Many business owners wrongly assume that when they sell their business through an asset sale it will result in a tax rate to be nearly 50%. For example: if they sell their business for $2 million, they assume their after- net tax proceeds will be around $1 million. This misconception stems from the assumption that the tax rate on an asset sale of a business is equivalent to the ordinary income tax rate, which is the highest tax rate. However, this is not accurate.
In general, asset sales are subject to two types of tax rates. Tangible assets such as equipment and vehicles are taxed at the ordinary income tax rate based on the difference between the value assigned in the price allocation and the balance sheet value. On the other hand, Intangible assets including Goodwill, non-compete agreements, are typically taxed at the capital gains tax rate, provided the business has been owned for more than one year.
The allocation of value between goodwill and other intangible assets versus tangible assets like equipment is determined during the price allocation process agreed upon by the buyer and seller.
At Pacific Business Sales, as professional business brokers, we include Price Allocation as a key part of our closing process. Once Due Diligence is complete, we provide the Price Allocation to both the Buyer and Seller well ahead of the closing date. This allows ample time for both parties to consult with their tax advisors about the tax implications of the business sale.
It’s important to have your business broker collaborate with your CPA to ensure the Price Allocation is accurate and compliant, as it must be consistent for both the Buyer and Seller. Additionally, since the Price Allocation is often subject to negotiation, having professional guidance helps streamline the process and avoid potential conflicts.
About Price Allocation in an Asset Sale of a Business
The Price Allocation is required by the IRS for asset business sales and establishes the asset values for tax purposes. The Price Allocation must add up to the total purchase value and the values assigned to each asset which are negotiated between Buyer and Seller prior to closing. At closing an IRS form 8594 is filed with the IRS.
The Price Allocation determines the tax rates on the transaction for the Seller and the depreciation schedule on the assets for the Buyer.
For the Seller, goodwill and other intangible assets are taxed at the lower capital gains rate, while tangible assets are taxed at the higher ordinary income rate. For the Buyer, goodwill and intangible assets are depreciated over a 15-year schedule, whereas tangible assets typically have much shorter depreciation periods. Most small and midsize businesses have most of the value assigned to Goodwill and intangible assets and the tangible asset values are usually a small portion of the total value.
In most small to midsize business sales, most of the value is assigned to goodwill and intangible assets, with tangible assets representing only a small portion of the total value. Despite its importance, Price Allocation is often overlooked or not carefully coordinated with tax advisors.
It’s essential to discuss Price Allocation with your tax advisor early in the transaction process. By maximizing the allocation to goodwill and intangible assets, Sellers can reduce their tax liability, bringing the taxes on an asset sale closer to those of a stock sale when the allocation is favorable.
Why a Stock Sale is not necessarily All Capital Gains Tax Rate
A note regarding business stock sales: While it is true a stock sale is taxed at capital gains; certain transaction structures can result in the Seller being taxed on tangible assets.
In a typical stock sale, the Buyer inherits the balance sheet along with the depreciated values of the business’s assets. This means the Buyer often has little or no depreciation available for those assets going forward. To address this, there are two transaction structures—an IRS 338(h) (10) election and an F Reorganization—that allow Buyers to “step up” the asset values to their full market value, essentially treating the assets as newly acquired.
However, in these structures, the Seller may incur ordinary income tax on some of the asset values. These strategies are commonly used in stock sales, reducing the tax benefits typically associated with this type of transaction.
As a result, the tax difference between a stock sale and an asset sale is often minimal, especially when these structures are applied.
Tax Strategies to Further Reduce and Defer Taxes on the Sale of Your Business
Regardless of whether your transaction is an asset or stock sale there are numerous tax strategies that can further reduce and even defer taxes on the sale of a business.
These tax strategies are most effective for transactions over $1 million due to the fees involved in setting them up. Many of these tax strategies must be set up by a tax attorney to meet IRS rules.
Pacific Business Sales collaborates with experienced tax and financial advisors who are well-versed in business sale tax strategies and skilled in their proper implementation. If you need guidance, Contact us for a referral to our tax strategy advisor partners.
We strongly encourage all our clients to consult with their CPA and tax advisors about tax planning and strategies when preparing to sell their business and throughout the transaction process. If you don’t currently have a CPA or tax advisor with expertise in business sale tax strategies to help minimize or defer taxes, feel free to reach out for a referral to one of the experts we work with.
This blog is for informational purposes only and is not intended to provide tax or financial advice. Pacific Business Sales, its Broker, and its agents are not CPAs or licensed financial advisors.
Note that our firm, Broker, and agents do not accept any referral fees from the tax strategy advisors and CPAs we refer our clients to.
