Selling your business can be a life changing event. Whether you are a small business owner, or a shareholder in a much larger business, a “liquidity event” brings complexity and stress, but also the potential of significant rewards.
One of the most complicated issues affecting a business sale is tax. With good planning, a business sale can be structured in a highly tax efficient manner. Without the right advice, the tax implications from a business sale can erode a large part of the value being realised from the transaction.
Here are five fundamental issues to address to ensure your business sale is as tax effective as possible.
Maximising CGT concessions
Structuring the business sale so that CGT concessions are maximised can be a highly tax effective action.
The small business CGT concessions are available to all taxpayers who satisfy either a $2 million turnover test or a $6 million net asset value test. Both tests are assessed on a group basis. There are four different concessions that constitute the small business CGT concessions, and each has its own eligibility criteria and nuances.
For a concessional measure targeted at smaller businesses it is perhaps surprising that the rules are as complicated as they are. However, the time invested to navigate the complexities is worth it as the concessions can mean that a $4 million capital gain is tax free.
The general discount concession reduces eligible capital gains by 50%. It is available only to resident trusts and resident individuals, but is available for gains made on all types of assets. The concession significantly influences deal structures.
A dramatically different tax outcome can be obtained by selling the shares in a company and accessing the general discount concession, as compared to selling the business conducted by that company and not accessing the general discount concession. When combined with the small business CGT concessions, the incentive to sell at the shareholder level is even stronger. This makes having a “clean” company an imperative.
Not getting taxed on scrip deals
Not all businesses are sold for cash. Mergers, roll-ups and numerous other situations involve consideration in the form of shares in the purchaser, or a combination of cash and shares.
From a commercial perspective, the seller exchanges shares in their company for shares of an equivalent value in the purchaser. Its economically neutral. From a tax perspective, the shares received are consideration for the sale transaction and the market value is used to determine the gain on sale. The transaction might be economically neutral, but it is still taxable.
CGT rollovers aim to match the tax consequences with the economic consequences and defer any tax liability that might otherwise arise. The scrip for scrip rollover is a key example. The challenge with these rollovers is that they are quite prescriptive. Common issues include where the purchaser is not a corporate (such as some US LLCs); where the target entity is not a company (for example, a unit trust structure); and where the deal offered to some shareholders differs to the deal offered to others (some receive cash and exit, others receive shares and stay in the business).
If the aim is to obtain the benefit of a rollover, the planning starts before negotiations start. The terms of a letter of offer can sometimes be the difference between accessing or not accessing a CGT rollover.
Managing the tax on earnout arrangements
Purchase consideration may be made contingent on future earnings where the historical profits may not be a reasonable reflection of the growth potential of a business, where there is a desire to “lock-in” and incentivise the existing owners, or for numerous other reasons. Such arrangements are commonly referred to as earn-outs. Earn-outs differ from deferred consideration as the payments are both deferred to a future point and are contingent on future events.
A particular class of earn-outs are “look through earn-out rights”. These earn-outs are taxed as payments are received, and future payments can benefit from the same CGT concessions as the original sale. Other earn-outs are often partially taxed upfront, with deferred payments not benefiting from all the CGT concessions.
The terms and structure of the earn-out arrangements are critical to ensuring the look through treatment can be obtained.
Cleaning up your company ready for sale
There is a real incentive to sell the shares in a private company, rather than have the private company sell the business assets. This is driven by the CGT concessions, as discussed above.
Where a purchaser acquires the shares in a company, their investment is exposed to the historical risks and liabilities of that entity, hence a purchaser tends to prefer an asset deal, and share deals tend to be subject to much more rigorous due diligence.
Having a “clean” entity can be critical to successfully negotiating a share deal. Personal expenditure and private assets are two key areas where private companies often fall down in due diligence. Not adequately documenting tax positions is another. Pre-sale planning will enable a private company to rectify these types of issues before starting the sale process.
The benefits of having a clean company extend to the ability to access the full range of CGT concessions. Many private companies maintain shareholder loan accounts. These may be Division 7A loans, or they may simply be advances made during the year that are cleared by an annual divided.
The small business CGT concessions require the shares being sold to be “active assets”, which means that the assets of the company also need to be active assets. Shareholder loans are passive assets, and a large shareholder loan can mean the difference between obtaining or missing out on the small business CGT concessions. Again, pre-sale planning is the best way to address these issues.
The key to a successful sale transaction is planning, and this is particularly the case for tax. Good tax planning is not crisis management. By starting your tax planning early, you can achieve outcomes that are just not possible if you wait until a deal is on the table.
The issues discussed above are just the start of the issues that will arise if you are looking to sell your business. However, with considered pre-sale planning, we can help you navigate the complexities and achieve your best possible outcome.
If you’d like to know more, contact your local William Buck advisor.