How to Structure the Sale of Your Business to Maximize Your After-Tax Gain

Selling a business is extremely exciting and often the realization of a dream years or decades in the making. Compared to other potential large payouts in life, such as the sale of real estate, selling a business can be quite complex.

There are many different ways to structure a transaction and each has aspects that can be optimized to minimize the tax on the sale. Here are a few different formats deals can take and what to keep in mind for each.

Outright Sale

The easiest agreement is an outright sale. The seller receives cash at close for the business, and the transaction is all recognized in the year of the sale. How this plays out depends a lot on the business entity you are selling and if you are selling assets or stock.

Selling stock of an S or C corp results in a capital gain for the seller, which is taxed at favorable tax rates for individuals. However, a buyer may want just the assets or selected assets of the corporation. In that case, the C Corp has to pay tax on the asset sale and the owners have to pay capital gains tax on the distribution, creating two layers of tax.

If you are selling partnership assets or S Corp assets, there is just one layer of tax because the shareholder or partner is the taxpayer (not the business entity). The sale of assets by an S Corp results in the same taxable gain as the sale of shares; however, the gain could be partially ordinary income, taxed at a higher rate.

The sale of partnership assets works the same as the sale of S Corp assets, one layer of tax. However, the sale of partnership units is not automatically taxed at capital gains rates. A rule exists that characterizes part of the capital gain to ordinary income on so-called "hot assets" such as inventory and accounts receivable.

The hidden gem for the sellers of C corp shares is the tax incentive for qualified small business stock. It allows individuals to exclude from taxable income the greater of $10 million or 10 times their basis when they sell originally issued shares. The exclusion does not exist for partners selling partnership units or shareholders selling S corporation shares and has various requirements, but when you qualify, it's huge. If you sell for $10 million, instead of paying $2 million to the federal government for capital gains tax, you pay nothing.

Earnout

An acquisition gets more complicated when the buyer is unsure of the value of the company they're selling, so the deal includes some cash upfront as well as an "earnout." An earnout triggers additional payments when earnings or other negotiated targets are met.

Earnouts can take place over the course of years, and it's important for you to consider how likely you are to hit the targets laid out in the deal. If you end up with just the cash on the table, is that going to be ok with you? Will you still be happy if you don't hit your earnout?

From a tax perspective, you want the earnout to be tied to the success of the business, and not to you specifically in any way. If the earnout has some tie into you as an employee — if you need to be employed by the company to earn it, for instance — then it becomes compensation, which is taxed at the ordinary income rate, nearly twice the capital gains rate.

Owning a Piece of the Buyer

Sometimes a buyer, such as a private equity firm, wants the seller to continue to have skin in the game. One way to do that is to offer the seller a minority ownership in the buyer as part of the sale.

When you receive stock, you're taxed on it. Let's assume you're paying 20% tax. If you get $10 million in cash, you pay the $2 million in tax and put the residual in your pocket. But if you also got another $10 million in stock, that would double your tax bill and eat into your cash portion of the transaction significantly, leaving you with $6 million in cash and $10 million in stock. In addition, you take on the investment risk of the stock that you are receiving.

There may be ways to structure the deal so you won't pay taxes on the stock. You may be able to defer it, for instance. If the buyer is a partnership, instead of selling 100% of your business, you can contribute a portion of it into a partnership tax-free and take back units in that partnership without paying tax on them. For the cash portion, you would continue to pay tax, but you would defer the tax on the component that you contribute and take back ownership in the buyer. In the example above, you would pocket $8 million in after-tax cash proceeds and the $10 million in partnership units with $2 million in tax that has been deferred until you sell the partnership units.

Another factor to consider when you take an ownership percentage in the buyer is that you built the company and ran it, but, following the sale, someone else is calling the shots. As a stockholder or partner, you still have to worry about the value of the company going up or down, but you have much less control over it than you once did.

The transaction market is hot right now because a number of forces have combined to make the market favorable to both buyers and sellers. The situation is fluid enough that the advice of a CPA familiar with your particular business is key. Your CPA should be involved throughout your sale process, projecting the gain and potential tax liabilities at the letter-of-intent phase through the completion of the sale.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.