Many people spend long hours starting their business. But what about exiting a successful business? Creating a strategy to exit takes the same dedication given to the business over the years.

One common option is a sale of your business to a third party. In this situation, it’s important to know the tax implications of a business sale.

Valuation Process

Start by obtaining a professional valuation of your business to understand what it’s currently worth, including the factors that drive value and weaknesses that reduce it. Then you can make changes to potentially increase the selling price.

For example, if the valuator finds that the business relies too heavily on your management skills, bringing in new management talent may make the business more valuable to a prospective buyer. A valuation can also reveal concentration risks. For instance, if a significant portion of your business is concentrated in a handful of customers or one geographical area, consider steps to diversify your customer base.

Sale Structure

Corporate sellers generally prefer selling stock instead of assets. That’s because the profit on a stock sale is generally taxable at more favorable capital gains rates, while asset sales generate a combination of capital gains and ordinary income. For a manufacturer with large amounts of depreciated machinery and equipment, asset sales can generate significant ordinary income in the form of depreciation recapture.

In addition, if your company is a C corporation, an asset sale can trigger double taxation: Once at the corporate level and again when the proceeds are distributed to shareholders as dividends. In a stock sale, the buyer acquires the stock directly from the shareholders, so there’s no corporate-level tax.

Conversely, buyers typically prefer to buy assets, especially when purchasing equipment-intensive businesses, such as manufacturers. This provides the buyer with a fresh tax basis in the assets for depreciation purposes and allows the buyer to avoid assuming the seller’s liabilities.

Purchase price allocation

Given the significant advantages of buying assets, most buyers are reluctant to purchase stock. But even in an asset sale, there are strategies a seller can employ to minimize the tax hit. One is to negotiate a favorable allocation of the purchase price. Although tax rules require the purchase price allocation to be reasonable in light of the assets’ market values, the IRS will generally respect an allocation agreed on by unrelated parties.

As a seller, you’ll want to allocate as much of the price as possible to assets that generate capital gains, such as goodwill and certain other intangible assets. The buyer will prefer allocations to assets eligible for accelerated depreciation, such as machinery and equipment. However, depreciable assets are likely to generate ordinary income for the seller.

Allocating a portion of the purchase price to goodwill can be a good compromise between the parties’ conflicting interests. Sellers enjoy capital gains treatment, while buyers can generally amortize goodwill over 15 years for tax purposes.

If your company is a C corporation, establishing that a portion of goodwill is attributable to personal goodwill — that is, goodwill associated with the reputations of the individual owners rather than the enterprise — can be particularly advantageous. That’s because payments for personal goodwill are made directly to the shareholders, avoiding double taxation.

You can transfer personal goodwill to the buyer by executing an employment or consulting agreement that defines your responsibility for ensuring that the buyer enjoys the benefits of your ability to attract and retain customers. The buyer may want a noncompete agreement. These are common in private business sales and can help protect the buyer from competition from the seller after the deal closes.

The Future is Now

Exiting a business you’ve created can be hard. It may take some time to put your exit plan in motion. Contact your CPA to help develop a strategy that minimizes taxes and maximizes value.

For more information, contact Adam Pechin at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group. Sign up to receive our blogs, newsletters and Client Alerts.