Structuring the Sale When Selling a Business

Selling a business involves numerous steps, including assessing its value, listing it for sale, managing offers, and successfully completing due diligence. As you approach the final stages before closing the deal, the focus shifts to structuring the sale. The seller must meticulously negotiate and agree upon four variables:

• What you are selling.
• The price.
• How the price is allocated among IRS asset classes.
• How the price will be paid, which is called the payment structure.

Determining What You Are Selling: Asset Sale vs Entity Sale

There are two kinds of business sales: asset sales and entity sales, which are also called stock sales. Each form of business sale has distinct advantages for the buyer and the seller, but rarely the same advantages for both.

Asset Sales

In an asset sale, the seller keeps the actual, legal structure of the business, called the business entity, and sells only the tangible and intangible assets of the business, which the buyer moves into a newly formed business entity.

If you are selling a sole proprietorship, without question yours will be an asset sale because sole proprietorships have no stock to sell. The sale of a corporation or LLC, however, can take the form of an asset sale or an entity sale, and so the structure becomes a point of negotiation.

Benefits to a seller in an asset sale include:

• Nonessential assets can be excluded from the sale, such as cash, investment accounts, vehicles, equipment, and other assets for which the buyer may not want to pay.
• Valuable assets can be retained by the seller and leased back to the business. For example, if a seller owns the building the business is in, the seller might retain the asset, therefore avoiding taxes that would result from its sale – and also generating future income from a lease or lease-purchase agreement with the new business owner.
• A portion of the purchase price can be allocated to goodwill, which is treated as a capital gain and taxed at a rate currently substantially lower than the tax on ordinary income.
• Due diligence is less time consuming or intensive because the buyer does not need to search for potential liabilities.

Benefits to a buyer in an asset sale include:

• The buyer purchases only assets and specifically listed liabilities. Responsibility for any hidden or unanticipated liability that arises after the sale remains with the seller.
• The buyer can exclude nonproductive or nonessential assets from the purchase.
• The buyer does not acquire the depreciation history of the business. In an asset sale a good portion of the sale is usually allocated to the purchase of equipment, which is acquired at the stepped-up basis – the price at which they were purchased. The buyer, the new owner, can begin depreciating those purchased assets and realizing tax deductions that reduce reported earnings and, therefore, taxes.

Entity Sales

In an entity sale, the owner of a corporation sells its stock – or the owner of an LLC sells its member shares – to a new owner. With the sale of the stock or shares, the buyer acquires all the assets and all the liabilities of the corporation or LLC, except liabilities that are specifically listed as exclusions.

CAUTION: Be aware that while entity sales are taxed at preferential capital gains rates, if the business being sold is a C corporation, it can result in what is called double taxation. First, the business pays tax on gains from the sale. Second, the owner or owners are subject to a second tax when the proceeds are distributed to them, this time as ordinary income. However, if the business is an S corporation, business income passes through directly to shareholders and is taxed only once.

Obtain tax advice well in advance of the sale regarding the possible benefit of converting a C corporation to an S corporation. The conversion comes with a lineup of conditions and complications. The tax benefits are often well worth considering, but do not consider going forward without legal and accounting advice.

Benefits for the seller in an entity sale:

• Entity sale proceeds are taxed at the capital gains rate, which is currently considerably lower than proceeds taxed as ordinary income.
• In an entity sale, liabilities transfer to the buyer unless they are specifically excluded. This eliminates the seller’s risk of responsibility for an unforeseen liability that arises in the future. In an asset sale, responsibility for unforeseen liability remains with the seller.

Benefits for the buyer in an entity sale:

• In an entity sale, leases and contracts transfer with the sale. Because contracts, even government contracts, were with the business, they remain with the business as part of the entity sale. In an asset sale, the business is being dissolved and each contract must be transferred to the new owner, sometimes involving renegotiation and, as a result, sometimes less favorable terms.
• An entity sale delivers the buyer a future tax advantage when and if the business is again sold as an entity. During a future sale of the business, the difference between what the owner paid to buy the business – the owner’s basis in the business – and the amount paid by a new owner, would be taxed as a capital gain rate rather than as ordinary income.

Most buyers prefer asset sales, primarily because in an asset sale the buyer avoids the risk of inheriting hidden liabilities, and also because assets can be quickly depreciated, resulting in lower reported earnings and taxes.

Most sellers prefer entity sales over asset sales, primarily due to tax advantages.

During buyer-seller negotiations that result in agreement to an asset sale, sellers aim to arrive at a price and price allocation that offsets the accompanying tax concessions.

Negotiating the Selling Price

In the letter of intent, the buyer and seller agreed to a selling price, but after due diligence and after negotiations leading to an agreement either to an asset sale or entity sale, almost certainly the initially presented price of the business will be adjusted.

Price adjustments will reflect some or all of the following considerations:

• The higher or lower value placed on business assets following the due diligence examination.
• The amount of cash required at closing. Higher amounts due at closing, up to an all-cash payoff, are often accompanied by the buyer’s effort to negotiate a lower price.
• Items excluded from the purchase. To accept a lower price, sellers may exclude assets that can be sold separately or leased back to the buyer.
• The seller’s ongoing involvement with the business. Sometimes, in return for accepting a lower price, a seller agrees to sign and accept future compensation through a management contract. The upside for the buyer is the chance to pay some of the purchase price as a business expense that lowers taxable business earnings. The downside for the seller is that compensation will be taxed as ordinary income. Negotiating employment benefits and perks may offset the negative tax implications.
• How the purchase price is allocated among IRS asset classes. A seller might agree to a lower price if a good portion is allocated to asset classes taxed at capital gains rates rather than as ordinary income. The buyer might agree to a higher price if a good portion is allocated to asset classes that result in the fastest possible tax write-offs.

