Authored by Steve Zacharias, Managing Partner, Transact Capital
Many small business owners file taxes on a cash basis even when they prepare accrual basis financials. Besides a vastly simplified tax return, the filer gets the benefit of deferring the payment of taxes on sales until the cash is ultimately collected. But beware: there can be a big unplanned tax bill when it comes time to sell.
Cash basis tax filing serves very well for a small growing company with slow receivable collections. Since accounts receivable are not considered sales revenue by the IRS, it is many times ignored in cash basis financial statements.
The negative surprise comes when the owner goes to sell his/her company. Most small business sales are structured as asset sales rather than stock sales. Because the business is small, buyers do not want to take the risk of assuming unknown liabilities, claims or unfiled regulatory forms which transfer with the sale of stock. There are other reasons buyers desire the purchase of assets rather than stock, including the benefits of writing up fixed assets to get higher depreciation deductions post-sale. [See article in April 13, 2017 newsletter: Should I Sell the Assets or the Stock of my Company?].
So when the owner sells assets of a corporation and terminates the legal entity, the accounts receivable that are on the books are considered immediately “sold” for IRS purposes, and ordinary income taxes are owed by the seller. Sellers will try to push for a stock sale to avoid this treatment, but buyers respond by significantly lowering the sale price as they realize there will be a future debt to be paid to the IRS. If strategic buyers or private equity groups buy the stock, again the high tax bill is not avoided because they will immediately want to convert the business to an accrual basis upon closing, triggering the recognition of receivables as income received by the owner. This results in recording a “deferred tax liability” on the books of the seller which essentially recognizes the future taxes that will be paid. It will also decrease the net book value of the business.
It is important to realize the impact of various tax treatments associated with any sale of a business. Transact Capital guides owners to get the answers to these questions early in the sale process to avoid unpleasant surprises when it comes time to calculate the after-tax cash proceeds of a sale.
