When planning for a sale of your business, understanding the taxes you will owe on the sale and structuring the transaction in a tax-efficient manner are two very important considerations.
We recently discussed M&A taxes with Nichol Chiarella, a tax partner with the tax M&A practice at accounting firm Citrin Cooperman. Nichol has over two decades of experience providing tax compliance and consulting services to business owners, and frequently works with investment bankers and their clients to structure transactions in a tax-efficient way. Read on for her valuable insight:
Sally Anne Hughes: Nichol, let's start with the basics of how the sale of a business is typically taxed. Can you discuss the difference between a stock sale and an asset sale, and how each are taxed?
Nichol Chiarella: The tax implications of a stock sale and asset sale are vastly different for both buyer and seller.
The sale of stock by an individual is generally subject to capital gains tax, whereas with an asset sale the type of assets being sold as well as the type of seller determines the character of the type of gain that must be recognized on the sale.
Gain on the sale of stock is equal to the proceeds less the shareholder's basis in that stock. If the shareholder has held stock for more than a year, the sale of that stock would be subject to long-term capital gains tax, which was 20% in 2021. If the shareholder is selling C-Corp stock, it would be subject to an additional net investment income tax of 3.8%. But if the shareholder sells S-Corp stock of a company in which they materially participate, it would not be subject to the extra 3.8% net investment income tax.
If there's an actual or a deemed sale of assets rather than a sale of stock, the gain on the sale of certain business assets will result in an ordinary gain, and other types of assets will result in a capital gain. That gain is computed by taking the amount of proceeds less the tax basis of those assets.
There is a qualified small business stock exclusion, which allows for an individual taxpayer to exclude up to 100% of the gain on qualified small business stock issued after 2010 and held for more than five years. The amount that can be excluded is the greater of $10M or 10x the basis that a shareholder sold during the year. Generally, a qualified small business is a domestic C-Corp with aggregated gross assets of less than $50M before and up until the issuance of the stock. Certain industries, such as banking, financing, and investments and service industries, do not qualify as small business stock.
Sally Anne: Why do buyers prefer asset sales?
Nichol: If the buyer buys stock, whatever they pay for that stock is their basis in the stock. They hold it until they dispose of it and it remains their basis. However, if a buyer buys assets for that same amount, they get to amortize and/or depreciate the basis in those assets based on what they paid for them over the recovery period. Depending on the type of asset, the recovery period varies from three years to 15 years. So that's usually a huge benefit.
Sally Anne: So what's generally a benefit for the buyer is not great for the seller and vice versa.
Nichol: Right. If the seller is organized as an S-Corp or a C-Corp and they decide to do a deemed asset sale, because that's what the buyer would like, a gross-up calculation may become part of the negotiation. The seller might say, “Hey, look, OK buyer, you'd like to do an asset acquisition, that's fine, but it's now going to cost me this much more in tax. As long as you're willing to gross me up for that, that sounds good to me.”
Sally Anne: Can you share more details on how an individual seller who owns an LLC or an S-Corp is taxed in an asset sale?
Nichol: In an actual or deemed asset sale, by an LLC or an S-Corporation, the entity is treated as selling its assets, and the character of the gain for each type of asset sold will pass through to the member of the LLC or shareholder of the S-Corporation.
We first determine the allocation of that purchase price to each of the asset classes. The tax regulations provide for a reasonable allocation based on fair market value of each of the asset classes of the business, with a residual amount being allocated to goodwill. We then determine the tax basis of each of the asset types.
So, let's say for an example we're selling all the assets of a company -- and those assets comprise of cash, accounts receivable, equipment, a license, a trademark, and goodwill. That's a nice combination of hard assets and intangibles.
If the entity is an accrual-basis taxpayer, then accounts receivable will have a tax basis equal to its balance. If the entity is a cash-basis taxpayer, then accounts receivable will have a zero tax basis. Any gain on the sale of the accounts receivable will be subject to ordinary income tax treatment, just as it would in the ordinary course of business.
For any depreciable assets, such as equipment, the tax basis of those assets would be the original cost of the asset placed in service, less any tax depreciation taken through the date of transaction. The amount of depreciation recapture in the sale would be subject to ordinary income tax treatment as well, followed by capital gain treatment on the rest.
Intangible assets, including goodwill, generally receive capital gains treatment. However, there are exceptions to this. For example, the Tax Cuts and Jobs Act, passed in 2018, eliminated capital gains treatment for certain self-created intangible assets. The law provides that intangibles such as patents, inventions, models or designs, whether or not patented, secret formulas or processes and copyrights are not capital assets, if the taxpayer created them or acquired them as a gift from their creator.
Sally Anne: I want to understand that a little more. If a patent is one of the assets included in the purchase price allocation in an asset sale, are you saying that portion of the purchase price allocated to the patent would be taxed at ordinary income?
Nichol: If it was considered self-created. Let's say I start a business and then I incorporate a few years later as an S-Corp or an LLC. Twenty years later, I sell that business and I've got a patent in there. Even worse, I've got some sort of process like know-how. There's value to that that gets allocated in the purchase price. I could get stuck paying ordinary income because I as a person that started the business created it. If I start a corporation and I pay employees to go out and create a process or patent something, that's different. That would not be considered self-created.
Sally Anne: That's an important nuance to be aware of when thinking about an exit.
Nichol: There's not a lot of case law surrounding it right now, but if you’re aware of the issue, you may be able to address it with the buyer and allocate that purchase price to goodwill. The buyer gets the same treatment and can amortize it over 15 years whether it's a patent or goodwill, but it's going to significantly impact the tax treatment to a seller if you receive capital gain treatment on goodwill or ordinary income treatment on the sale of know-how.
