This is last article in a three-part series that offers a very general overview of how understanding the taxes and terms of a business sale can help a seller discern the true value of an offer and, in a competitive bidding scenario, recognize which offer constitutes the best deal. Bear in mind that the factors that shape the value of a business sale are deal-specific.
POST-CLOSING PERFORMANCE
One of the roadblocks that commonly arises in structuring a business sale stems from differing viewpoints of value. As we discuss in another article, when an impasse occurs, an “earnout” can bridge the value gap between buyer and seller. Earnouts involve a certain future dollar amount that the buyer agrees to pay to the seller based on the business’s performance after the transaction is completed.
Earnouts can be structured in a number of ways and based on a variety of financial benchmarks, such as revenues, gross profits, or net income. An earnout agreement also has tax questions that need to be answered, mainly: Will the money that the earnout generates for the seller be treated as part of the purchase price or as ordinary income?
Using a conditional seller note can keep the value as a capital gain for the seller, whereas calling it an “earnout” will typically turn those payments into ordinary income and allow the buyer to deduct the payment as a current expense.
TAX-PLANNING THE SALE
To recap, how your sale will be taxed depends on a combination of the structure of your business, what is being sold, and the terms of the sale. We will wrap up this article with a primer on the taxing of a sale and how some types of sellers can reduce their tax bill.
Capital Gains Basics. A business sale usually triggers a long-term capital gain for the seller. An oversimplified example: You started your business seven years ago with a $200,000 investment. You sell it now for $15.2 million, producing a long-term capital gain of $15 million that will be taxed (as the proceeds are received) at the federal capital gains rate of 20%, or $3 million.
As straightforward as that appears, things can get complicated when the aforementioned issues of double taxation arise. That’s not a threat if the seller is an LLC, S corp, or other pass-through entity, but, again, it’s a major threat if the seller is a C corp.
The effective attribution of personal goodwill can provide some welcome relief.
Personal Goodwill. The cost of double taxation can be reduced by how the terms of the deal address the company’s intangible assets or “goodwill.” What is good for the seller is usually bad for the buyer, and vice versa, but not always, and the treatment of personal goodwill is one of the exceptions.
Let’s tweak our $15.2 million sale example to add two facts:
If that goodwill had been attributed to the corporation along with all of the other assets, it would be taxed at 20% to the corporation and then, as we mentioned earlier, taxed again to the shareholders after they receive their shares of the proceeds.
But because the buyer and seller agreed that the seller’s reputation, expertise, relationships, and other items of personal goodwill would be segregated from the corporation’s assets and attributed to the seller personally, the $6.2 million in personal goodwill is paid directly to the seller, bypassing the corporation and avoiding double taxation on that portion of the price. (See our popular article, “Martin Ice Cream and the Sale of Personal Goodwill.”)
CONTACT US
With a track record of more than 1,100 successful closings, at an 86% closing rate (three times the M&A industry average), IBG Business is well-equipped to help you explore the successful sale of your mid-market business.
To start the process of selling your company for top dollar, to the best-fit buyer, contact an IBG Business M&A professional near you.