Three years ago, I wrote a blog post about tax planning considerations involving the sale of a business. Three years is a fairly long time in the context of taxes, particularly when major tax reform takes place in the interim. With this in mind, I decided to revisit my earlier post.
When starting a new business or managing the operations of an existing business, considerations regarding a potential future sale are not typically front and center. However, having a general understanding of potential sale structure scenarios – and, in particular, a rough idea of the before and after income tax proceeds that can result – is a valuable planning tool that should be considered at inception and reviewed periodically over the lifecycle of business ownership.
The sale of a larger privately held business typically entails a transfer of entity ownership, which generally involves either stock (in the case of a corporation) or membership interest (in the case of a limited liability company). The complexities that may arise relating to customer relationships and various commercial agreements are examples of considerations weighing in favor of keeping the business entity intact and selling ownership interest.
An asset sale may be more appropriate for a smaller transaction or where a purchaser may be interested in acquiring only select components of the business (e.g., operating assets but not real estate). An asset sale may also be preferential in cases where there are buyer concerns relating to potential undisclosed entity liabilities which may not be adequately covered by escrow or indemnification provisions in a purchase agreement.
An asset transaction will yield a step-up in tax basis of acquired assets to the buyer where the fair market value exceeds the seller’s tax basis. This is often a key economic consideration in the negotiation of the purchase price. A purchase of an entity-level interest may not result in this outcome. From the seller’s perspective, an asset sale can produce a higher tax liability as some components of the sale may generate ordinary income, which is taxed at a higher rate than capital gains. Or, it may be subject to tax in states with higher tax rates than would apply to an entity interest sale.
Income tax provisions provide opportunities for entity-level transactions to be reported by the seller and the buyer as if the underlying assets have been sold. Where such provisions are available, an entity-level transaction may be the best practical business option. Internal Revenue Code section 338(h)(10) provides such an election, which is commonly employed when the business being sold is an S corporation. The buyer and seller will often work out purchase price adjustment terms to address any increase in income tax to the seller.
Another technique that is becoming more common involves the selling shareholder(s) forming a new holding entity, to which ownership of the corporate entity to be sold is transferred. This corporate entity (now a subsidiary of the holding entity) next converts into a limited liability company (LLC). The buyer then purchases post-conversion LLC membership interest. This approach accomplishes similar outcomes as occur under an IRC 338(h)(10) election. This alternative approach, although more complex, can better address some issues presented in the context of an 338(h)(10) election; for example, some of the selling owners retaining an ownership interest in the combined business of the buyer and seller going forward.
Here are two other areas that are important to keep in mind as it relates to the sale of a business.
Selecting an Organizational Structure
Having a good understanding of sale-related tax considerations can be valuable even from the beginning of a business, when you are evaluating organizational structure options. The provisions resulting from the Tax Cuts and Jobs Act (TCJA) have made the C corporation structure more appealing to some business owners due to an entity-level Federal tax rate of 21 percent, as opposed to a potential effective tax rate as high as 29.6 percent or 37 percent for pass-through entities. Where the business will internally reinvest much of its operating profits, the savings from a C corporation’s lower tax rate may provide a higher rate of growth in the value of the business. This may be particularly appealing where the ultimate exit opportunity involves a straight sale of stock. In this context, the TCJA provisions may change traditional planning which leaned in favor of an S corporation or other pass-through entity structure.
However, where the exit strategy will likely involve a sale of the business’s assets, the interim benefits of the lower C corporation tax rate can be eclipsed by a significantly higher ultimate cost when a second incidence of tax is triggered upon the sale and liquidation of the business. Plus, if a material amount of the profit is anticipated to be paid out to owners, the dividend or salary options available under a C corporation scenario can be more costly to recipients than the distribution alternatives available to owners of pass-through entities. This has been a focus of much of the post-TCJA discussion about the pros and cons of C corporations versus pass-through entities.
Segregating Business Components
Decisions about whether and how to segregate certain operational components may be easier if you know the related tax consequences that may arise upon the sale of the business. A buyer will often only be interested in acquiring segments of a business. Being aware of this can facilitate a more proactive means to address concerns up front, rather than under the constraints of a pending transaction. Placing assets that will potentially be excluded from a future sale in a separate entity from the inception of ownership can help you avoid both transaction related complexities as well as the higher tax costs that can result from refining the organizational structure at the time of sale.
TCJA provisions also introduced some planning considerations for structuring lease arrangements in connection with the new 20 percent deduction for qualified business income. This may be mitigated during periods of self-rental, but can become important once the operating and rental business components are no longer under common ownership should the operating business be sold.
Effective tax planning for a business and its owners should include a focus on longer-term outcomes. Reducing income taxes for the current year may be first and foremost. However, it’s a good idea to periodically review your longer-term objectives, including the possibility that a future exit strategy may involve a sale.
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