When the Business Must Be Sold Outside the Family: Key Negotiating and Tax Issues

When the Business Must Be Sold Outside the Family:Northeastern University
Key Negotiating and Tax Issues

Family Business Quarterly
by Stephen Minson and Gary Hayes

As accountants for closely held businesses, we are normally concerned with the transition of a family business to the next generation. In some cases, however, it may be impossible for the business to be passed on to the next generation. For example, the owner of a closely held business may not have children who are interested or qualified to run the business. In this situation, the owner may have no choice but to plan for the sale of the business.

In this event, a number of important issues should be considered. Once a potential buyer is identified, there is normally a period for due diligence, during which the buyer and seller exchange financial and legal information about the companies. Before this exchange of information, the parties may sign a letter of intent. The letter of intent may require that all information exchanged will remain confidential, and the parties agree not to entertain offers from other parties during the due diligence period.

What Will Be Sold?

In addition to negotiating the purchase price, there is also a negotiation as to what is being sold (i.e., stock of the corporation or the assets and liabilities of the existing company). This decision has a number of accounting, tax and legal issues for both the buyer and seller.

When an offer is made to purchase a business, the buyer would usually prefer to buy the individual assets of the business rather than the stock of a corporation. For tax purposes, this allows the buyer a step-up in the cost basis of the assets, and enables the buyer to depreciate or write off the entire purchase price over a period of time.

If the deal is to purchase the stock of the corporation, the buyer simply takes over the corporation, and assumes all assets and liabilities. In this situation, the buyer is not allowed to depreciate or amortize the purchase price of the stock.

Type of Organization

The current structure of the selling business may also play a significant role in determining the type of transaction. If the business is a C Corporation, there is a significant risk of double taxation upon the sale of the assets and eventual liquidation of the business. This potential double tax could raise the federal and state tax rate on the sale of the business to an overall effective tax rate as high as 60% to 70%. The tax rate varies depending on how much of the sale qualifies as a capital gain and ordinary income.

On the other hand, if the selling business is structured as an S Corporation, Partnership or Limited Liability Company (LLC), the tax impact will typically be dramatically reduced, as these flow-through entities incur only one level of tax.

As an example, assume that a corporation sold all its assets, resulting in a gain of $1,000,000 on the sale. At current corporate tax rates, a C Corporation would pay approximately $400,000 in federal and state income taxes. On liquidation, the corporate shareholders would pay approximately $200,000 in additional taxes. An S Corporation, Partnership or LLC pays no entity level tax, while individual owners would pay taxes in the amount of approximately $325,000, leaving the owners of a flow-through entity with net after tax proceeds of about $275,000 more than the owners of a C Corporation.

Sale Terms

One important consideration for the seller is how the sale price will be paid. Obviously, a cash sale is the best possible situation, but may not be acceptable to the buyer. One of the more common transactions is for the buyer to pay some cash up front and pay the remainder of the sale price over a period of time. Assuming the seller is eligible to use the installment sale methods of accounting, this will allow the seller to delay the payment of tax over the term of the installment note. However, the seller must be comfortable that the note is adequately secured and that the buyer has the ability to pay.

Another form of consideration for the sale may be stock of an acquiring corporation. This may qualify as a tax-free reorganization. The tax would be paid as the stock received in the acquisition is sold at some later date. In accepting the stock of another corporation, the seller must be willing to accept the market risk of the stock, which may appreciate or depreciate in value.

Other Issues

In addition to the purchase price of the business, the seller may be asked to sign an employment contract to run during the transition phase of the business, and a covenant not to compete. Both of these agreements should result in additional income for the seller.

One of the most important steps in any sale of a business is to perform a cash flow analysis to compare the lifestyle and retirement needs of the seller to the stream of cash flow generated by the sale. In reviewing this stream of cash flow, it is important to consider items such as the annual payment of taxes and the payment of any remaining liabilities of the business.

If the seller is uncertain about the selling price of a business, it may be wise to seek the advice of a business valuation expert. It is also important that a member of the professional team include legal counsel that is familiar with the latest issues relating to the sale of a family business.

Stephen Minson and Gary Hayes are partners of Tofias, Fleishman, Shapiro & Co., P.C., which specializes in providing public accounting and consulting services for closely-held, family-owned businesses.