Important Tax Implications to Consider in a Sale or Acquisition

When the owner of a propane company sells their business, most often their chief concern centers on the selling price. But the focus should be on the portion of that sales price that the seller gets to keep after taxes. This article will look at some of the factors that go into assessing and collecting taxes on the proceeds generated, as well as ways the tax impact may be reduced or otherwise mitigated.

Entity Type Matters

When Selling Is your business a C corporation? An S corporation? An LLC? The choice of entity you made when you started your company led to (hopefully) favorable tax strategies over the years. But your form of business entity plays a very important role when the decision is made to sell. The impact can be so significant in terms of taxes owed that some sellers change their entity election and endure a five-year waiting period before selling.

Many propane companies in the United States are set up as C corporations (corps), which has likely resulted in lower corporate tax rates over the life of the business. On the other hand, “pass-through” entities, such as S corps, sole proprietorships and LLCs, are typically taxed at the shareholders’ individual tax rate, which could be much higher, especially if the business has been successful in generating substantial revenue.

But when it comes time to sell, a C-corp could result in “double taxation,” with taxes being levied at both the corporate and individual level. The sale of assets by the C-corp creates a tax liability for the business. The subsequent distribution of cash proceeds to the owner(s) in the form of a dividend creates an individual tax liability for the owners. However, owners of a pass-through entity like an S-corp or LLC are taxed only once on the proceeds of a sale at their individual tax rate, be it ordinary income or capital gain.

Asset Allocation Is Critical

When business assets are sold, they are categorized for the purposes of determining tax implications for the seller and establishing the new cost basis of those assets for the buyer. The income derived from the sale of business is taxed at different rates, either ordinary income rates or capital gains rates depending on the characterization of the asset sold. The allocation breakdown must be approved by both seller and buyer and is part of the purchase agreement filed with the IRS.

Historically, the gain calculated on the sale of tangible assets such as vehicles and propane tanks is taxed at the ordinary income rate because of “depreciation recapture.” As the term implies, the IRS requires that the gain calculated from the sale of such assets is apportioned between gain due to basis reduction via depreciation and actual gain due to appreciation of the asset sold. The gain due to depreciation (recapture) is taxed at ordinary income tax rates and the gain due to appreciation is taxed at capital gain rates.

Because each asset category sold is subject to different tax rates, the seller would typically like to see the sale proceeds allocated toward intangible assets like the customer list (where tax rates on the calculated gain are often lower capital gain rates) instead of being allocated to equipment and rolling stock that would be taxed at the higher ordinary income tax rates.

But if you are the one buying a propane company, you want to recoup your investment as soon as possible. Therefore, you may wish to have more of the transaction price allocated to tangible assets such as vehicles, inventory, tanks, equipment and fixtures, which can be fully depreciated for federal taxes in the year the acquisition is made through a combination of Section 179 depreciation (up to $2.6 million) and bonus depreciation. Intangible assets, on the other hand, are not eligible for such depreciation treatment and would have to be depreciated over 15 years.

This dichotomy often makes allocation of the selling price a point of contention during negotiations and frequently results in an adjustment of the price of a business to accommodate the needs of the buyer and seller.

State Tax Issues

Depending on your business’s location, you may find yourself owing state and local taxes in addition to federal taxes on the sale of your company. For C-corps, almost all states and some cities have a corporate income tax (even if they do not collect individual income taxes) and most have their own capital gains tax. The only states that do not tax capital gains as income are those that levy no income taxes at all (Alaska, Florida, Nevada, South Dakota, Texas and Wyoming). There are two states (New Hampshire and Tennessee) that tax only dividends and interest income earned by individual taxpayers.

For S-corps and LLCs, not all states recognize or treat such entities as a flow-through (as the federal government does) but impose an income tax at the entity level and not at the individual level. In addition, most states limit or do not allow accelerated depreciation; therefore, the seller would have higher basis on these assets or less gain for state tax purposes.

Interest Rates Influence Selling Prices & Timing

Interest rates have a direct influence when it comes to valuing a propane business. Lower rates generally result in higher company values. Typically (and with all other factors being equal) as the cost of money increases, the relative value of a business decreases. Simply put, the higher the cost of money, the higher the cost of acquiring a business.

For the past several years, interest rates have been at historically low levels. This has helped to generate more M&A activity in a “seller’s market” where less of every dollar goes to the cost of financing. While rates remain comparatively low, they have been increasing, and the Federal Reserve has indicated its intention to continue to push interest rates higher.

This is likely to make it more challenging to sell your propane company at the time of your choosing while still obtaining your target price. This factors into when to sell your business. Wait too long and higher interest rates may restrict the number of buyers and reduce the selling price you’ll get. Sell too early and you may leave money on the table.

Taxes on Noncompete Agreements & Consulting Agreements

As part of the sale of many propane businesses, the seller and key employees enter into a compensated noncompete agreement, and sometimes the owner may sign a consulting agreement. Compensated noncompete agreements entered with the individual shareholders/members are taxed separately from the business sale and therefore are subject to the individual owner’s personal tax rate.

A consulting agreement between buyer and seller could be used to lower the value of the business, especially in a C-corp environment, as it is an agreement between the individuals and the buyer. Such agreements must be at arm’s-length and properly documented to avoid being considered part of the sale. When selling a propane business, it is not the price you get that matters but how much of that price you get to keep.

Taxes continue to take the largest bite out of the proceeds of a sale. Careful planning, strategic allocation of the purchase price, investment planning, and knowing in advance how much you will need from the sale to fund your expected lifestyle and life expectancy can help you maximize the value you receive from the sale of your company.