For those business owners that are thinking of selling an asset or their business, I can unequivocally advise that it is crucial to consult with a tax attorney early in the process. It was not long into my now 25-plus-years of experience that this point became crystal clear. To be more specific, I’ve compiled a list of the top ten reasons for doing so, but as is fairly apparent from reading on, this list will encompass just about every situation when buying or selling a business. This blog is a quick summary, but if you’d like a more detailed outline, please email me at email@example.com. Also, if you’d like to discuss your particular situation, please email me and we can set up a quick consultation.
- The Business Is An LLC Or A Partnership. LLCs with more than 1 member are treated as partnerships under the tax code, and wholly owned LLCs are generally disregarded (unless another election has been made otherwise). Partnerships are extremely tricky. If there’s any debt on the balance sheet, then the selling member’s share of that debt will be treated as gain to such member (e.g., it is added to the purchase price). Furthermore, even in an equity sale/purchase, a portion of the sales prices will be allocated to assets that trigger ordinary income instead of capital gain (these are generally referred to as “hot assets”). Before running numbers and counting profits, a business owner needs to understand the tax impact from debt and these hot assets. I have seen numerous entrepreneurs re-think the timing of a sale after they fully understood the taxation of selling an LLC or partnership.
- The Business Is An S Corporation. Only certain persons can be shareholders of an S corporation and if this rule is broken the S election will be lost with the corporation being treated as a C corporation, the profits of which would be subject to two levels of taxation. Additionally, if the S corporation had previously been a C corporation, then there could be trapped earnings and profits or gain embedded in its assets from that prior “life” as a C corporation, which could trigger a double tax effect from the sale/purchase transaction. Additionally, even if the transaction is a sale of stock, there is a potential to make an election to treat it as an asset sale for tax purposes. An asset sale is more favorable to the purchaser who can then benefit from depreciating the purchase price that has been allocated to the assets (see the description for Asset Sales below as well).
- Asset Sale. If the transaction involves a transfer of assets, then the purchase price will need to be allocated among the assets. After the transaction, the purchaser will depreciate the purchase price so allocated to each asset according to the useful life of such asset. Additionally, the seller can recognize ordinary income from some assets. Thus, this allocation (of the purchase price) results in tax savings to the purchaser and potentially higher taxes to the seller (to the extent of allocations to ordinary income assets). Some assets depreciate faster than others; therefore, allocations to faster depreciating assets can result in significant tax savings, which will benefit the purchaser. Best practice is to quantify the tax savings and negotiate how the parties will apportion such tax savings.
- Non-Cash Payment/Roll-Over Equity. If the purchase price includes something other than cash, such as roll-over equity (e.g., equity in the purchaser or an affiliate of the purchaser) or other assets, then it might be possible to defer the taxable gain, which would otherwise be attributable to such roll-over equity or other asset, depending on the transaction and if structured properly. The issues here are highly complex.
- “Other Agreements” Between the Parties. If there are other agreements in connection with the transaction – such as a noncompete agreement or a consulting agreement – these agreements will trigger ordinary income. If there’s no provision in the various agreements, then a portion of the purchase price will be allocated to these agreements, potentially converting capital gain into ordinary income. Thus, it’s best to structure these properly.
- Self-Created Intellectual Property. Self-created property – such as patents, copyrights or software — can be taxed as ordinary income if structured as an asset sale or if it is the sale of a partnership or LLC. Additionally, if the transaction has contingent payments in connection with a trademark, trade name or franchise, then such payment could be treated as ordinary income. The rules are extremely complex here. It’s best to reach out to your friendly tax attorney if you have any questions about this area.
- Seller Financing. If not all of the purchase price will be paid on closing, then taxable gain is generally subject to the installment sales rules for tax purposes. If the transaction document does not include an adequate amount of interest on such seller financing, then the tax rules will re-characterize a portion of the deferred payments as the payment of interest income, which is subject to ordinary income tax rates. Furthermore, if the entity being sold is an LLC/partnership, then any income attributable to “hot assets” (e.g., inventory, accounts receivable, depreciation recapture for non-real estate assets) will be recognized on the closing date. Additionally, a member’s share of the company debt will be recognized as income on the closing date. Thus, the seller will need to understand the tax impact and make sure there is enough liquidity to pay these taxes.
- Escrow Holdback. The amount held back in escrow could be treated as part of the purchase price, which would result in capital gain to the seller. Alternatively, depending on how it’s structured, the escrow holdback can be treated as ordinary income to the seller.
- Tax Compliance Issues. It’s better to understand the issues upfront before a purchaser conducts due diligence. If there are any tax compliance issues – either income tax or sales tax issues – then a potential seller should discuss these issues before having any contact with a potential buyer. Recently, sales tax compliance has become a huge issue in M&A transactions, especially with Internet-based or SaaS technology companies.
- Employee Equity or Deferred Payments. If the business has issued equity (or deferred compensation) to employees or consultants in exchange for services, then, such issuance could have triggered tax withholding obligations on behalf of the business (e.g. just as businesses are required to withhold on cash payments of salary to employees) – many businesses do not realize this and fail to withhold. Moreover, the business should have valued the equity when granted to the employee, and corporate records should be examined to determine if the business properly valued the equity.
Additionally, if any employee or independent consultant received deferred compensation – which includes a contractual right to receive a payment at a later date – then those agreements need to be examined in the context of the transaction. An excise tax can be imposed on those contractual payments in addition to the regular income tax . Thus, a careful review of those agreements is warranted.
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