What to Consider When Buying Or Selling a Business
Guide to Buying and Selling Businesses
The first step in the process is determining the value of the entity to be acquired or sold. This is done in many ways but primarily focuses on the goodwill value of the earnings stream (see my article on valuing a closely held business). The major asset in any business is its relationships with its customer base. The other assets of the entity to be acquired or sold are of little interest in all likelihood.
Once the value of the business is determined, it becomes necessary to structure the transaction. There are many ways to structure the transaction as the nature of the contract and the desire to have separation of risk from contract to contract will determine transaction form. Forming a Limited Liability Company (LLC) is a flexible way to handle business acquisitions and sales. The LLC can be treated as a partnership, sole proprietorship, or corporation for income tax purposes with the partnership offering the best benefit in the purchasing and sale of businesses in this particular model.
The LLC can be formed each time a new business is to be acquired keeping the contract separate from all other contracts. There is also the opportunity to have different partners for each transaction with the partnership offering a flexible allocation of earnings and losses. Income tax savings will result from the sale of partnership assets.
Businesses are bought and sold considering two basic concepts. A business will either sell its assets or will sell its capital stock or capital. Buyers of businesses will typically want to buy assets of a business as it will generally provide for better tax benefits going forward. Sellers will typically want to sell stock or capital as to create the most favorable of income tax rates; long-term capital gain. There is even the opportunity to exclude half of the gain from income under Internal Revenue Code 1202 (IRC 1202). This sale of stock must be of a qualified small business corporation (C-corporation) and will cause for a 7% add back to arrive at alternative minimum taxable income of the amount of gain excluded from income. When the stock or capital is purchased, the new owners are liable for whatever has gone on in the entity for prior years. Whoever has the best negotiating position (buyer or seller) will determine how the transaction is structured.
At this point, it makes sense to discuss briefly the business entity types that are most common. The LLC has already been discussed as a flexible entity that can be taxed as a corporation, sole proprietorship, or partnership. In addition, business entities might be organized as C-corporations or S-corporations. The C-corporation is an entity that is taxable on its own. Typically, the owners of the C-corporation decide whether the entity or they will pay income tax on earnings. Income earned by the C-corporation can be distributed out to the shareholders in the form of compensation creating a deduction for the entity and income to the shareholders. This income is ordinary and is taxed at the highest marginal rate of the individual shareholders and is subject to payroll tax expense.
When assets of the C-corporation are sold, there is inherent double taxation to contend with. Typically, the C-corporation will have to pay tax at the corporate level and again when assets are distributed to shareholders. The S-corporation, on the other hand, is a flow-through entity with corporate earnings generally escaping corporate level taxes and passing through directly to the shareholders. Upon the sale of assets in the S-corporation, there is no corporate level tax with gains passing directly to the shareholders. This is true if the entity has operated as a subchapter S-corporation since its beginning or has out lasted the ten year waiting period upon converting to S-status from a C-corporation (IRC 1374, built-in gains tax). If a C-corporation is contemplating a future sale and it appears that an asset sale is inevitable, it might make sense to convert to S-corporation status to begin running the 10 year recognition period.
When buying a business or its assets, it becomes important to understand the other side of the transaction. Knowing what the seller faces will help negotiations and will help to form strategies ahead of the transaction. There is a concept known as personal goodwill which can be explained simply as business relationships developed and nurtured by the individual shareholders or owners of a business. This concept allows for beneficial tax attributes on both sides of the business acquisition transaction. Suppose that a newly formed LLC wishes to acquire the assets of a C-corporation. The selling C-corporation would like to sell its stock to take advantage of the long-term capital rate. As mentioned earlier, this strategy does not bode well for the buyer as tax attributes will be minimal. Enter the personal goodwill concept. If the buyer approached the C-corporation owners with a three part acquisition proposal that would benefit both sides of the transaction, the deal would remain alive and hopeful.
The three parts of the transaction would involve stock sale, consulting agreements, and personal goodwill. The stock sale might encompass the book value of the shares adjusted for tax depreciation. A business that requires the renewal of contracts might find it beneficial to hire the outgoing ownership as consultants. Part of the transaction could be structured to offer the owners of the entity being sold a consulting fee for a period of time to help secure contracts when they are due for renewal. The purchasing entity would get a deduction for amounts paid for consulting and the former ownership would have taxable ordinary income subject to payroll taxes. The stock purchase of the transaction would create capital gain for the departing ownership group taxable at the long-term capital gain rate. The purchasing owners would not get a tax benefit for shares or capital acquired. The final part of the transaction would relate to buying the personal goodwill from the departing owners as it is deemed that the goodwill was created at the individual level (1).
There should be no employment contract between the owner-employee on the sale side of the transaction and the entity. The entity doing the purchasing will get a tax deduction for the personal goodwill subject to a 15 year amortization (IRC 197) and the sellers of this personal goodwill will get long-term capital gain treatment. In summation, both buyer and seller will get favorable tax treatment for some of the transaction, along with items that are not treated favorably for tax purposes. Another variation of this transaction could be that the personal goodwill is purchased directly from the departing shareholders with the selling remaining intact to perform some other business venture (subject to a covenant not to compete) or to liquidate at some later date. This would still give the sellers long-term capital gain treatment while providing the buyers with a 15 year amortization of goodwill (see Martin Ice Cream Co. v. Commissioner, 110 TC 189).
(1) McDonald v. C.I.R.; Bryden v. C.I.R.; Longo v. C.I.R.; Martin Ice Cream v. C.I.R.; Norwalk v. C.I.R.
Ron Piner, CPA
Host of "Better Business"
Saturday mornings at 10ET
WBIS AM 1190
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