Figure Taxes Into the Equation When Buying or Selling a Business

by: Jeff DeWeese

Jeff DeWeese is a partner with O’Sullivan Creel’s Business Consulting division. Jeff brings diversified experience in financial statement examinations, counseling entities on compliance with regulatory and governmental agreements, litigation support services and forensic accounting investigations. Jeff has been recognized as an expert in business valuation in state courts in Alabama and Florida, and the U.S. District Court.

No one ever said it was going to be easy: Buying or selling a company requires plenty of business acumen and due diligence. Not only must you work with the other party — and its accountants and lawyers — but you also have to interpret the facts and figures of the deal.

Even though you’re likely focused on achieving a fair sales price, it’s also important to consider the taxes associated with the transaction. The way the deal is structured can greatly affect the tax impact. An installment sale and a taxable sale are two ways to structure a business sale that have different tax consequences.

Installment sale

A sale is often structured as an installment sale when the buyer lacks a sufficient amount of cash. This type of sale is also used if a company is sold with an “earn-out” provision, under which the buyer pays a contingent amount over a number of years based on the business’s performance.

Bear in mind that installment sales require careful planning — both for the economic terms and the tax impact. For example, an installment sale may leave the seller with a tax bill and no money to pay it. Why? Because the tax on any depreciation recapture must be paid in the year of the sale, regardless of the amount of payments received that year. If not planned for, this acceleration of gain can make for an unpleasant surprise.

Additionally, payments are subject to the rates in effect at the time the payment is received, and the lower capital gains rate of 15% is scheduled to be good only through 2010. If you’re negotiating an installment sale with substantial amounts of long-term capital gain that’s eligible for the lower rate, don’t forget to factor in the time frame over which the installment payments will be made.

Another thing to remember is that the tax benefits of gain deferral are lost for installment sales of more than $5 million. For sales that, in the aggregate, have outstanding installment obligations of that magnitude in one year, you pay an interest charge on the deferred tax.

Taxable sale

If dealing with taxes upfront doesn’t scare you off, a taxable sale can be advantageous. The seller receives cash, a note or both. This type of sale can be structured as either an asset sale or a stock sale.

Typically, the seller will lobby for a stock sale while the buyer will prefer an asset sale. A stock sale will usually result in capital gains treatment for the seller but not allow the buyer to maximize depreciation deductions because stock is purchased — not depreciable assets. In an asset sale, the buyer receives a stepped-up basis in the assets.

See the big picture

If you’re contemplating buying or selling a business, don’t get tunnel vision and focus on only the sales price. There are other important figures to consider, one of which is taxes.

No matter which side of the transaction you’re on, have your tax advisor review the documents. Also have him or her review general provisions in the contract, because they may also affect tax treatment.