Allocating the Purchase Price

At this point in negotiations, advice from your accountant and your buyer’s accountant will be necessary and valuable.

Before closing can take place, you and the buyer must agree on how the purchase price will be allocated among seven IRS asset classes. After the sale, the IRS requires that you both file the identical price allocation using Form 8594, “Asset Acquisition Statement.”

• Make purchase price allocation part of your negotiations well before closing day, when the allocation will be included in your closing documents.
• Realize that the IRS requires that the purchase price be allocated among the seven asset classes described in the following section. Also be aware that the IRS can challenge the price allocation, for example by questioning the fair market value of tangible assets or the value placed on intangible assets. For that reason, professional valuations are important for complicated assets.

IRS Asset Classes

The first three asset classes, Class I, II and III, include cash and bank deposits, securities including certificates or deposits, and accounts receivable. Allocations to these categories are not a point of negotiation because they are straightforward to calculate and often not included in the purchase, and therefore have no tax impact.

How the price is allocated to each of the other classes, however, is usually highly preferred by the buyer or highly preferred by the seller, but rarely highly preferred by both, due to tax ramifications. Seek your accountant’s advice before negotiating or agreeing to allocations.

• Class IV - Stock in trade or inventory, usually valued at original cost or at a defensible fair market value. Buyers often prefer as high an allocation as possible to this asset class, which will qualify as business expenses or for short-term depreciation.
• Class V - Other tangible property, including fixtures, furnishings, real estate, vehicles, equipment, and other physical assets, is usually valued at current market replacement value. Buyers prefer a high allocation to physical assets that qualify as business expenses or for short-term depreciation (however, if the buyer must pay sales tax on the assets acquired, the tax may offset the depreciation benefit). Sellers prefer a lower allocation, unless the tangible property includes appreciated assets that have been held long term and qualify for taxation as capital gains.
• Class VI – Intangible property. This asset class covers the value of the operation of the business, including its systems and procedures, intellectual property, customer lists, business books and records, and other assets detailed in IRS Form 8594 instructions. It does not include the value of goodwill or going concern value of the business, which is covered in the next and final asset class.
  
  These assets are frequently purchased in return for a covenant not to compete – a non-compete agreement – and/or a personal services contract. If payment is made in return for a personal services contract, the buyer can deduct the payment as a business expense, while the seller receives the payment as ordinary income. If payment is made in return for a non-compete agreement, the payment must be amortized over 15 years, making it less attractive to sellers and more attractive to buyers.

• Class VII – Goodwill and going concern value. Arriving at the value allocated to this asset class is the result of math and negotiation. The most that can be allocated is the purchase price of the business minus the agreed-upon amounts allocated to the previous six asset classes. The seller will want to allocate as much as possible to goodwill, because the proceeds will likely be taxed as capital gains.

Agreeing to the Payment Approach

There are various payment approaches that finance business sales: Third-party financing, SBA 7(a) loans, home equity loans, stock exchanges and – the most common – seller financing in which the buyer makes a closing-day payment, and the seller agrees to accept the remainder over time.

The letter of intent to purchase that the buyer and seller agree upon states the purchase price, payment structure, and payment conditions of the proposal, including whether the purchase would involve all-cash payoff at closing or, more likely, a closing day payment with the balance paid over future years.

It is now time to structure how the payoff will take place, which involves both negotiation and tax implications.

The two most common options include:

• Cash down plus a seller-financed note. The upsides to this approach include tax advantages for sellers, allowing the sale proceeds to be spread over several years and avoid the tax impact of a one-time payoff. Plus, sellers will receive interest income on which you will pay taxes but over the duration of the loan.
  
  The risk is that the buyer could default, and by that point the business could be devalued of the inventory, physical assets, or going-concern value it had on closing day.

• Deferred payments through an earn-out. An earn-out is an agreement that the seller will accept part of the purchase price based on how well the business does in the future. It reduces the buyer’s requirement for cash on closing day. It also enhances business attractiveness by demonstrating the seller’s faith in the future of the business.
  
  The risk is that earn-out payments are subject to default if the new owner fails at sustaining the business. Especially if you feel the new owner will grow the business, an earn-out is an attractive payment approach. It provides a negotiating chip that can protect sale pricing while also spreading income over future years and likely providing a tax advantage.
  
  The earn-out must be defined in the purchase and sale agreement, including when payments are to be made (typically quarterly, semiannually, or annually), how they are to be calculated, and whether earn-out payments are subject to maximum and minimum amounts, often referred to as caps and ceilings. Most agreements stipulate “calculations must be made by an independent certified public accountant mutually agreeable to the parties.”

Navigating the sale structure involves careful negotiation of what, how, and when. Seek professional advice to optimize tax implications and ensure a smooth transition for both parties. Visit the BizQuest Broker Directory to find a business broker to help you structure the sale of your business.