We hear it all the time. A business owner comes in and wants to sell their business for $5 million. Or $10 million. Or even upwards of $25 million. Regardless of the amount an owner needs to retire with, all the focus on exiting their business boils down to sale price.
Unfortunately, the actual sale price creates an incredibly poor indication of what you walk away from the table with. While you may sell the business for $10 million, once it goes through taxation, giving Uncle Sam his fair piece for watching you do all the work, you’re only going to see a small portion.
The tax ramifications add up.
One area that highly influences the rate in which you fork money over to the government hinges on entity type. Depending on which type of entity your business is, you may be swallowing that tax bill twice.
Defining an Entity
When you create an official entity, such as a corporation, the government views the business as its own “person.” This new “person,” or business, is assigned its own business social security number (EIN) and is obligated to pay taxes on profits. The main reason people form entities for their business is to create legal protections. For example, should your corporation be sued, you are not personally liable for damages.
As tax law has evolved, there are different rules and classifications for entity types.
Corporations and the Double Tax
The government likes to get their hand in the pot whenever they can. When it comes to corporations, they double dip into the owner’s profit.
Here’s how: When you own a corporation that makes money, the corporation is taxed on the profits at the corporate tax rate. Then, when the profits are distributed to the owner or shareholders, the receiving parties must pay personal income taxes on those monies again.
If the corporation is taxed at 35%, and your personal tax rate is 25%, you’re effectively paying 60% in taxes.
The same is true when you sell the business as an asset sale. The corporation recognizes the profits from the sale of the business, which creates a taxable event at the corporate level. Then when the profits from the sale are distributed to the owner(s), it activates another personal taxable event. One transaction results in two taxable events.
Corporate Entity Work Around
If the thought of ponying up twice to the government is making your skin crawl, know there is another option for corporations. When you own a corporation, you actually own shares of the company. To make the example simple, let’s assume you own 100% of the shares.
When you personally sell the shares of a business, you are only taxed on the gain of the shares at the individual level only, not at the corporate level. The business doesn’t pay corporate income taxes when ownership of shares transfers hands. It’s the same as when you buy or sell stock in the stock market.
So instead of selling your business in the traditional asset sale method, you can actually sell off all of the shares of the business. This is called a stock sale. It’s one transaction with one taxable event.
Let’s say you sell 100% of the shares for $1 million. Since your selling the shares personally, there will be no corporate tax applied. Instead, you will pay your personal tax rate. If that’s a 25% tax rate, you’ll only pay $250,000 compared to the potential $600,000 through the traditional model.
This option doesn’t come without limitations and drawbacks.
When you do an asset sale, typically the new owner forms a completely new business entity, purchases all the assets from your company, and transfers the name and brand equity to the new business entity. In essence, the new business is an identical twin. The business looks exactly the same but has a different EIN.
The important aspect falls to the fact that while it looks the same and serves the same need in the marketplace, all the liability associated with the previous business entity is washed away. When you sell off the shares of a company, the buyer maintains all the liability, which causes a big dip in price. The good news: that adjusted price only gets taxed once.
S-Corps, LLCs and the Tax Break
At some point, someone in the government realized the hurdle they created for small business owners desiring corporate legal protections but unable to pay twice on taxes. Thus the creation of Small Business S-election for tax filing. This gives small business owners the ability to maintain the corporate legal protections but when filing for tax purposes the profits are all pushed to the individual level only. Rather than taxing both the business entity and the owner, S-Corps give business owners the ability to combine both personal and business taxes into the owner’s personal taxes.
When it comes to a business exit and taxes , S-Corps and LLCs are viewed in the same light.
Rather than the proceeds from the business sale being taxed twice, S-Corps and LLCs roll the profits into the owner’s personal taxes. For example, if the owner sells their business for $1 million while in a 25% tax bracket, the tax bill will roll in at $250,000. As with the traditional sale of a corporation, the new owner creates a new business entity to remove any lingering liability from the previous owner.
Importance of a Tax Strategy Going into the Sale
No business owner wants to send off the majority of their profits to the government. They’ve worked too long and hard to end up with pennies. In order to achieve a successful exit, one where you take home more of the profits from the sale of your business than Uncle Sam, it’s essential to create an exit plan with built-in tax strategies.
Regardless of if you are a C-Corp, S-Corp or LLC, there are different measures or ways of structuring the deal that limit your tax bill. The key is to implement them.
At Exit Consulting Group, we help mid to large sized businesses develop and execute strategic exit strategies. If you are thinking about retiring or passing the business on in the few years, call us today. Together we can work to ensure you realize the most profitable exit possible.