Buying or Selling a Business: Why Tax Planning Should Happen Before the Agreement Is Signed

By the time a business sale agreement reaches its final form, most of the tax consequences of the transaction have already been determined. Whether the deal is structured as an asset sale or a stock sale, how the purchase price is allocated, and whether any portion of the proceeds is deferred can each have a meaningful effect on the taxes owed by both the buyer and the seller. ESBS encourages business owners considering a sale or acquisition to involve their tax advisor while the transaction is still being negotiated, not after the closing documents are drafted.

Asset Sales and Stock Sales Are Taxed Differently

In an asset sale, the business entity sells its underlying assets, and the character of the gain or loss depends on the type of asset involved. Equipment, real property, goodwill, and inventory are each treated differently under the tax code, and a single sale can generate a mix of ordinary income and capital gain. In a stock sale, the owner sells their equity interest directly, which is generally taxed as a single capital transaction but may carry over certain liabilities and tax attributes that a buyer would prefer to avoid. Buyers and sellers frequently have opposing preferences regarding structure, which is one reason this issue is often negotiated as part of the purchase price.

Purchase Price Allocation Affects Both Parties

When a transaction is structured as an asset sale, the purchase price must be allocated among the various asset categories using the residual method prescribed by the tax code. This allocation determines how much of the price is treated as ordinary income to the seller versus capital gain, and it determines the buyer's basis in each asset going forward, including how quickly the buyer can depreciate or amortize that basis. Buyers and sellers do not always have aligned interests here: a seller may prefer more of the price allocated to goodwill, while a buyer may prefer allocation to assets with shorter depreciable lives.

• Allocation among asset classes should generally be documented and agreed upon by both parties in the purchase agreement.
• Depreciation recapture on certain assets can create ordinary income even within an overall capital transaction.
• Covenants not to compete and consulting agreements have their own tax treatment separate from the sale price itself.
• State tax treatment of the sale can differ from federal treatment and should be reviewed separately.

Installment Sales and Deferred Payments

Some transactions include a portion of the purchase price payable over time, whether through a seller note, an earnout, or a holdback. Depending on how the arrangement is structured, gain may be recognized over the payment period rather than entirely in the year of sale. Earnouts tied to future business performance introduce additional uncertainty, since the amount ultimately collected may differ from initial projections, and the tax treatment of contingent payments has its own set of rules.

Entity Structure Can Change the Analysis Considerably

The tax consequences of a sale can differ substantially depending on whether the business is a sole proprietorship, a partnership, an S corporation, or a C corporation. Owners of C corporations, in particular, should be aware that a sale of corporate assets followed by a distribution of proceeds can result in taxation at both the corporate and shareholder level, sometimes referred to as double taxation, whereas other structures generally do not present this issue in the same way.

Why Timing Matters

Our tax team is familiar with reviewing draft purchase agreements before they are finalized, modeling the tax impact of different structures, and discussing these results with the business owner's attorney and other advisors. Once an agreement is signed, the allocation and structure are generally locked in, and it becomes far more difficult to adjust the tax outcome after the fact. These situations often require additional analysis specific to the assets involved, the entity type, and the timing of payments, and the appropriate treatment depends upon the taxpayer's individual circumstances.

Contact ESBS early in the process if you are considering buying or selling a business, so that tax considerations can be factored into the negotiation rather than discovered afterward.

The information provided is for general educational purposes and should not be considered individualized tax, accounting, legal, or financial advice. Tax rules and reporting requirements depend upon individual circumstances. Please consult with an appropriate professional regarding your specific situation.