The Tax Trap: What to Know Before You Sign
The tax decisions that shape what you actually keep from a sale, and why most of them have to be made long before closing.
Please note: this is general education, not tax advice. Every deal has its own facts. Work with a CPA who has transaction experience before making any decision.
Asset sale or stock sale
This is often the most important tax decision in a deal, and buyers and sellers usually want opposite things.
Stock sale (sellers usually prefer)
- You sell your shares in the company
- Proceeds are generally taxed at long-term capital gains rates
- The buyer inherits the company's history and liabilities
- Simpler from the seller's side
Asset sale (buyers usually prefer)
- You sell the company's assets rather than its shares
- The buyer gets a stepped-up basis and new depreciation
- Some of your proceeds may be taxed at ordinary income rates
- The buyer leaves most historical liabilities behind
Many lower-middle market deals end up structured as asset sales because buyers prefer them. Your entity type (C corporation, S corporation or LLC) changes how much this costs you, which is one reason to plan early.
Purchase price allocation
In an asset sale, the price is split across categories of assets, and each category can be taxed differently. This is where planning can save, or cost, real money.
| What the price is allocated to | Typical treatment for the seller |
|---|---|
| Cash and receivables | Ordinary income |
| Inventory | Ordinary income |
| Furniture, fixtures and equipment | Mixed: depreciation recapture at ordinary rates, any remaining gain at capital gains rates |
| Real property | Mixed: recapture rules apply, remaining gain generally capital |
| Goodwill | Generally long-term capital gains, usually the best outcome for the seller |
| Non-compete agreement | Ordinary income, usually the worst outcome for the seller |
| Consulting or employment agreement | Ordinary income, and may carry payroll or self-employment tax |
Sellers generally want more of the price allocated to goodwill. Buyers generally want more allocated to assets they can depreciate quickly. It is a negotiation, and both sides' tax advisors will push.
The non-compete trap
Buyers will almost always ask for a non-compete. That is reasonable: they are paying for the business, not for you to open a competitor next door.
The trap is how much of the price is allocated to it. Money allocated to a non-compete is generally taxed as ordinary income, which is usually a higher rate than capital gains. Negotiate the allocation, and keep the non-compete's geography, length and scope to what is commercially reasonable.
Getting paid over time
If part of your price is paid later, through a seller note or an earnout, you may be able to use installment sale treatment and pay tax as you receive the money rather than all in the year of sale. Keep in mind:
- Spreading income can help if your income varies year to year
- You are extending credit to the buyer, so their ability to pay matters
- Not everything qualifies, and depreciation recapture is generally taxed in the year of sale
- Interest you earn on a seller note is ordinary income
State taxes
State tax can change your result significantly. Some states have no income tax; others tax capital gains at the same rate as ordinary income. If you are thinking about moving, residency rules are strict and timing matters, so plan it with your CPA well before closing.
Reinvesting gains
Some sellers look at reinvestment strategies, such as qualified opportunity funds, to defer or reduce capital gains. The rules are complex and change over time, so ask your CPA whether anything applies to you.
What to do now
- Bring in a CPA with transaction experience now, not at closing
- Estimate your tax under both an asset sale and a stock sale
- Model your net proceeds under different allocation scenarios
- Ask whether your entity structure should change before a sale; some changes need years to take full effect
- If you are considering a move, plan it well in advance
To see how taxes, fees and debt change a headline price, try the net proceeds calculator.