Financing and Tax Implications of Selling Your Business
Taking the time to research the financing and tax implications of a sale can provide you with a strong advantage come negotiation time.
Before you can understand the importance of negotiating a final small business sale agreement, it pays to brush up on facts about how sales are financed and how proceeds are taxed. Why? Because every decision regarding the payment structure affects when and how money transfers from the buyer to the seller and how the payments are taxed.
No one is asking you to become a financing or tax pro. That’s what your sale advisors do, and you’ll want to call on their advice through every step from here through to the closing of your deal and the transition of your business to its new owner.
But knowing some basic information will help you understand the advice you’re receiving from those who are trained and up-to-date on the legal, financial, and tax implications of small business sales.
STEP 1. UNDERSTAND THE IMPLICATIONS OF EACH PURCHASE-PAYMENT APPROACH.
Each payment approach provides either you or the buyer – but rarely both of you – an advantage, which means every decision translates to a financial benefit to one or the other, and therefore a point of negotiation.
The following provides an overview of the approaches for funding and paying off small business purchases. Your broker or your accountant will be able to provide more in-depth information and descriptions for how the approaches affect your particular sale.
Cash Payoff at Closing
Though rare, all-cash at closing eliminates concern about the buyer’s ability to make after-closing payments.
An all-cash payoff has the potential to move you into a higher tax bracket, since you receive all proceeds as revenue during a single tax year. It also limits the buyer pool to those with cash resources or the ability to obtain cash through third-party loans. Research shows that cash-at-closing sales generally result in lower selling prices.
Third-party loans allow the buyer to obtain the required down payment or to pay for the business at closing.
Bank loans are increasingly hard to come by and time-consuming to obtain. If during prescreening a buyer indicates need for a third-party loan, request a prequalification letter from a lender prepared to provide the funding. Also, in advance of the sale, contact your bank or SBA office to learn whether and how the purchase of your business sale might qualify for an SBA loan.
Home Equity Loan
Homeowners can self-finance purchases by tapping the equity in their residences through a second mortgage.
If the buyer requires a home equity loan to provide the source of the closing-day down payment, and if you provide a seller-financed loan for all or some of the outstanding balance, don’t accept the buyer’s home as loan security since you’ll have a subordinated position should you need to call on the asset.
By offering to accept deferred payments through a seller-financed loan you attract more prospective buyers, ease and speed up the purchase transaction, convey faith in the future of your business, and, as a result, tend to obtain a higher purchase price. You also spread sale proceeds over multiple years, which may spare you from taxation at higher rates. A seller-financed loan is detailed in a promissory note that explains the repayment promise and loan terms.
By signing a secured promissory note the buyer gives you legal right to valuable assets – collateral – you can seize as recourse if loan repayment terms aren’t met. Beware of collateral in which you take a subordinated or secondary position. Also beware of accepting business assets as collateral, as they can become devalued before you seize them. Should we mention that the business itself is often collateral for the seller loan, which means the seller gets the business back if the buyer defaults?
By requesting a personal guarantee as loan security (and buyer’s spouse’s personal guarantee as well, if they live in a community property state) you obtain a personal repayment promise that allows you to pursue personal assets as recourse if necessary.
By agreeing to accept part of the purchase price based on how well the business does in the future you enhance business attractiveness by demonstrating faith in its future. You also reduce closing day cash requirements and provide yourself with a negotiating chip that often protects sale pricing. Further, you spread sale income over multiple years, which may provide a tax advantage.
The earnout must be defined in the purchase and sale agreement, including when payments are to be made, how they’re to be calculated, and whether earnout payments are subject to minimum and maximum amounts. Most agreements stipulate that “calculations must be made by an independent certified public accountant mutually agreeable to the parties.” Yet, this approach is risky, as your loan payments are subject to default, if the new owner fails at sustaining the business.
If your business sells to a corporation, the buyer may want to execute the purchase using stock rather than cash.
Be aware that there are typically process and time restrictions that limit when you can sell the stock you receive, and that unless the stock is widely and heavily traded a sale at a high price may be difficult.
STEP 2. UNDERSTAND THE TAX IMPLICATIONS OF HOW YOU RECEIVE AND ALLOCATE PURCHASE PRICE PAYMENTS.
Here’s where your advice from your accountant can really pay off. Before agreeing to the payment approach and price allocation, be sure to get professional advice on the following topics:
- How you can qualify for tax deferrals by accepting part of the purchase price in installment payments over upcoming years and by allocating deferred payments to assets that will be taxed at capital gains rates.
- How you can allocate the purchase price among IRS-defined asset classes to avoid taxation at the highest rates. The IRS requires that you and the buyer both report the price allocation identically, using Form 8594. The allocation must follow IRS stipulations, and it also must win agreement from you and the buyer (second part of this sentence, after the comma seems awkward, redundant from previous sentence?). Price allocation becomes a point of negotiation because tax advantages hang in the balance. Some allocations will benefit you. Some will benefit the buyer. None benefit you both at once. Again, don’t proceed without professional advice from your accountant.
The following provides a quick overview of the seven IRS-defined asset classes, along with the rules and tax implications that apply to each.
The current-market value of all certificates of deposit, foreign currency, government securities, and publicly traded stock that will be transferring as part of the sale.
Accounts receivable, credit card receivables and loans due to your business if those assets are transferring as part of the sale.
Class V assets: Tangible/Physical assets
The value of furniture and fixtures, buildings, land, vehicles, and equipment that is transferring as part of the sale. The buyer will benefit from allocating as much as possible to assets in this class, which will qualify as business expenses or to which short-term depreciation rates apply. Conversely, you’ll benefit from allocating as much as possible toward appreciated assets you’ve held long-term, which qualify for taxation as capital gains.
Class VI assets: Intangible assets not including goodwill
The value of the all the non-physical assets of your business (not including goodwill), such as workforce, business books and records, systems and procedures, intellectual property, customer lists, and other assets that the IRS details in Form 8594 instructions (see link on this page). Frequently intangible assets are purchased in return for a non-compete agreement and/or a personal services contract, each of which offer different tax implications. Payment for a personal services contract allows the buyer to deduct the price as a business expense, while it will be taxed as ordinary income on your return for the year the payment is received. Payment for a non-compete agreement must be amortized or deducted over 15 years even if the agreement is for a much shorter time period, making it less attractive to buyers but more attractive to sellers.
Class VII assets: Goodwill and going-concern value