The High Stakes of Selling Your Business

How Allocation in an Asset Sale Can Impact Your Tax Bill

When the time comes to sell a business, most entrepreneurs are focused on striking a deal that reflects the value they’ve built over years and years of hard work. However, one major issue usually goes unnoticed until it’s too late: The tax implications tied to how your sale is structured. This oversight can lead to significant financial consequences.

You need to recognize the importance of understanding asset allocation before finalizing any sale. This will be the difference between a tax-savvy transaction and an avoidable financial misstep that could have repercussions for years to come.

Asset vs. Stock Sales: Knowing the Basics

First, you should know there are two primary ways to sell a business: as an asset sale or a stock sale. An asset sale involves selling the tangible and intangible assets of the company — everything from computers and furniture to intellectual property and customer lists. Conversely, a stock sale means selling the ownership shares of the business itself.

Ask any broker and you’ll learn asset sales are by far the most common in small businesses. And in an asset sale, it will matter how you allocate the value of those assets. Depending on how you do it benefits either the buyer or the seller.

The Role of Goodwill

One of the most significant components of an asset sale is Goodwill, which represents the intangible aspects of the business; things like brand, reputation, and customer relationships. Goodwill carries substantial weight in how taxes are calculated.

Goodwill is taxed at a more favorable rate. If a larger portion of the asset sale is allocated to Goodwill, you’re going to have a lower tax liability compared to tangible assets.

Why Asset Allocation Matters

To make things easy, let’s look at the hypothetical sale of a business for $1 million to illustrate what’s at stake. If $900,000 of the sale price is allocated to Goodwill, that portion benefits from long-term capital gains tax rates. In contrast, if $900,000 is assigned to physical assets like machinery or equipment — assets that may have been depreciated over time — then the seller could face recapture rules that classify this income as ordinary income. Ordinary income is taxed at higher rates than long-term capital gains.

As a seller, you’ll want to maximize the portion of the sale tied to Goodwill.

The Buyer’s Perspective

Buyers, on the other hand, have an incentive to push for a higher allocation of the purchase price to tangible assets. The reason? They can often depreciate those assets quickly, sometimes even in the first year, which provides them with immediate tax benefits.

Goodwill is usually amortized over 15 years. This means it takes much longer for the buyer to recoup that investment through tax deductions.

A Balancing Act

Negotiating asset allocation often becomes a tug-of-war, with sellers aiming for a high Goodwill valuation and buyers seeking to maximize the tangible asset value. However, the IRS only steps in to ensure that both parties are consistent in how they report the allocation. This means that any discrepancies between the buyer’s and seller’s reported values can lead to scrutiny or penalties.

The Importance of Legal Documentation

You’re going to need meticulous documentation. Your attorney should clearly outline the asset allocation in the sale agreement. If the business is sold for $1 million, it should be broken down: $100,000 to equipment, $900,000 to Goodwill, or whatever the agreed-upon values are.

Having this breakdown included in the contract can prevent costly headaches down the road. Without it, you might find yourself scrambling after the sale to agree on allocations — an unenviable situation that often leads to financial repercussions.

Final Thoughts

The bottom line? Before you sell your business, prioritize the tax implications of asset allocation. Consult with your attorney and CPA to ensure that the sale agreement reflects a strategic distribution of assets. This proactive step will safeguard your earnings and set the stage for a more financially secure future. It’s better to address these details before the deal closes. After the fact? Good luck.

(*Are you considering exiting your business? Get help selling here.)

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