Navigating the sale of a business is one of the most critical events in an owner’s professional life, and the central question for many is: How much will I pay in taxes? The complexity of tax liability in mergers and acquisitions (M&A) transactions is significant, depending on variables like business structure, deal type, and the latest changes in federal tax law. For business owners seeking an exit, understanding these factors is essential to maximizing their net proceeds.
The M&A advisory team at Walden M&A understands taxation is a primary concern for the founder and family-owned businesses we represent. Bob Tankesley, Principal at Walden M&A with decades of experience advising entrepreneurs on their exit strategies, takes a deep dive into how to structure a tax-efficient exit strategy.
The Foundation of Tax Planning: Capital Gains vs. Ordinary Income
When a business owner contemplates a sale, they need to prepare for two primary types of federal taxes: capital gains and ordinary income tax. The distinction between these two is vital because the tax rates differ significantly.
Capital Gains Tax: This is generally the more favorable rate for a seller, typically applying to the profit derived from the sale of capital assets, such as stock or goodwill.
Ordinary Income Tax: Rates here can be considerably higher than capital gains. A portion of the transaction proceeds will be classified as ordinary income, including those tied to depreciation recapture, inventory sales, and compensation agreements in the deal.
Business Structure and Tax Liability
The underlying tax liability for the seller is heavily influenced by the legal structure of the business.
S-Corps and LLCs (Pass-Through Entities): Most Walden M&A clients operate under one of these structures. Income and, importantly, the gain from the sale “pass-through” directly to the owners’ personal tax returns, generally avoiding taxation at the business level. Especially when combined with a stock sale, this structure is typically more favorable for sellers.
C-Corps: This structure can introduce the dreaded double taxation in an asset sale. First, the company pays income tax on the sale of assets, and then the shareholders pay a second layer of tax when the sale proceeds are distributed. This makes the C-Corp structure generally unfavorable from a seller’s tax perspective.
Asset Sale vs. Stock Sale: A Critical Tax Structuring Decision
The choice between structuring a transaction as an asset sale or a stock sale is one of the most consequential decisions in the deal, and it carries vastly different tax implications for both the buyer and the seller.
Stock Sale (Seller’s Preference): This is generally a much simpler and more advantageous approach for the seller. Because the stock itself is a capital asset, the entire gain is typically taxed at the more favorable long-term capital gains rate. However, the buyer tends to inherit all the company’s existing liabilities, both known and unknown, and does not get a “step-up” on the basis of the underlying assets for future depreciation.
Asset Sale (Buyer’s Preference): The buyer typically prefers an asset sale because it offers a significant tax advantage. They get a “step-up” in the asset basis, meaning they can re-depreciate the assets from the purchase price, regardless of what the seller had depreciated them down to. This greatly benefits the buyer, but for the seller, the purchase price is assigned to individual assets, potentially triggering higher-taxed ordinary income on items like inventory and depreciation recapture.
“Sellers often are not in control of how things get structured. They can suggest, they can recommend, they can say what their tax advisor said to do, but I find more often than not the buyer’s driving that train,” says Tankesley.
A buyer prefers an asset sale in an asset-heavy business because they get to re-depreciate all the equipment. This preference often means a seller must negotiate hard to minimize the tax bite from the ordinary income components of an asset sale.
How Recent Tax Legislation Can Impact Sale Value
Recent tax legislation, such as the One Big Beautiful Bill Act (OBBBA), has introduced changes aimed at encouraging certain business behaviors, specifically domestic investment and innovation. While these immediate deductions for investments like R&D and equipment purchases can feel good in the current year—driving down taxable income—they often come with a “bite on the back end” at the time of sale.
“With taxes, for every give there is a take. For every headline item you want to focus on, there’s fine print. What the big print giveth, the small print taketh away,” says Tankesley. Expensing items too quickly can ultimately result in a larger tax liability, often as ordinary income, when it comes time to sell the business. A strong M&A advisor ensures you understand the trade-offs of these decisions long before a sale.
