How much cash a seller walks away on an after-tax basis when a deal is closed will always impact the outcome of a transaction. There are some common tax strategies that can be used in the buyer-seller transaction of middle market businesses to minimize taxes payable.
Tax planning is one of the most complicated parts of completing deals. It is always best to consult a CPA with M&A experience early on in the process. In this article, we will examine the installment sales, the transaction structure, and the balance of capital gains vs. ordinary income.
Installment sales often involve either owner financing, or earn-outs. They can be used to create tax advantages that can help seal the deal. This is the common way for a seller to get a portion of income immediately, but it may be amortized over a three, five, or seven year period to avoid bumping into a higher tax bracket.
The seller then reports this income as it is received. let's say it's a $1 million transaction, and for simplicity of illustration, the seller gets $100,000 a year with no interest over 10 years. That puts the seller in a lower tax bracket. It allows the seller to pay less over a period of time and maybe budget for and plan for those tax items without one big pop.
Many times, unless a transaction occurs in January, the seller has a major tax burden in the year the company sells. That is because most businesses in the small to medium-sized income range are cash-basis taxpayers, and they do everything they can to pay as little tax as possible each year.
If you no longer own a business at the end of the year, there is not much you can do to defer your income. There's no new equipment to buy, no new cars, no extra expenses at the end of the year. When you still owned the business, it may have has a sizable income. You face taxes on that, as well as on the proceeds from the business sale. It's like a double whammy in the year of the sale. By receiving your proceeds in installments, you can spread the income out for years. Be aware however, that laws could change and the prevailing laws in the years you receive the funds are the tax rates you are stuck with, not the laws in the year you sold.
Another reason installment sales can be attractive for the seller is that the seller can earn interest. A 6 to 9% interest rate is fairly typical.
In most instances, buyers want to buy assets, and sellers want to sell stock. Buyers want to buy assets because they can depreciate and amortize them faster. Sellers want to sell stock because they get to recognize it all as capital gains. However, 99% of closely held businesses are asset sales. It's just a reality.
Another issue is the seller's status as a C corporation, an S corporation, or an LLC. They each have distinct tax ramifications when it comes to a sale. No matter which type of corporation you own, you should have thorough discussions with your professional advisor. C corporations, for instance, have no capital gains. It doesn't matter how much goodwill you sell, there are no capital gains at the C corporation level in an asset sale.
That's an example of why it's important to make sure you understand your current corporate structure. If you're 5, 7, 10 years away from a potential liquidation, you should have a discussion with your attorney, your CPA, or other professional counsel on what the strategy should be if you were to sell. It's always better to have that discussion now than it is to wait until you're in the process of selling, when nothing can be done to change your structure.
Once you've explored the culture fit and done your due diligence, you have now moved on to designing the deal, its structure, financing and allocation. All these items are negotiable, the key here is you want to be at least as informed as the other party in the transaction. The less informed you are, the more risk losing out on potential opportunities.
Capital Gain vs. Ordinary Income
The tax on capital gains in the United States can range anywhere from zero percent up to 23.8 percent. A lot depends on your individual tax strategy and tax bracket. Much has been written on how all that works. Just understand for tax savings, capital gains are, on the whole, significantly better than ordinary income, for which the tax can range up to 43 percent in the United States. That's just the federal side for both the capital and ordinary income. And that, of course is why, as the seller, you want as much of the deal as possible in capital gains.
Again, it's a negotiation. What types of items are categorized as capital gains? Stock could be one such item, if you can persuade the buyer to accept stock in your company.
It's important to understand the corporate structure and where you have room for give and take. Buyers prefer ordinary income because they can write it off quicker than capital gains. For instance, intangibles typically are a 15-year amortizable asset whereas ordinary income items - inventory, accounts receivable, and some of the fixed asset costs - can be written off much faster.
When you're the seller of a business, the things that can stick you with ordinary income include the debt the buyer assumes. For instance, if you're transferring your line of credit to the buyer, or you're transferring your accounts payable or your bank debt, all of those things are considered additions to the purchase price.
Common tax questions always come up in a deal. How much will I get to keep? How can I save on taxes for the transaction? Do I have to pay it all at once? Can I average income for tax purposes? How much gifting can be employed to my advantage?
Be sure to get qualified tax professionals involved early in the process to find answers to these common but complicated questions.