Owners selling a small business frequently focus only on the final sale price, since this will heavily influence how much money they walk away with. Deal structure, though, is critical to the total profits of the deal. Selling a small business means a sudden windfall of income, and that can often mean a significant tax burden. Small business owners pursuing M&A should consult with a tax advisor to assess which deal structure might be best for them. These considerations are important to weigh when determining the tax implications of a business sale.
M&A Taxes: The Basics
The IRS restricts how owners can structure sales, and explicitly bans transactions designed to totally avoid taxes. Nevertheless, the sale owners negotiate will still heavily influence how much they end up owing. For most owners, these four factors will be the most important:
- Taxation structure: ordinary income vs. capital gains. Capital gains taxes are lower—15% in most cases, with a taxation rate of 37% for ordinary income.
- Payment structure: all-cash deal vs. installment payments.
- Deal structure: stock vs. asset sale.
- Merger vs. sale: whether it is possible to structure the deal as an all-stock merger.
Numerous factors determine how the IRS views the sale. One important factor is which assets are involved, and how long the company has owned them. Consult with an M&A tax advisor for guidance on this subject, since the way you structure your assets can have significant tax implications.
Asset Allocation Decisions
Most owners want to sell off all or most of their assets, both to fully move on and to incur capital gains taxes rather than income taxes. The IRS limits this practice, though. Inventory counts as ordinary income. There are ways around this, that allocates a significant portion of the sale price to costs that are tax deductible. This is often where buyers and sellers get into conflict, since what is good for the buyer’s taxes is often bad for the seller’s tax burden. Sellers sometimes negotiate other terms, such as price or payment structure, to get a tax break.
Deal Structure and Taxes
Deal structure, too, is important. An installment-based payment system can allow the seller to defer paying taxes. This can also mean a higher total price, since buyers may pay more over time. The walkway price increases even more if sellers finance the deal and charge interest. Installment agreements do pose some risks, though, especially if a novice owner purchases the company and lacks the skills necessary to make it profitable. Moreover, taxation is not the only relevant factor here, so again, owners must consult tax professionals.
Other Deal Considerations
Corporate structure also plays an important role in tax liability. Sole proprietorship, LLCs, and partnerships are usually treated as separate assets, but corporations can be sold as stock sales. This leads to an additional possibility for mitigating tax liability: an all-stock sale that functions as a merger or reorganization may incur no tax liability.
Seeking the sage guidance of a Tax Specialist and an M&A advisor is critical for mitigating tax liability. The earlier a company begins planning its strategy, the better are its chances for reducing tax liability.