When you’re creating a new business or managing the day-to-day of an existing business, it can be difficult to think ahead and plan for the eventual sale of that business. But having a general understanding of the likely sale structure scenario for your business, as well as a rough idea of the potential after-tax proceeds – well prior to the actual sale – can be a valuable planning tool during the lifecycle of business ownership.
Businesses are typically sold either at the entity level or as a collection of related assets. Entity transactions – for example, a sale of stock of a corporation – are more common for larger businesses, and often reflect the desire for an orderly and thorough transfer of all the relevant components of a complex business enterprise. Asset sales are more common for smaller transactions, particularly in situations where a purchaser may be wary of potential undisclosed liabilities not identified during purchase-related due diligence.
Federal tax provisions provide opportunities for certain entity-level transactions (like the sale of corporate stock) to be reported by the seller and the buyer as if the underlying assets were sold. This is accomplished through an election filing and is fairly common when the business being sold is an S corporation. It allows the buyer to attain a stepped-up tax basis in the business assets without materially impacting the seller, with any such effect addressed in the negotiation of the sale price.
Here are a few other areas that highlight the value of thinking ahead of the potential sale of a business:
- Selecting an organizational structure. Having a good understanding of sale-related tax considerations can be valuable even from the very beginning of a business, when you are evaluating your organizational structure options. For example, a C corporation structure may offer appealing current bracket-related tax saving opportunities over an S corporation. However, it may also create significantly higher tax implications in the event of a future sale. Rules relating to distributions and allocations of profits are typically less restrictive in the context of a partnership than an S corporation.
- Segregating business components. Decisions involving whether and how to segregate certain operational components may be better made if you know the related tax consequences that may arise upon a sale of the business. A buyer will often be interested in acquiring only segments of a business; for example, operating assets and not real estate. Being aware of the significance of this situation can facilitate a more proactive means to address concerns up front, rather than under the constraints of a pending transaction.
- Structuring executive compensation. When designing performance incentives for key employees, it is common to match the award criteria to measures that will ultimately maximize not only current profits, but also the value realized upon a sale of the business. There are a variety of important tax considerations to take into account when designing these plans to assure that the anticipated outcomes for both employer and employee are realized.
Traditional tax planning for a business and its owners focuses on short-term outcomes; for example, reducing income taxes payable for the current year. However, effective tax planning should also include a periodic review of longer-term objectives, including the possibility that a future exit strategy will involve a sale rather than an internal transfer.
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