The Role of the M&A Advisor in Tax Strategy
Tax strategy is crucial for maximizing net proceeds, and the M&A advisor’s role is one of coordination and guidance. At Walden M&A, we collaborate with a client’s Certified Public Accountant (CPA) or tax advisor from the very start, looping them in early and often. This multi-party conversation between the owner, M&A advisor, and tax advisor is non-negotiable.
“Walden doesn’t want to be in a position where the client says, ‘You should have made me aware of this backend bite, which hit me pretty hard when my tax return was filed,’” says Tankesley.
Our goal is not to let the “tax tail wag the economic dog”. We will not advise a seller to do something purely for a tax benefit if it means receiving less overall value for the company. The best strategy ensures the client has the maximum after-tax proceeds possible.
Avoiding Tax Surprises in Due Diligence
Due diligence is where a lack of preparation can lead to costly and deal-breaking tax surprises. To ensure a clean and efficient process, sellers must begin preparing years in advance.
“There is only so much you can do in the 12 months before a transaction gets done,” says Tankesley. He recommends getting ahead of potential issues by ensuring all tax-related matters are buttoned up early.
Common tax-related issues that arise during due diligence include:
- Entity Structure and Tax Elections: Ensuring the current business entity structure (S-Corp, C-Corp, etc.) is the most advantageous and adheres to all necessary waiting periods for tax elections.
- Income Tax Compliance: Confirming all federal, state, and local returns are filed and current. This includes properly accounting for Net Operating Losses (NOLs) and addressing any prior IRS or state audits.
- Aggressive Tax Positions: Buyers and their advisors scrutinize aggressive tax positions the seller may have taken, like overly-rapid depreciation, which can make the buyer skittish.
- Sales and Use, Payroll, and Employment Taxes: Ensuring compliance across all these categories, as liabilities can be inherited by the buyer in a stock sale.
A seller should constantly strive for tax transparency and conservatism in the years leading up to a sale.
The Impact of Earnouts and Seller Financing
When a seller receives payment over time through an earnout or seller financing, it directly affects the tax timing and allows for a strategic spreading of the tax burden.
Seller Financing (Installment Sale): If the seller receives fixed payments over a set period, this qualifies as an installment sale. This allows the seller to literally chop up the gain into the number of future payments and spread the recognition of the capital gains tax over multiple tax years. Interest on seller financing is always taxed as ordinary income.
Earnouts: Earnouts are payments contingent on the business reaching certain performance metrics post-closing. The tax treatment of an earnout is often a point of negotiation:
- Purchase Price Allocation: The seller wants the earnout pushed toward a purchase price allocation because this part of the compensation is taxed at the favorable capital gains rate.
- Services Rendered: If the seller continues to work for the company and the earnout is tied to their continued employment, the IRS may treat a portion of those payments as ordinary income.
The ability to defer capital gains tax through an installment sale can keep a seller in a lower tax bracket over the years, making this a powerful tax strategy.
Beyond the Sale: Planning for the Future
The sale of a business is a major liquidity event, and the tax planning does not end at closing. The immediate step is to work with your CPA to settle the estimated tax liability for the current year to avoid interest and penalties on underpayment. Once the immediate liabilities are settled, the focus shifts to strategic investment and wealth planning to minimize future tax liabilities.
Working with your financial and estate planning team immediately post-closing is essential to ensure your new wealth is managed in a tax-efficient manner. You must coordinate with a CPA or financial advisor to determine the best strategies for settling tax liability and creating an investment plan tailored to your long-term goals.
Choosing an experienced M&A partner is the first step toward a successful, tax-efficient exit. Walden M&A’s expertise and collaborative process guide you through a complex financial transaction, ensuring your business is positioned to achieve the optimal value and tax structure you deserve.
Contact us today to learn more about how Walden M&A can help you achieve your M&A goals.