By John Nardozzi, CPA, CVA, Nardozzi Consulting, LLC
For somebody in my line of work there is no worse feeling than walking into the closing of the sale of a business, only to have the seller turn to me and ask, “How much will I have to pay in taxes?” Argh!
The closing is not the time or place to start thinking about taxes!
This question should be one that is asked at the very beginning of the sales process, just as soon as you start thinking about selling your company. The reason? Every decision you make while preparing your business for sale, through the negotiations with a buyer, right into settling the terms of the deal, will have an impact on the “tax bite” to which a seller will be subject.
There are two major factors that affect tax liability in the sale of a business: 1) the type of business entity being sold, and 2) the way the deal is structured. Both need to be addressed early in order to keep the IRS from getting more than their fair share of the proceeds of the sale.
Are You a C or an S?
The first question I always ask is: Are you a C corporation or an S Corporation (or LLC)? The answer has a profound effect on the tax consequences following the sale of a business. In some cases I have urged a client to call off the sale in order to make a change of entity, which can take several years. That’s how much money is at stake!
To Illustrate I present a simplified typical oil dealer:
|Balance Sheet||Pre- Sale|
|Vehicles net of Depreciation||
|Intangibles (Customer List)||
|Bank & Truck Loans||
|Due to Customers||
|Equity (Assets- Liabilities)||$205,000|
|Total Liabilities & Equity||$625,000|
We make certain assumptions about the pending sale: that the assets sold will include the customer list, trucks and inventory; that cash and receivables remain with the seller; that inventory has been physically counted and verified; all loans and open accounts will be paid off at closing; and that the customer list value was paid in cash (not retained gallons).
The sale of certain assets (Asset Deal):
|Inventory||$ 50,000||$ 45,000||$(5,000)|
|Vehicles net of Depreciation||$125,000||$125,000||$ –|
|Intangibles (Customer List)||$ –||$475,000||$475,000|
|Bank & Truck Loans||$125,000||$125,000||$ –|
|Accounts Payable||$185,000||$185,000||$ –|
|Due to Customers||$110,000||$110,000||$ –|
|Total Liabilities||$420,000||$420,000||$ –|
|Equity (Assets- Liabilities)||$205,000||$645,000||$440,000|
|Total Liabilities & Equity||$625,000||$1,065,000||$440,000|
So we see that the sale results in a net taxable gain of $ 440,000 for the buyer, primarily due to the value of the customer list, which is almost always the most valuable asset of an energy retailer. Based on that gain, what is the potential tax? It depends on what kind of entity structure the business operates under.
- C Corporation that sells its assets and then liquidates has two levels of tax. The first is at the corporate level at regular corporate rates (federal 35%). The second is capital gain tax (federal 20%) to the shareholder when they liquidate the company and distribute the cash.
- S Corporation (or LLC) is what is known as a “flow through entity” that pays taxes only at the shareholder level, and most likely at the lower capital gain tax rate (20%).
|Using our example, the taxes are likely to be:|
C – Corp
|Gain Realized on the sale ($645,000-$205,000)||$440,000||$440,000|
|Federal (using 35%)||$140,140||$ –|
|State (using 9%)||$ 39,600||$ –|
|Federal Tax (using Cap Gain rate of 20%)||$ 49,449||$83,600|
|State Tax (using 5%)||$ 13,013||$22,000|
|Total Tax from sale||$242,202||$105,600|
|Tax percentage on the sale||55%||24%|
Ouch! The tax consequence for a C corporation is more than double that of an S corporation or LLC. You can see why, when it comes time to sell your oil business, it pays to be an S corporation. But what if you are already established as a C corporation? Is there still hope?
Yes. You can change your entity by electing to be taxed as an S corporation. The election is simple, all shareholders must agree to the change. Once the election is effective the income of the company flows through to the shareholders and is taxed on their personal tax returns.
As of this writing, in order to avoid the double tax the entity must be an S corporation for five years (previously this was a 10-year “look back” term). Obviously, if there is even a remote possibility of selling your company in the future, you should seriously consider making the S corporation election now.
As a footnote, this article does not apply to the sale of your corporate shares. If you are in a position to sell your shares to a partner, family member or employee, this double tax will not apply to you. But if you think you can simply sell your shares, and not assets, be advised that an unrelated third party – the most likely buyer for your company – will not want to purchase your shares because that would mean they would be assuming all of your liabilities, including litigation, environmental, tax penalties, etc.
The strongest advice I can give you is to think about taxes first when making a decision about selling your business. Do the preparation well in advance – at least five years – so that you don’t end up with a huge tax bite after the sale is complete.