When you decided to start your company, you may or may not have had legal or tax advice. You may or may not have considered your exit strategy at the beginning in order to choose a corporate structure that would best serve you 20, 30, or even 40 years later.
But now, as you consider exiting your company, it is important to not focus entirely on the sales price but to understand how much money you will ultimately get to keep.
The biggest variables will be your corporate structure, the deal structure, and your personal financial situation as they will govern the tax implications of your sale.
Deal Structures
There are three basic ways the purchase of a company can be structured:
- Asset purchase – You retain ownership of the legal entity, and the buyer purchases specific, identified company assets, such as contracts, equipment, fixtures, leases, licenses, goodwill, trade secrets, trade names, etc.
- Stock purchase – The buyer purchases your stock in the corporation; thereby, obtaining ownership of your company.
- Interest purchase – This happens if your company was formed as an LLC. Because there is no stock, you could sell your interest in the company.
Buyers generally prefer to structure any purchase as an asset purchase. Asset sales generally do not include cash, and you would typically retain the long-term debt obligations. This is commonly referred to as a cash-free, debt-free transaction.
Sellers on the other hand may prefer a stock or interest purchase. Let’s explore why.
Asset Purchases
Within IRS guidelines, asset sales allow buyers to “step up” the company’s depreciable basis in its assets.
By allocating a higher value for assets that depreciate quickly (like equipment, which typically has a 3–7-year life), and by allocating lower values on assets that amortize slowly (like goodwill, which has a 15-year life), the buyer can gain additional tax benefits.
This reduces taxes sooner and improves the company’s cash flow during the vital first years. In addition, buyers prefer asset sales because they more easily avoid inheriting potential liabilities, especially contingent liabilities in the form of contract disputes or employee lawsuits.
However, asset sales can be problematic if your contracts require association consent or provide they are not assignable.
For sellers of a company that is structured as an LLC or Subchapter Corporation[1] (S-Corp) or even a partnership, there is generally no increased tax burden for selling assets. However, it is prudent to evaluate the proposed purchase.
As LLCs and S-Corps (as well as partnerships) are pass-through entities, the portion of a purchase price attributable to intangible assets such as contracts and goodwill less your investment in the company (basis), will be taxed at your personal capital gains rate which is likely 20%[2] for federal and an additional percentage which varies greatly by state.
The portion of the purchase price attributable to other “hard” assets such as equipment, real property, etc. less your basis will be taxed at your ordinary income tax rate which is generally greater than both federal and state capital gains rates.
Asset Purchase Example
| Purchase price (assume all intangible assets) | $ 5,000,000 | |
| Initial investment in company at startup | $ -25,000 | |
| Long-term capital gain (assume all contacts 1+ years old) | $ 4,975,000 | |
| Federal capital gains tax (same as an ordinary tax rate of 21%) | $ -1,044,750 | |
| State taxes (assume a 6% rate) | $ -298,500 |
| Net Income to Corporation/Distributed to You | $ 3,631,750 |
If your company is a C-Corp, the assets being purchased are owned by the corporation and it must pay taxes on the monies received for the sale of those assets at corporate tax rates.
Then when the proceeds are distributed to you, you will be taxed on the proceeds again at your personal tax rates – double taxation.
Once you receive this distribution you will be taxed on it again at both the federal and state level, further reducing the actual money you receive depending on what state you live in and your overall financial position.
Here is an example of the possible tax implications continuing from the example above:
| Distribution to you as owner | $ 3,631,500 | |
| Federal capital gains tax (assuming 20%) | $ -726,350 | |
| State taxes (assuming same as average ordinary income tax 6%[3]) | $ -217,890 |
| Net to You | $ 2,687,260 |
Stock/Interest Purchases
If your company is an LLC, there is no stock to be sold. Instead, your ownership interest in the LLC versus your stock in the corporation would be transferred to the buyer and the tax implications would be the same.
With stock sales, buyers lose the ability to gain a stepped-up basis in the assets and thus do not get to re-depreciate certain assets. The basis of the assets at the time of sale, or book value, sets the depreciation basis for the new owner.
As a result, the lower depreciation expense can result in higher future taxes for the buyer, as compared to an asset sale. Additionally, buyers may accept more risk by purchasing the company’s stock, including all contingent risks that may be unknown or undisclosed.
Future lawsuits, employee issues, and other liabilities become the responsibility of the new owner. These potential liabilities can be mitigated in the stock purchase agreement through representations, warranties, and indemnifications, but these are not foolproof and may need to be underwritten by you, at a significant expense, with appropriate insurance products.
Consequently, if a buyer agrees to a stock purchase the price is usually lower than it would be with an asset purchase.Sellers of C-Corps often favor stock sales because all the proceeds are taxed at a lower capital gains rate, and in C-corporations the corporate-level taxes are bypassed and only you as a seller would pay taxes on the funds you received for your stock.
Likewise, sellers are sometimes less responsible for future liabilities, such as contract claims, employee lawsuits, and benefit plans. The purchase price of a stock purchase is lower than the price if the deal was an asset purchase as discussed above.
Stock Purchase Example
| Purchase price (assume all stock) | $ 4,000,000 | |
| Initial purchase price of stock | $ -25,000 | |
| Long-term capital gain (assume owned more than 1 year) | $ 3,975,000 | |
| Federal capital gains tax (assume 20%) | $ 795,000 | |
| State taxes (assuming same as average ordinary income tax 6%[1]) | $ -238,500 | |
| Net to You | $2,941,500 |
As you can see, the tax implications for both buyer and seller play a significant role in the overall deal structure and the value of a company. Further, selling a C-Corp presents a much more complicated deal and may result in less money for you as a seller.
Therefore, both parties should consult with their business intermediaries, legal counsels, and accounting professionals early in the process to fully understand the issues given your unique structure and situation to obtain the desired results.
This article is not legal, financial, or tax advice. It is recommended that anyone considering selling their management company consult with an experienced attorney, financial planner, and/or accountant.
[1]If your company converted from a C-Corp to an S-Corp and if the sale is within the 10-year built-in gains (BIG) tax recognition period, the S-Corp asset sale could trigger corporate-level BIG taxes, under IRS Sec. 1374.
[2]Assuming all the assets are considered long-term, e.g., held for more than 1 year.
[3] In NV, WY, SD, TX, TN, FL and AK there would be no state tax due. In WA, and MN the capital gains tax would be higher than ordinary income tax rate. In AZ, MN, MS, ND, WI, AR, and SC the state tax rate would be lower than the ordinary income.
[4] In NV, WY, SD, TX, TN, FL and AK there would be no state tax due. In WA, and MN the capital gains tax would be higher than ordinary income tax rate. In AZ, MN, MS, ND, WI, AR, and SC the state tax rate would be lower than the ordinary income.