February 24th, 2008 quantum
Further to our last blog post regarding income taxes, the business buyer and seller must also pay attention to sales tax and property tax considerations.
Sales Tax Considerations:
When a business is sold, the seller typically transfers two types of tangible personal property to the buyer: (1) equipment and furniture, and (2) stock in trade and merchandise. Because the stock in trade and merchandise of the business is usually sold to the buyer for purposes of resale in the regular course of business, the sale of that type of property is not taxable as a retail sale. However, because the State Board of Equalization may presume that all gross receipts are subject to sales tax and the seller has the burden of proving that a sale of tangible personal property is not a retail sale, the seller should always obtain a resale certificate from the buyer. Because the other business assets, such as furniture and equipment, are not generally sold for resale, the gross receipts from their sale are subject to taxation unless they are ”intangible” or otherwise exempt under the Revenue and Taxation code. A common exemption available to some taxpayers relates to “occasional sales exemption” which is a sale of business furniture and equipment used in a business that does not involve retail sales – i.e., the taxpayer conducts an activity (providing a service) for which a sales tax permit is not required. Although the seller must report any taxable proceeds on his or her final sales tax return this tax is often chargeable to the buyer.
Property Tax Considerations:
If the sale of the business includes the real property on which the business is conducted (or personal property that is affixed to the real property), the buyer faces property tax consequences. All property in California is subject to property taxation at its full value on an annual basis.
Therefore, in order to conduct a smooth transaction, it is very important for a business seller and the business buyer to consider implications of both Sales and Property Tax.
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February 20th, 2008 quantum
In order to effectively negotiate and structure the sale of your business, you need to be aware of the tax impact of the transfer and how to minimize your liability. Summarized below are the income tax considerations that apply to the sale of a business. Your own tax adviser should assist you in applying these considerations to your specific situation.
Income Tax Considerations
The rules for computing the income taxes with respect to the sale of your business is extremely complex and it is important to obtain sound tax advice early in the sale process and before you enter into a binding purchase and sale agreement so that you can avail yourself of tax-savings opportunities.
In considering the income tax consequences of the sale of a business, several factors need to be considered:
- Whether your business is conducted individually or through an entity
- If you conduct your business through an entity, how the sale is structured – i.e., whether you sell the entity or the entity sells the assets
- Whether you receive the sales price in a lump-sum or in installments
- If an asset sale, how the sales price is allocated among the different categories of assets - an intricate process (see below).
- Whether any of the consideration received from the sale is paid as compensation for future consulting or employment services
These factors will dictate which of the four separate tax rates will apply to the proceeds of the sale. An overview of the applicable rates is as follows:
1.) Ordinary income rates - The highest marginal tax rate is 35 percent.
2.) Long-term capital gain rate – This rate applies to the gain from the sale of a capital asset which has been held for more than 1 year (if held less than 1 year, it is taxed as a short-term capital gain and the ordinary income rates apply) and is generally 15 percent.
3.) Real Estate Depreciation Recapture Rate – This rate is 25 percent and only applies if you’re selling real estate as part of the sale of your business.
4.) Corporate Income Tax Rate – The corporate income tax rates range from 15 to 39 percent; in addition, the owner then pays individual income taxes upon receipt of the sale proceeds in the form of a corporate distribution – hence, there is “double taxation” when a C corporation sells appreciated assets and then distributes the proceeds to its shareholders.
Note that if instead of the corporation selling its assets, the C corporation shareholder sells her stock of the company held more than a year (i.e., an “entity sale”), there will be only a single tax of 15 percent – the long-term capital gain rate. If this is not possible, because the buyer insists upon an asset sale, fortunately, your exposure to “double taxation” can sometimes be somewhat minimized by again, structuring the transaction in a certain manner (for example, by having a percentage of the sale proceeds paid to you individually for a covenant not to compete or for consulting). There is also the possibility of converting a C corporation to a Sub-Chapter S corporation prior to the sale (which might eliminate your exposure to a double tax); however, there may be exposure to tax at the highest corporate income tax rate if the corporation held assets, prior to the conversion, with a fair market value greater than their tax basis.
By reviewing the tax consequences in advance and presenting the proposed sale structure in a certain manner, you have a better chance of completing the sale on your terms and conditions.
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February 10th, 2008 quantum
The most appropriate valuation method applied by qualified Business Brokers for valuing a small business (defined as a business with annual sales of $5 million or less) - is an Income Based Valuation.
An Income Based Valuation approach can be broken down into four generally accepted methods as follows:
- Present Value of Future Earnings
- Gross Revenue Multiples
- Capitalization of Excess Earnings
- Multiple of Discretionary Earnings
The valuation method applied by most qualified business brokers or business appraisers for businesses for sale will likely be a combination of both the widely used and professionally accepted Capitalization of Excess Earnings method and the Multiple of Discretionary Earnings method. This is a powerful way of estimating the value of a business and allows for the business to be fairly valued as an investment opportunity without many of the uncertainties that other valuation methods introduce. This method assumes that a business owner is entitled to a fair return on the value of the business (his/her investment) over and above his/her fair wage (if the owner(s) works in the business). This combined approach will assign a financial value to the company’s reconstructed earnings (resulting in available discretionary earnings) that are reflective of the risk associated with the continued operation of the business in light of recent proven financial results that can reasonably be expected to continue after the business purchase for an indefinite but substantial duration.
Using the two valuation methods described above also enables one to calculate the goodwill value in the business as well as its estimated fair market valuation. Furthermore, this approach works equally well whether the business to be purchased is operating as a sole proprietorship, partnership or as a corporation. Thus, these valuation methods are based on the income a business has proven it can earn with the expectation being that the recent level of actual earnings of the business will continue at or above that level for some reasonable period of time. The estimated fair market value of the business based on its proven earnings will be strongly affected by applying a factor (a return on investment multiplier/capitalization rate) taking into account the projected risk and certain investment considerations associated with new ownership.
It is always beneficial to obtain and Income Based Valuation method as an accurate reflection of the List Price and is often relied upon by most buyers to justify their acquisition.
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