BUYING OR SELLING A BUSINESS?
Key Principles and Insights
GEORGE WILSON ADAMS CPA MBA
June 25, 2024
Introduction
In these tumultuous times more and more people are buying and selling businesses. This phenomenon runs parallel to the recent buzzing market in residential real estate sales.
People buy businesses because they want to buy a job and be their own boss, among many other reasons.
People sell a business because they want to retire, or are sick, disabled, or want to leave Maine.
This article will explain in simple terms the most important income tax considerations that apply to buying and selling a business.
Key Insights for Buyers
Buyers will purchase an existing business to avoid the headaches and effort of creating a new business from scratch. Here are key points every buyer must consider:
(1) Check out what you are buying. Perform reasonable due diligence by examining the tax returns, sales tax reports and bank statements for any business you are thinking about buying. Ask the seller to “show you the money.” This means not just business revenue, but, more importantly, business profit. Revenue is a poor indicator of the health and vitality of a business. There are companies out there with billions of dollars in annual sales who have huge losses every year.
(2) Buy assets. Every business purchase can be accomplished in one of two ways: buy the assets of the business including any real estate, equipment, inventory and goodwill. Or, alternatively, buy stock which gives you ownership of the business. For buyers, a stock purchase is a bad idea because you will not be able to claim a tax deduction for equipment purchased. Further, you will step into the seller’s shoes with regard to any environmental or other legal liabilities facing the company. An asset purchase provides a clean start for a buyer.
(3) Allocate purchase price. One of the most important elements of your negotiation with the seller will involve allocation of sale price for tax purposes. Most people simplistically think negotiation is just about the purchase price. This is false. Both Buyer and Seller must formally agree on how to allocate sale price on IRS Form 8594.
Purchase price is typically allocated to the following categories of assets:
Real Estate – use the appraised value of real estate if an appraisal was performed. (Make sure an appraisal was performed, or at least obtain a Brokers Price Opinion from a realtor.)
Inventory – allocate sale price equal to the wholesale (not retail) value
Equipment – Buyers should maximize dollars allocated to equipment. In most cases (per current tax law as of June 25, 2024) the buyer may claim the entire amount allocated to equipment as a depreciation deduction in the year the business is purchased. This generates a potentially huge tax benefit to the buyer.
Goodwill/Customer Lists – the Buyer will amortize the cost of goodwill and other so-called intangible assets over 15 years per IRS rules. This is not a great result for the buyer. Beware of idiots who talk about the "anti-churning" rules of IRC Section 197. The most expensive things in this world are stupidity and ignorance.
Key Insights for Sellers
The interests of buyers and sellers are adverse. What’s good for the buyer is generally bad for the seller, and vice versa.
Operationally, here are some key insights for sellers of a business:
(1) Clean up your books. Line up all your ducks, including important business records buyers will want to look over as a part of the ordinary diligence practiced when buying something important. Tax returns and related records for at least the past three years should be readily available. It's a wonderful thing to have CPA compiled or reviewed financial statements for the past three years. A full blown audit is generally not needed and the cost of an audit is astronomical.
(2) Get a business valuation. Regardless of whether or not your business has real estate you should obtain a business valuation report from a competent, experienced CPA. This report will provide a rough estimate of the value of your business based on cash flows, assets and overall business performance.
Real estate is a separate matter. If you are selling real estate in addition to an operating business obtain a real estate appraisal from a qualified appraiser.
(3) Get a tax projection. Here again accountants can provide valuable information to keep sellers out of trouble. The sale of a business is a taxable event. It is crucial that seller’s know what their tax exposure will be prior to executing a transaction. Taxes will have a profound effect on the sales price the seller must charge. Every seller must set their sale price at least equal to an amount that will generate sufficient funds to pay off all business debt and also pay off all taxes due from the sale.
(4) Try to sell stock. A stock sale is the most tax advantaged way for seller’s to sell their business. Gain from selling stock is generally taxed as capital gain, subject to 15% federal tax (plus Maine tax.) In some scenarios the capital gain rate could be as high as 23.8%. But this is still far better that ordinary tax rates (as high as 40.8%) that may apply to gain from selling assets.
The sale of business real estate is usually subject to Section 1250 recapture tax of 25%.
(5) When it comes to allocating sale price to categories of assets and filling out IRS Form 8594, seller’s should maximize the amount allocated to goodwill and other intangible assets. The sale of such assets generates capital gain taxed at the lowest rate – usually 15%.
The Process
In a nutshell, here is the process both buyers and sellers must go through to achieve a successful transaction:
THINK
CALCULATE
NEGOTIATE
REPEAT THE ABOVE AS NEEDED UNTIL YOU REACH A DEAL
Some people accuse me of building an encyclopedia of tax, business and accounting knowledge here on my website. Guilty as charged! Here are links to related articles I have written that bear on this subject:
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339
©2015 Copyright George Adams CPA MBA. All Rights Reserved.
