Maximizing Your After-Tax Proceeds from a Business Sale

Kevin was ready to sign a letter of intent to sell his business (“SellCo”) to a private equity firm, but he needed clarity on his after-tax proceeds from the sale. Kevin engaged me to represent him in the transaction to ensure that the terms were favorable and his after-tax proceeds were maximized. The private equity firm sent a letter of intent that included the following key terms:

• The purchase price was $10 million in cash.
• The private equity firm would purchase all of the assets of SellCo.
• The private equity firm would not assume any liabilities of SellCo.
• 50% of the purchase price would be allocated to ordinary income items.
• 50% of the purchase price would be allocated to capital items (e.g., goodwill).

Kevin expected his tax liability to be $2 million and his after-tax proceeds to be $8 million. Kevin calculated his tax liability by multiplying the long-term capital gains tax rate (20%) by the purchase price ($10 million). Kevin was wrong. Kevin’s tax liability would be significantly larger and his after-tax proceeds would be significantly less if the sale was structured as provided in the letter of intent. Kevin did not understand the difference between an asset deal and a stock deal.

There are two principal structure to acquire a business: an asset deal (the buyer purchases the assets from the entity) and a stock deal (the buyer purchases the stock from the shareholder).

Asset Deal

• The “seller” is the entity.
• The buyer acquires specific assets and assumes specific liabilities from the entity.
• The deal is completed through an asset purchase agreement.
• After the sale, the seller will own excluded assets (i.e., assets not purchased by the buyer), excluded liabilities (i.e., assets not assumed by the buyer), and the cash paid as consideration.
• After the sale, the seller will distribute the cash paid as consideration to the shareholder.

Stock Deal

• The “seller” is the shareholder.
• The buyer acquires the stock from the shareholder.
• The deal is completed through a stock purchase agreement.
• After the sale, the seller will own the cash paid as consideration, and the entity will continue to operate without any changes (other than a different shareholder).

Facts About Kevin and SellCo

• SellCo was taxed as an S corporation for tax purposes.
• SellCo’s only liability was an SBA loan with a balance of $1 million.
• Kevin’s basis in his SellCo stock was $0.

I explained to Kevin that the letter of intent provided for an asset deal, which meant that the mechanics of the transaction would be as follows:

1. SellCo would sell all of its assets to the private equity firm;
2. SellCo would receive $10 million in cash;
3. SellCo would pass through the ordinary income and capital gain to Kevin;
4. Kevin would report a total tax liability of $2,850,000 on his individual tax return:
   • $1,850,000 of ordinary income tax ($5 million * 37%)
   • $1,000,000 of capital gains tax ($5 million * 20%)
5. SellCo would pay off the SBA loan ($1 million);
6. After paying off the SBA loan, SellCo would distribute the $9 million in cash to Kevin as a dividend distribution.
7. Kevin would pay zero tax on the distribution because his basis would be $10 million after reporting the ordinary income and capital gain from the sale.
8. Kevin’s after-tax proceeds would be $6,150,000 ($10 million – $2,850,000 – $1 million).

Kevin expected his tax liability to be $2 million. His tax liability would be $2,850,000 under the letter of intent.

Kevin expected his after-tax proceeds to be $8 million. His after-tax proceeds would be $6,150,000 under the letter of intent.

Kevin was initially discouraged to learn that his after-tax proceeds would be 23% lower than expected. Fortunately, Kevin engaged me before he signed the letter of intent and we were able to negotiate more favorable terms in the letter of intent.

We closed the transaction a few months later. Kevin’s after-tax proceeds were about $7,500,000. We negotiated the following terms in the asset purchase agreement, which increased Kevin’s after-tax proceeds:

• The private equity firm agreed to assume the SBA loan;
• We agreed to allocated more of the purchase price to capital items; and
• We agreed that the purchase price would be increased by a tax gross-up.