reorganizations, which are defined under IRC Section 368, and divisive reorganizations which are described under IRC Section 355. Certain other provisions under the tax code, such as IRC Section 351 for tax free transfers to a newly formed corporation, might be used in a particular strategy. Although most of the reorganization provisions have historically applied to C corporations, there are some provisions that will work for S corporations as well. In addition, there are some very limited circumstances where even a limited liability company can be a party to a transaction. Without going into specifics, since this subject matter can be rather involved and complex (e.g., entire books are written about this topic), this area of the tax law can provide significant tax benefits relative to the deferral of income taxes, including tax on capital gains.
Non-Corporate Entities
For limited liability companies not treated as a corporation for tax reporting (general, limited and limited liability partnerships, trusts, and proprietorships), an asset sale will not give rise to a double taxation effect to the business owner. Although there are fewer tax deferral and exclusion benefits under the tax code in connection with the sale of a non-corporate business, there are some tax deferral tools available. For example, if the statutory requirements are met and there are no conflicts with common law doctrines, the assets can be transferred into a newly formed entity in exchange for securities without gain recognition.
Timing of Consideration Paid
Under IRC Section 453, the installment sale method can be used for deferring taxes based on when payments are received from the sale of property. For example, there might be an earn-out element in a business sale whereby payments are based on future events and such payments extend beyond one year. In such a case, there is an opportunity to defer a portion of the tax into future years based upon what is paid and the nature of such payments. Bear in mind that the tax code also provides for imputed interest rules, particularly if interest is not stated in an agreement or note, so there will be an ordinary income component respecting future payments from the sale of property.
Armed with a skillful advisor, you can work out the details so that both the buyer and the seller in a transaction leave the bargaining table with some tax advantages. As with any significant transaction involving tax consequences, it is wise to seek the advice of competent tax counsel before entering into any business sale.
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