Sally Anne: Can you talk a little bit about taxation for a client who owns a C-Corp, especially if it's an asset sale?
Nichol: We talked a little bit about the stock sale of the C-Corp earlier, but if it's an asset sale then a C-Corp only has one rate of tax. So the character of the gain on those different classes of assets doesn't matter for a C-Corp, and as of 2021 was that 20% tax rate. The shareholders would then be taxed on any proceeds distributed to them as a dividend, resulting in two layers of tax. So that is a downside to having a C-Corp structure, particularly in an asset sale. It becomes very costly for the shareholders.
We have a client who has shares in the C-Corp that they had started and later exchanged those shares for shares in another C-Corp in an exit transaction, and then later was going to dispose of that stock. They had held it for five years and their current advisor had not realized that this qualifies for qualified small business stock treatment. They were going to pay tax equal to $6M but were able to completely exclude it under the 1202 small business stock exception.
Sally Anne: Sometimes in a transaction the seller might have a note or an earnout. How and when do those proceeds get taxed?
Nichol: There's two different ways that proceeds from a note can be taxed, as far as timing goes. A taxpayer can opt to pay tax on all of the anticipated proceeds up front, so let's say I get paid half cash, and half with a note. I could say that I want to recognize it all right now, even though I don't have the cash. Believe it or not, we saw this a lot at the end of 2021, as people were trying to accelerate income in a year where they knew they had that lower capital gains tax rate. The other method is the installment method of recognizing that gain. The taxpayer is able to defer a percentage of that gain based on the amount that they'll receive in later years. Both of those methods are opted out of or opted into based on how they get reported on their individual tax return. Pretty simple to do.
An earnout is a little bit different because an earnout can be subject to ordinary income. You don't necessarily get capital gains treatment. It depends on how the contract is written.
Sally Anne: Another important issue is state and local taxes, especially for those of us who live in high tax areas like New York City. What should a seller know about state and local taxes?
Nichol: Over the last two years, a new pass-through entity tax regime has come into play for some states including New York, New Jersey, and Massachusetts. Previously, generally speaking for state taxes, income passed through and was recognized at the ultimate partner or shareholder level. Now, some states are allowing you to elect into paying a pass-through entity tax that gets determined and paid at the entity level. This now allows for a federal deduction of that entity's state and local tax paid that flows through to the taxpayer who receives a credit on the backend on their individual tax return for the amount of tax paid at the entity level.
So now electing provides us this great federal deduction, and then the seller gets a credit against it at the individual level. So that's something that's really important to know about.
Some of these states are tricky depending on the timing for making the election. New York is a big one. As of right now, the way the law is written, you must elect in by March 15th of the current tax year. If we expect we're going to have a transaction occurring, even if we don't know if it might be an asset sale, in 2022, we would have to make that election by March of 2022.
Kind of crazy, but that is the way it's written right now. Our state and local tax experts at Citrin Cooperman have called the state to discuss. What if a deal closes in October, and you have missed the opportunity to opt in with a huge tax savings? We are advising that any clients who expect a situation where they're potentially selling their business in an asset sale to create a new entity, make an election, and have this vehicle in place, so that if we later need to take advantage of the opportunity we can restructure and make it happen.
New York City, as you know, doesn't recognize the S-Corp. In New York City or other locations with state or city tax, it’s important to ensure taxes gets paid at closing to ensure that the seller gets to capture that deduction. If the seller is an accrual basis taxpayer, we make sure that the purchase agreement is written in a way that provides the opportunity to take advantage of the deduction if and when they have to pay that tax when they file their return.
Sally Anne: What happens for sellers who may rollover some equity into a new entity? How is that equity taxed?
Nichol: That depends on the type of equity they're receiving. If a taxpayer is contributing equity or any type of property in exchange for LLC units, or a partnership interest, then this would be what we call a non-recognition transaction under Code Section 721. The basis of the equity or property that they're contributing in exchange for those LLC units or partnership interest carries over and becomes their basis in the new entity. There would not be any recognition of income in that case at the time they receive the units or the partnership interest, rather they would recognize gain at a later date when they ultimately dispose of the interest. It gets a lot more complicated if you're receiving stock in exchange for stock or your partnership interest because the non-recognition rules for corporations are much more restrictive. Let's say I have an LLC and I'm selling it to a C Corp and they're going to give me equity. Or I've got some stock and I'm selling that and I'm getting cash and getting equity in a corporation.
There are ways to structure it that it does become a non-recognition transaction, but it has to be looked at very closely, and we frequently work alongside tax attorneys to make sure that everything is buttoned up nicely. It's a huge area of exposure, probably the largest.
Sally Anne: Thank you for your insight! I hope that anybody watching or reading this understands that not only should you be speaking with an investment banker and an attorney about the sale of your business, call your CPA. Nichol, if anybody has specific questions for you or would like to learn more about Citrin Cooperman, what is a good way to reach you?
Nichol: All of my information is on our website at https://www.citrincooperman.com/professionals/nichol-chiarella. My email is firstname.lastname@example.org.
Sally Anne: Nichol, thank you for sharing this information – it’s interesting and important for any entrepreneur considering an exit.
Every situation and every transaction is different -- be sure to consult with your own CPA regarding taxes on a sale of your business.
To discuss planning for a sale of your business, please contact us at email@example.com for more details.