The tax implications when selling a manufacturing business can impact your tax bill and therefore, your net proceeds from the sale. The way that a business (as well as the transaction) is structured needs to be considered before the sale. Here are some issues to think about:
Stock Sale vs. Asset Sale
If your business is a corporation (either an S corporation or a C corporation), deciding whether to structure the transaction as a stock sale or an asset sale may have a significant impact on its tax treatment. Generally, a stock sale is preferable from the seller’s perspective. That’s because when shareholders sell their stock, the profits generally are taxed at favorable long-term capital gain rates — currently a top rate of 20%, compared to a current top rate of 37% on ordinary income. In contrast, asset sales usually generate a combination of ordinary income and capital gains, depending on how the purchase price is allocated among the business’s various assets.
From the buyer’s perspective, on the other hand, an asset sale is usually the structure of choice. A buyer of stock generally inherits the corporation’s basis in its assets. If the corporation has already taken significant depreciation deductions on those assets, there may be little or no basis for the buyer to write off. But a buyer of assets generally receives a basis equal to the portion of the purchase price allocated to each asset, generating valuable tax write-offs.
The seller’s form of business is another important consideration. If the seller is a C corporation, for example, a potential drawback of an asset sale is double taxation.
First, the business pays corporate tax on any gains from the sale. Then the shareholders are subject to a second tax when the sale proceeds are distributed to them as dividends. (Note: It may be possible to defer the second tax by having the corporation hold and invest the sale proceeds.) Double taxation isn’t an issue for stock sales. The buyer acquires the stock directly from the shareholders, so there’s no entity-level tax.
Double taxation usually isn’t a concern for S corporations. As pass-through entities, their income is taxed directly to shareholders at their individual tax rates. So, there’s no entity-level tax, even if the transaction is structured as an asset sale.
There’s a possible exception for a business that had previously been taxed as a C corporation but later elected S corporation status. Depending on how much time has passed, asset appreciation during the business’s time as a C corporation may be subject to two levels of tax.
Partnerships (including limited liability companies taxed as partnerships) don’t have stock, but it’s possible for the owners to sell their partnership or LLC membership interests to a buyer. It’s important for the sellers to understand, however, that this isn’t the same as selling stock for tax purposes. A sale of partnership or LLC interests is treated essentially as a sale of the underlying assets, typically resulting in a mix of ordinary income and capital gain to the sellers.
Allocation of the Purchase Price
When a transaction is structured as an asset sale, the allocation of the purchase price among various assets has significant tax implications for both buyer and seller. Often, the parties have conflicting interests, which can lead to intense negotiations on this issue. Keep in mind that the parties’ allocation of the purchase price isn’t binding on the IRS, though the IRS generally will respect the parties’ agreement so long as it bears a reasonable relationship to asset values.
Sellers generally prefer to allocate as much of the purchase price as possible to goodwill and other intangible assets that generate lower-taxed long-term capital gains. And they prefer to allocate as little as possible to equipment and other depreciable assets. Why? Because previous depreciation deductions taken on these assets are subject to “recapture” at ordinary income tax rates. Buyers, on the other hand, prefer to allocate as much of the price as possible to these assets because they can depreciate them quickly or in some cases claim 100% bonus depreciation in the first year.
Knowledge is Power
The tax implications when selling a manufacturing business need to be addressed in advance of signing the papers. Assessing the impact of various transaction structures and purchase price allocations on your net proceeds from the sale can potentially allow you to adjust the purchase price accordingly. Our manufacturing and business tax specialists can guide you through the complexities and tax implications when selling a manufacturing business. Talk to a member of our Manufacturing Team to explore the available options.