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How to sell a small business
What you should know about taxes, deal structure and getting paid

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What you should know about taxes

Excerpt from The Business Sale System: Insider Secrets To Selling Any Small Business

In any business sale, there’s another party besides the buyer and seller with a big financial stake – the government. Minimizing taxes plays a major role in structuring and negotiating a deal. Many promising deals have fallen through because the buyer and seller couldn’t agree on how to structure the deal to minimize taxes.

Tax laws are complex and ever changing. But here is a brief summary of some of the major tax implications of selling your business.

If your company is set up as a sole proprietorship or partnership, you will be selling the assets of the company. Although there are some technical differences, the income from the sale of your business will flow through into your personal tax return in a similar fashion as it does now.

If your company is an S-Corporation or LLC Corporation, you can choose to sell either the assets or the stock of the corporation. Because the income flows directly into the stockholders’ personal income in these types of corporations, a stock and asset sale yield similar taxation, so the asset vs. stock decision is usually made for non-tax reasons. If you own an S-Corporation/LLC, you have some flexibility from a tax standpoint in whether you sell stock or assets.

C-Corporations are a tax nightmare for the seller if assets (not stock) are sold. If you are selling a C-Corporation, for all practical purposes you must sell the stock, not the assets. If you sell the assets, the corporation will have to pay tax on the sale, then you will personally pay tax again on the after-tax amount you remove from the corporation. For example, let’s use a combined state and federal tax rate of 40% for the corporation and individual. For each $1,000 in assets sold, the corporation pays $400 in taxes and keeps $600. Then the corporation pays you $600, but you must pay $240 in taxes. You are left with $360 – so the total tax rate is 64%.

While an asset sale is a tax nightmare for the seller of a C-Corp, a stock sale can be a nightmare for the buyer. By definition, the buyer of stock assumes all liabilities of the corporation, both on and off the balance sheet. If a lawsuit that nobody foresaw comes up three or five years from now, it’s the buyer’s problem. That understandably makes buyers extremely nervous about buying stock. The buyer also loses a lot of tax advantages that an asset purchase carries with it. In an asset sale, assets can be depreciated starting from the buyer’s (high) basis – if it’s a stock purchase, the buyer can only depreciate assets starting from the seller’s (already depreciated and usually low) basis.

Regardless of the legal form of business, there are two tax considerations for all sellers. First is how income is taxed – as personal income or capital gains. With long-term federal capital gains rates at 20% and top personal income rates over 30%, this can be an important factor. The other consideration is when income is earned (and taxable). There are methods (see the articles below) for structuring payments that can help the buyer and seller to work out a mutually agreeable payment structure for tax purposes.

With the importance of tax considerations, your accountant and/or tax attorney should play a major role in helping you plan the sale. A good professional tax advisor is a necessity in selling a business.

About the author: James Laabs is an experienced business seller and author of the book The Business Sale System: Insider Secrets To Selling Any Small Business (First American Publishing) Click here to find out how to buy the book.

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Powerful deal structure and financing techniques

Excerpt from The Business Sale System: Insider Secrets To Selling Any Small Business

It comes as a shock to some small business sellers, but a 100% cash sale where the seller receives a huge check at closing, turns over the keys to the buyer and walks away rich and carefree is an extremely rare exception. Almost all businesses that are sold require the seller to “carry paper,” in other words, loan the buyer a substantial portion of the sale price.

The plus side of this fact of life is that it allows a great deal of flexibility in structuring and financing a business sale. An all cash sale would probably create serious tax problems for the seller – not an entirely bad problem to have, but a problem nonetheless. Using a partial cash deal plus some of the techniques below can help the seller as well as the buyer, by reducing the seller's tax bite. This article lists some financing methods that have been successfully employed in business sales.

Installment purchase: The buyer puts up anywhere from 20% to 50% of the price and the seller receives a note for the balance. Payments are made monthly or quarterly and include interest on the loan. The loan should be secured by company assets or stock and a UCC filing should be made with the local secretary of state. Sellers usually prefer a contract for deed to a mortgage, because they can get the business back more quickly if the buyer defaults. The buyer should also sign a personal guarantee, which allows the seller to pursue the buyer’s personal assets in event of a default. Sellers often have a (legitimate) fear that the buyer will run the business into the ground, default and leave the business owner with a company worth much less than it was sold for. Getting a personal guarantee allows the seller to go beyond business assets and it is highly advisable in smaller transactions where the buyer’s personal assets are valued at a substantial part of the sale price.

