In last month’s column, we reviewed some of the proposed changes to federal taxes on the horizon. Since this is the April edition, let’s continue with the tax theme and investigate how sale transactions are taxed under today’s laws. I’ll use various deal structures so you can understand the impact this can have on net proceeds after tax.
Let’s start with the big one: federal capital gains tax. Most transactions in the tire and service business are structured as asset sales, but some are done are stock sales, in which you sell the shares of your company. Most buyers want to avoid purchasing “hidden liabilities” when they buy your stock and that’s why asset transactions are preferred.
The tax impact between the two deal structures matters the most when the seller is organized as a C-corporation, as compared with “pass-through” entities like S-corporations, LLCs, partnerships and sole proprietorships.
So, imagine you are the seller of a C-corp, you make more than $446,000 ($502,000, if filing jointly) and your long-term gain is $10 million in a transaction. Your capital gains tax rate and qualified dividend tax rates are effectively 20%, plus the 3.8% Obamacare tax. An asset sale in this C-corp would first result in a corporate tax of $2,100,000 and then a dividend tax of $1,880,200 for a total tax of $3,980,200, while a stock sale of this C-corp would result in a capital gains tax of $2,380,000.
Clearly, if you are organized as a C-corp, you’d prefer a stock sale because you would avoid double taxation, as well as save $1.6 million to put that money into your personal bank account. See, in an asset sale, the C-corp actually owns the assets, while you own shares of the company stock. Your company first pays a tax on that gain and then to get that money out of the company and to you as the “shareholder,” you pay yourself a dividend, which is taxed, as well. Note that this is before state capital gains taxes. (See last month’s column, which lists the states that have no capital gains tax.)
Note that if you are actively involved in an S-corp, LLC or partnership, you avoid the 3.8% Obamacare tax, as those are intended for passive investments, like C-corps. Technically, an S-corp can sell stock and an LLC can sell “interests.” There are no stock sales involving partnerships or sole proprietorships.
Now there are certain things that the owner of a C-corp can do in an asset sale to minimize taxes – like purchase price allocation and personal goodwill – but that’s why you hire investment bankers and attorneys with experience to help structure these deals.
To bridge the gap between what a seller wants and what a buyer is willing to pay, “earn-outs” are sometimes negotiated as part of the total transaction value. Earn-outs are based on hitting agreed-upon targets – often revenue, gross profit dollars or EBITDA – that you want to make as achievable as possible. The first thing to know is that there is a basic tax principal that goes something like, “You only pay tax when you get the money.” So, if there is an earn-out comprising 15% of the total price, capital gains tax is only applied to the 85% received at closing. The remainder, if intended as deferred purchase price, is subject to long-term capital gains taxes, when received, and not ordinary income taxes.
In transactions between friendly parties – like when a tire dealer is selling to a trusted employee – a structured sale can be used. First, the employee gathers up a down payment by tapping personal assets, taking out a bank loan or perhaps mortgaging a house. Then a structured sale price is negotiated and the remainder is paid over time. Those payments, over time, are taxed to the seller at capital gains rate when received in a structured sale.
In many transactions, employment, consulting and non-compete agreements are other ways that a buyer offers value to a seller. Just know that however the value is paid, it will most likely be taxed at your ordinary personal income tax rates.
In sum, deal structure affects the taxes you may pay. Planning ahead and consulting a tax advisor will help minimize your taxes and prevent common mistakes.