08 Jan Early Stage, Step 16: Sale of business a taxing exercise
Editor’s note: This is the 16th in a series of articles on developing start-up companies in the technology or biotechnology sectors.
Madison, Wis. – Your business has been successful, and now someone wants to buy your company. There are several ways to do so, and they will be addressed over the next Early-Stage column or two. A key issue is the income tax consequences, so let’s first talk about income taxes. (Hereafter, taxes means only federal income taxes.)
Let’s assume you own 80 percent of the business entity with family members, with friends owning the remaining 20 percent. There are essentially two ways to sell your business. You can sell the ownership interests or you can sell the business’s assets.
If you sell the ownership interests, if that ownership interest is stock of a corporation, you are selling a capital asset for which you will be paying capital gains taxes on that sale. The gain is based on the difference between the sales price and what your tax basis is for those shares of stock. Tax basis is essentially what you paid for the ownership interest. However, it can be quite complicated if the business entity is an S corporation. So if you do not know what your “tax basis” is, then I suggest that you consult your tax advisor or tax lawyer.
Another option, if your entity is a corporation, is to trade the buyer for stock of the buyer’s corporation (whether it is publicly traded or not). When you trade stock for stock, this may qualify as a re-organization and may result in a “tax deferred exchange.” You will pay income taxes on this transaction when and if you sell the stock that you take in trade. Again, the gain at that time, that is when you finally sell it, will be the difference between the sales price and your tax basis.
The other option is to have your business entity sell its assets. (Hereafter, I will refer to the entity selling assets as an asset sale.) Selling a membership interest in an LLC is more like an asset sale because certain assets held within the LLC will cause the taxation of that sale of the ownership interest, generally a capital asset, to be taxed as ordinary income. When assets are sold, the entity, if that entity is a taxpaying entity for this purpose (a C-corporation or S-corporation with built-in gains) pays income taxes on the asset sale based upon the nature of the asset. That is, you will pay ordinary income taxes on the sale of ordinary income assets such as accounts receivable and inventory, while for capital gain assets such as equipment and the like you pay capital gains taxes.
With respect to capital gain assets such as equipment and real estate, there may be ordinary income elements based upon the nature of depreciation deductions you took on these assets or for other reasons. This can be quite complicated so, again, you should seek advice from your tax advisor. Suffice to say that when you sell assets for which you have taken depreciation, there may be ordinary income when you sell these assets later. Generally, the ordinary income is limited to the depreciation taken, so if you receive a sales price for those assets that is greater than what you originally paid for them, that element will be taxed as a capital gain. Again, this may be limited depending on what you may have previously done.
There are then assets that are always capital gain assets, such as goodwill. These assets will receive capital gains treatment, with some exceptions, to the extent you may have been allowed to amortize the acquisition of the goodwill. Also, some of what you are selling may include a non-compete and/or consulting arrangements. Payments on a non-compete agreement are capital gain assets while the payments on a consulting agreement are ordinary income. Again, this may become complicated as to whether the non-compete is with the business entity you are selling or personal to you.
So as you can see, it can be quite complicated to determine what your taxes are if you sell assets. If you sell stock, it’s quite simple. It is the difference between the sales price and your tax basis times the capital gains rate. For assets or the sale of ownership interests in a partnership or LLC, it is a complex mix. This will most likely require a consultation with your tax advisor.
Next time, we will address how to sell stock and how to sell assets.
Previous Early-Stage articles by Joe Boucher
• Joe Boucher: Early Stage: Step 15 – A license to sell
• Joe Boucher: Early Stage, Step 14: Strategic partnerships require legal protections
• Joe Boucher: Early Stage, Step 13: The advantages of leasing real estate
• Joe Boucher: Early Stage: Step 12 – Alternative forms of business finance
• Joe Boucher: Early Stage: Step 11 – Other forms of finance
• Joe Boucher: Early Stage 10: The nuances of federal laws
• Joe Boucher: Early Stage, Step 9: Raising capital in the securities landscape
• Early Stage, Step 8: Misclassifying workers brings risk
• Joe Boucher and Bonnie Wendorff: Early Stage 7, Part I: Just what is an employee?
• Joe Boucher: Early Stage: Step 6 – Taxes, taxes, taxes!
• Joe Boucher: Early Stage: Step 5 – Forming the entity
• Joe Boucher: Early Stage, Step 4: Cautionary trademark tales
• Joe Boucher: Early Stage, Step 3: Naming the entity
• Joe Boucher: Early Stage Step 2: Choosing a domain name
• Joe Boucher: Starting a tech business? Step 1 is minding the intellectual property
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