It’s a question as old as currency, “how much money would I need to just walkaway from my job?” When it comes to answering that question, entrepreneurs and business owners find themselves in a unique position. Often times a significant portion of their wealth is invested in the business they have helped develop and grow. In order to cash out of their investment, they need to find a buyer for their business. While the sale price is usually the biggest focus for many business owners, the structure of the deal can be equally important. The deal structure can have a significant impact on the after-tax cash retained by the seller. A key feature to watch for in any business sale transaction is the distinction between an asset sale and an equity interest sale.
In an asset sale, the purchaser acquires specified assets and liabilities of a company. Asset sales can be designed to sell all assets and liabilities or only specific items, depending on the needs of the parties. The legal entity still exists and is still owned by the seller, however there are generally no assets remaining after an asset sale and the legal entity is typically liquidated and closed. Asset sales are often preferred by buyers because any legal liabilities that may exist remain with the seller.
In an equity interest sale, the purchaser acquires the ownership interest in the current legal entity. The purchaser owns all the assets, liabilities, contingencies, agreements, and legal liabilities of the company. The seller is left with nothing from the company with the exception of the consideration received.
From a tax standpoint, asset sales generally result in a larger tax burden for the seller than equity interest sales. The reason for this depends on the type of entity. If the entity being sold is a C-corporation, an asset sale results in double taxation, described later. If the entity is not a C-corporation, a higher tax rate may apply to gains on the sale of items such as inventory, depreciated fixed assets or receivables. These assets are taxed at the seller’s ordinary tax rate, which could be as high as 39.6%. In addition to the federal ordinary rates, asset sales are also subject to the 8.5% New Hampshire’s Business Profits Tax. The potential total tax rate, net of the benefit of the state tax deduction, could reach 44.7%. In comparison, equity interest sales, which are taxed at the more favorable capital gains tax rates, have a maximum tax rate of 23.8%.
The greatest disparity in tax consequences can occur when the entity sold is a C-Corporation. An asset sale can result in double taxation, once at the corporate level and once at the shareholder level. In an equity sale, there is no double taxation. For example, if a buyer approaches a business owner and makes an offer that would result in both cash received and a gain of$10,000,000, the tax consequences vary greatly based on the deal structure. In an asset sale, the corporation could pay up to $4,000,000 in federal and New Hampshire taxes on the $10,000,000. Additionally, when the remaining $6,000,000 is distributed to the shareholder they could pay up to $1,500,000 in federal taxes, leaving them with $4,500,000 from the original $10,000,000. However, if this deal was structured as an equity sale the seller would have a $10,000,000 capital gain which could result in $2,400,000 in federal tax. The equity sale leaves the seller with $7,600,000 while the asset sale leaves the seller with $4,500,000, a $3,100,000 difference.
Buyers tend to prefer an asset purchase over an equity based purchase as it allows them to recognize certain tax benefits earlier and will allow them to leave any unknown liabilities such as lawsuits, with the seller. As a result, buyers might be willing to pay a premium for an asset purchase or might require a discount if the seller will only accept an equity structure. If a buyer insists on an asset sale, don’t fret, there are other planning opportunities that can potentially allow the seller to reduce their tax burden; including covenants not to compete, personal goodwill, asset allocation agreements, and consulting agreements.
There is more to selling your business than the purchase price, it’s important to always remember that not all deals are created equal.
This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation. Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business.