The financial focus in any business sale should be maximizing the present value of the after-tax amount received. Business owners and advisors must minimize the tax bite, as well as maximize the price.
In business negotiations we are always looking for win/win opportunities. Or at least having one party trade an asset or service with a lower real cost to them, and a correspondingly higher real value to the receiving party. Progressive tax planning often provides this opportunity in merger, sale and acquisition transactions.
Paying big taxes is really a voluntary act in most transactions. Only the ill-advised pay the big bucks to Uncle Sam. There are very few transactions where any double tax should result. Maximizing the gain/income taxed at capital gains rates vs. ordinary rates is the name of the game. And, quite often, it is possible to have no current taxes at all.
The first step in tax reduction starts well before a prospect knocks on the door. Closely held business owners should consistently strive to maintain a “sellable position” for their companies from a tax and business standpoint. This goal requires implementing a tax planning strategy throughout the life of the company that will set the stage for minimizing taxes in the event of a sale.
Methods to sustain a sellable position throughout the life of the company can include:
- Designing deferred compensation agreements that trigger deductions upon the sale of the business
- Implementing non-qualified stock options
- Documenting any “under-compensation” to justify bonuses and to offset tax gain
- Considering multiple business entities
- Recognizing and documenting the value of intangible assets possessed by the owners
- Switching from a C corporation to an S corporation at the opportune time
The first category includes:
- Management, consulting, and salary continuation agreements (However, in this area social security and self employment tax implications must be considered.)
- Non-competition agreements entered into with the owners
- Allocating sufficient amounts to intangible assets possessed by the owners
Tax Planning Along with the Sale of a Business
This last planning idea is gaining in popularity after recent favorable tax court rulings. These cases are the most significant development in tax planning for the sale of businesses in the last fifteen years. It is now often possible to reduce to one layer of tax at capital gains rates. The good news for buyers is additional amortization deductions.
Ways to create deductions in the company include:
- Bonuses for prior under-compensation
- Catch-up payments for use or property owned outside the company
There is a word of caution – do not gear all financial planning toward an eventual sale of your company. This future goal is only one of many that deserve advanced tax planning.
For example, many business advisors and owners overemphasize the tax consequences of an eventual sale. The overall tax structure is one of flow-through taxation (with partnership, limited liability, or S corporation vs. C corporation entity-level tax), and is often created to lower taxes on a hypothetical potential sale. However, this strategy is achieved at the cost of higher taxes on current operating profits.
While there are exceptions for turnaround and venture capital deals, most closely held business owners should focus on minimizing current taxes and maximizing current after-tax profits. This point is especially valid for the startup and growth phase of a business.
Stressing the tax consequences of an eventual sale requires broad assumptions. For example, this approach presumes primarily that the company will be sold (vs. passed down to family members), that the company will be successful enough to sell, and finally that the company is going to have a tax problem when it is sold. The sale of a business is normally too remote to warrant much consideration from the onset. Instead, business owners and advisors should focus on maximizing current after-tax profits and growing and expanding the business.
However, while not the most important consideration in the startup and growth phase, keeping the company in a sellable position from a tax standpoint still merits some serious attention. Future tax planning for an ultimate sale will become more important as the company matures and the owners near retirement age. Many tax-planning ideas for eventual sale can be implemented without adversely impacting other tax and financial planning priorities.
As you can see, paying significant taxes on the sale of a business is really a voluntary act on the part of many business owners and advisors. Keeping the company in a sellable position, and implementing the right planning ideas at the time of sale can greatly reduce the foreseeable tax burden. The key is maximizing the after-tax present value of every penny you put in your pocket.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.