BERKELEY HEIGHTS, N.J. (TheStreet) -- Small-business owners spend a lifetime building their business. They work countless hours growing it into something of value. When the owners decide to sell, it is critical for them to do some tax planning to maximize their net proceeds. This is even more important for small-business owners when their business is their single biggest asset.
When selling a business, some of the key considerations from a tax perspective are:
Small-business owners who sell their company need to understand how and when payment streams will be taxed.
- The sale structure: asset vs. entity sales
- A payment stream: lump sum vs. installment
- A covenant not to compete
- Future compensation
The sale structure is simply a question of what is actually being sold. In an asset sale, the underlying assets are sold to the acquirer. Sales of sole proprietorships or single-member LLCs are always classified as asset sales. In an entity sale the entire business or entity is being sold, which usually includes the underlying liabilities.
The buyer and seller typically have divergent interests in the asset vs. entity sale question. Sellers will prefer to structure the deal as an entity sale, which are considered as a sale of a capital asset -- meaning that as long as the holding period is greater than a year, preferable long-term capital gains rates apply. Buyers will prefer to structure the deal as an asset purchase so they can select the best assets, exclude the liabilities and get a faster recovery via depreciation.
A seller in an asset purchase may have a portion of the proceeds taxed as ordinary income rather than the preferable capital gains rate, while a seller in an asset sale set up as a C corporation also has to deal with possible double taxation. First the C corp will pay corporate tax rates on any gains from the asset sale. When the C corp distributes the proceeds to the shareholders, they are taxed as well. An asset sale requires classifying the assets being sold into seven broad asset classes and calculating the respective gains and losses by asset class.
The bottom line: Sellers typically prefer entity sales, while buyers prefer asset acquisitions.
A second consideration is whether to take the purchase price upfront via a lump sum or over time via an installment sale. With a lump sum sale the seller recognizes all the income upfront, while an installment sale allows the seller to defer some of the income by recognizing the gain over time using a concept called the gross profit ratio. Whether it makes sense to defer income will depend on where future tax rates are heading, as well as the projected future tax bracket of the seller.
On installment sales, whether stated or not, there is an interest component. When not explicitly stated, interest must be imputed using the Applicable Federal Rate. The seller recognizes the interest income while the buyer is entitled to a deduction for the interest payments.
When a business owner sells their business there is typically a covenant not to compete as part of the deal. Payments received are considered ordinary income and are reported as "other income." It's not considered self-employment income, though, and is not subject to self-employment taxes. Covenant-not-to-compete compensation is not considered earned income.
Future compensation is often part of business sales. Sellers staying on as employees will get a W-2 and be subject to the typical employee payroll withholding taxes; sellers retained as consultants will get a 1099. Any compensation paid this way is considered self-employment income, and the recipient will be subject to the employer and employee portion for payroll taxes. Whether the individual is considered an employee or contractor, these payments are considered ordinary income. These payments are considered earned income.
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Michael Maye is the founder and president of MJM Financial Advisors (www.mjmfinadv.com), a registered investment advisory firm in Berkeley Heights, N.J. He is a member of the National Association of Personal Financial Advisors (NAPFA) and has been a speaker covering tax topics at NAPFA's national and regional conferences. Maye has also been a frequent contributor to the Star Ledger of New Jersey's "Biz Brain" and "Get With the Plan" articles. In addition to NAPFA, he is a member of Financial Planning Association, American Institute of Certified Public Accountants, New Jersey State Society of CPAs and the Estate Planning Council of Northern New Jersey.