Balloon payment: A balloon payment eases the cash flow burden on the seller by delaying payment for a number of months or years. Instead of a monthly payment of $5,000 over three years, the seller may accept a balloon payment of $180,000 at the end of three years. Balloon payments are riskier because the seller is in suspense whether the buyer will pay for a long time period. With a monthly payment schedule, if the buyer starts missing payments, the seller can take corrective action immediately.

Stock sale: If your company is purchased by a corporation with publicly traded stock, you may be offered stock in lieu of cash. Stock can be risky because it often is not as liquid as it seems upon first glance. In order for stock to be sold, it must either be registered with the SEC or held for a minimum of two years. Registration is a costly procedure so it is likely the seller will need to hold the stock for two years and absorb whatever changes the market inflicts on it. Another problem with stock is liquidity – can the stock be sold quickly, in large chunks, with little impact on the stock’s market price? I was once offered stock in a public company that had an average daily trading volume of about $2,000. Imagine how difficult it would be to sell a million dollars worth of stock when the whole market only trades $2,000 of it each day! Certainly, stock can be a portion of a deal – but the deal should also include cash and you should check carefully to make sure the stock is high in quality and liquidity.

Earn-out: Buyers and sellers often disagree about the certainty of the rosy future the seller projects. The solution is an earn-out, in which the buyer pays the seller a “bonus” based on future company sales. An earn-out should be based on sales (not profits) and is typically pegged at increases over either current sales or some pre-determined sales level. An earn-out is a good way to increase the total selling price of the business, especially if the seller is confident of future sales and the new owner’s management ability.

Covenant not to compete: The total price of the business is often spread over several payment types, to assist both the buyer and seller in minimizing taxation. Almost every buyer would like an assurance from the seller that they won’t open up a similar business immediately after selling. This can be earmarked in the sale price as a covenant not to compete – the buyer can then amortize this amount over 15 years on their taxes. Note that the actual term of the non-compete is usually much shorter than 15 years – it is more likely to be 5 or 7 years.

Employment agreement: An employment agreement is a personal services contract. It allows the buyer to write off payments as a payroll expense and, although the seller must declare it as regular income (not lower taxed capital gains) it also may hold some benefits to the seller. For example, small business owners become accustomed to certain perks in their position – a yearly trip to a convention in a warm weather city, fishing trips with customers and other extras. Under an employment agreement these perks can be provided, as well as an ongoing salary. Warning: The employment contract should always be independent from the sale agreement – it is a common buyer ploy to combine the deals in one contract, and then fire the seller for non-performance. This allows the buyer to scrap the entire sale contract. Even under the best of conditions, it is highly unusual for the average entrepreneur to end up working the full length of his or her employment contract.

Consulting agreement: Here, the seller is retained as an independent consultant for a period of time. Again, this agreement should be separate from the sale contract. Also, the seller and buyer should spell out the duties and the amount of time the seller will spend. Any excess should be billable on an hourly basis. The seller should retain the right to assign the work to another individual. In many of these agreements there is little actual consulting work performed – but it allows the buyer to expense the payments in the year it was paid for tax purposes.

A successful seller is willing to work with the buyer and their professional advisers to decide upon a creative combination of the techniques just described. The best combination will: (a) make the seller comfortable that they will be paid in full, (b) share the tax advantages between the buyer and seller and (c) allow the buyer to operate the business with sufficient cash flow.

The Business Sale System: Insider Secrets To Selling Any Small Business (First American Publishing)

Click here to find out how to buy the book.

