All sellers focus on the amount they are selling their business for and how they are going to get paid. That makes perfect sense. However, it is rare they spend time planning for how the sale proceeds will be taxed. This could result in a tax savings of approximately 15% and a sizeable amount of the transaction.
How does a seller have any control over how much tax is paid? The tax laws require a seller and buyer to “allocate” the purchase price. This means that they must assign an amount of the purchase price to each of the assets that are sold. This could include equipment, inventory, intellectual property, goodwill, etc. Technically, there are rules and certain classes that the assets must be assigned to and included in Form 8594 when filing with the IRS.
From a seller’s perspective, it is advantageous to allocate as much of the purchase price to goodwill. The reason is that goodwill is taxed to the seller as a capital gain which has a much lower rate than if it were considered an ordinary income asset. On the other hand, a buyer will almost always want to assign more of the purchase price to assets such as equipment which can be depreciated quickly and used to offset their income.
If a seller has intellectual property, and in particular a patent, it should be aware of a recent change in the law that creates confusion over how this asset is taxed in a transaction like this. Prior to the Tax Act of 2017, the tax consequences of the sale of a patent was very clear. It was a capital gain. The tax law changed a provision in the code and in doing so has created ambiguity about this result. For this reason, if you have a patent, you should consider assigning much of more the value to assets such as goodwill. This should have no, or very little, impact on the buyer because the time period a buyer can amortize a patent is the same as goodwill.
Be proactive and start considering how to allocate the purchase price of a business early in the process. Ideally, include this in a letter of intent so that you and the buyer are on the same page. If you have any questions regarding these issues, feel free to contact me.
