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March 8, 2021

Buying or Selling a Business: What Are the Tax Implications?

tax implications

In many industries, merger and acquisition activity slowed in 2020 due to COVID-19. However, analysts expect things to improve as the country emerges from the pandemic in 2021. If you’re thinking about buying or selling a business, you’ll want to make sure you understand the tax implications.

Arranging a deal

There are two basic ways a transaction can be arranged under current tax law:

1. Stock (or ownership interest)

If the target business operates as a C or S corporation or partnership—or if it operates as a limited liability company (LLC) that’s treated as a partnership for tax purposes—a buyer can acquire a seller’s ownership interest directly.

Currently, a 21% corporate federal income tax rate means that buying the stock of a C corporation is somewhat more enticing, because the corporation will pay less tax and generate more after-tax income—any built-in gains from appreciated corporate assets will also be taxed at a lower rate if and when the corporation is sold later on.

Because of the current law’s reduced individual federal tax rates, the passed-through income from these corporations is also taxed at lower rates on the buyer’s personal tax return—another reason why ownership interests in S corporations, partnerships, and LLCs have also become more desirable.

However, keep in mind that with Democrats in control of the White House and Congress, business and individual tax changes are likely in the next year or two. Current individual rate cuts are scheduled to expire at the end of 2025—and they might be eliminated earlier, depending on actions in Washington. President Biden has also proposed increasing the tax rate on corporations to 28% and increasing the top individual income tax rate from 37% to 39.6%.

2. Assets

Buyers can also purchase the assets of a business. A buyer may wish to do this if they only want specific assets or product lines—and if the target business is a sole proprietorship or a single-member LLC that’s treated as a sole proprietorship for tax purposes, purchasing assets is the only way of acquiring the business.

Buyers’ preferences

For many reasons, buyers tend to prefer to buy assets rather than ownership interests. A buyer’s primary goal is to generate enough income from an acquired business to pay the acquisition debt and provide a strong return on their investment. As such, buyers want to limit exposure to undisclosed and unknown liabilities and minimize taxes after closing a transaction.

To reflect purchase price, a buyer can “step up,” or increase, the tax basis of assets they’ve acquired. Stepped-up basis increases depreciation and amortization deductions and lowers taxable gains when assets such as receivables and inventory are sold or converted into cash.

Sellers’ preferences

Unlike buyers, sellers tend to prefer stock sales for both tax and nontax reasons. One of a sellers’ objectives is to minimize the tax bill from a sale, and that can usually be accomplished by selling their ownership interests in a business (such as corporate stock, partnership, or LLC interests) instead of selling assets.

When a stock or other ownership interest is sold, liabilities generally transfer to the buyer. And if the ownership interest has been held for longer than one year, any gain on sale is generally treated as lower-taxed long-term capital gain.

Seek professional advice

It’s important to know that other issues, such as employee benefits, can also cause tax complications in M&A transactions. Since buying or selling a business could be the largest transaction you’ll ever make, it’s important to seek professional help. After all, once a transaction is complete, it may be too late to get the best tax results. Contact us today for advice on how to proceed.

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