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Steps to ensure you get paid

Excerpt from The Business Sale System: Insider Secrets To Selling Any Small Business

The biggest fear of all sellers is that they will not be paid the full amount of the purchase contract. There’s no “100% sure thing” in the business world, but the seller can take steps to close buyer loopholes and maximize their likelihood of getting paid. Here are some tools and traps to be aware of:

Representations and warranties: Every sales contract has a long list of “reps and warranties.” These are statements of fact and assurances about a company. An almost sure way to NOT get paid is to misrepresent something about the company in the sales agreement. Typically, reps and warranties include: promises that financial information provided to the buyer was accurate, tax returns have been filed (and lists any outstanding taxes due), assurances the seller owns the assets listed, that all liens and encumbrances have been revealed and many other promises. Avoid making promises about the future – for example, promising that sales will increase, a key customer or employee will not bolt, etc. The future is out of your control and those promises can easily backfire. If your attorney is cautious, he or she will grill you repeatedly on your reps and warranties to make sure they are 100% bulletproof. Remember, being less than honest or sticking your neck out with predictions in your reps and warranties gives a buyer a perfect reason not to pay you.

Security on loans: Don’t loan money to a buyer that is unsecured. Buyers want to give as little security as possible and you want the most possible, so it’s often necessary to compromise. But it’s easy to mistrust a buyer who refuses to provide a minimum level of assurance. At a minimum, business assets should be pledged as collateral. But that doesn’t protect you from the buyer running the business into the ground and then handing the keys back to you. Better yet, the buyer should provide a personal guarantee or security in a personal asset (home, real estate, etc.). If the buyer is married, it’s advisable to have their spouse sign a personal guarantee to avoid transferring of assets to the spouse to avoid paying you.

The quality of a secured position is important too – a subordinated position to a bank on business assets is worth very little if things go wrong. If the business tanks, the bank will probably exhaust the assets before you get paid. Think of these factors as negotiation chips – a buyer may need to give the bank senior position on assets in order to establish a line of credit, but in that case, should be willing to sign a personal guarantee.

All buyers negotiate for as little security as possible, but beware of a buyer who won’t provide some reasonable level of assurance. They obviously don’t have the confidence or willingness to assume risk that’s needed to run a small business.

UCC filings: Be sure that your attorney files a UCC (Uniform Commercial Code) statement with the secretary of state in the appropriate state. This creates a record of the debt agreement to make legal collection proceedings much easier if the need arises. If your attorney isn’t familiar with a UCC-1 filing, chances are they aren’t experienced enough in business sales to adequately represent you.

Cap and basket: One worry of both buyers and sellers is the unexpected “nickel and dime” things that arise after the closing. Maybe a small bill arrives that wasn’t included on the list of liabilities. Or a customer returns $2,000 in defective products unexpectedly. These things happen and can create bad feelings with the buyer (who may think you purposely hid them). They also can be a headache for the seller when the buyer calls to complain (or sends you the bill). A cap and basket sets ground rules to avoid these types of problems. Each time a small, unexpected expense occurs, the buyer puts it into a “basket.” The basket has a predetermined limit (say $10,000 for example). Until the amount of liabilities in the basket reaches $10,000, the buyer is responsible for them. If and when the basket is full (it reaches $10,000) the buyer can pass liabilities over and above $10,000 to the seller. It’s similar to a deductible on an insurance policy. The buyer knows up front they are assuming a certain (small) level of risk and the seller knows they won’t be bothered with minor oversights that are bound to happen in a sale.

A cap is a limit on total liability to the seller (assuming there is no fraud, in cases of fraud there is no limit on liability and there are possible criminal charges as well). It is set at some mutually agreeable level, but is often in the hundreds of thousands of dollars. It comes into play in stock sales where the buyer assumes unknown future liabilities (lawsuits that exceed insurance coverage, etc.). The seller may be required to pay back some portion of the sale proceeds in this extremely unlikely event, but the seller’s maximum liability is limited.

Fraudulent conveyance: Although it is unusual, it is possible to get into legal trouble by selling your business for too high a price. If the buyer becomes so strapped for cash that the business fails and doesn't pay its suppliers, you can be sued for creating a fraudulent conveyance. The seller's liability for fraudulent conveyance exists for up to six years after the sale. Do not allow a buyer to become unrealistically over-extended in order to purchase your business. If you do, you may end up giving up the proceeds you earned from the sale and then some.

The Business Sale System: Insider Secrets To Selling Any Small Business (First American Publishing)

Click here to find out how to buy the book.