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WHAT ARE THE TAX IMPLICATIONS OF BUYING OR SELLING A BUSINESS

ISSUE

This is a good question for every Seller to read and understand. 

A client asked: “Do I pay taxes on the entire sale price of my restaurant/business or is it only on any profit made…. example If I owe $200,000 and I sell it for $300,000 do I only pay taxes on $100,000?”

First, what kind of taxes?  State, Federal or local Income taxes?  Ultimately the Seller must see a CPA or tax attorney for the absolute and exact answer to one’s particular situation, but here are some general guidelines given I was a Chief Financial Officer for a Fortune 20 company. In most states there is no sales tax for the Seller.  The Seller is like the store here.  They sell the fixtures and equipment to Buyer and collect sales tax from the Buyer.  This sales tax is paid to the state sales tax authority by the Seller, just like Wal-Mart collects sales tax from a customer and pays it to the state.

Now, what is owed on the restaurant, or the debt, is not relevant to taxes.  What is relevant is what was paid for the business (Seller’s Purchase Price) and how much has been depreciated and/or amortized...Assets are depreciated (furniture, fixtures, equipment, leasehold improvement) while goodwill is amortized (goodwill is the excess amount paid over the asset value - Seller bought a restaurant for $300,000). Here is an example:

SELLER’S PURCHASE PRICE

Here is the purchase price allocation at the time the Seller purchase the business:

1. Equipment                                     $75,000

2. Leaseholds                                    $75,000

3. Furniture                                         $50,000

4. Liquor License                              $10,000

5. Covenant not to compete            $10,000

6. Goodwill                                         $80,000

Total Purchase Price                        $300,000

Equipment, Leaseholds and Furniture (FF&E) starting book value is $200,000, covenant not to compete is $10,000, liquor license $10,000, so goodwill is $80,000.  Goodwill is the “plug.”

So in this example, assume Seller depreciated $100,000 of FF&E (Liquor Licenses are usually not depreciated unless something dramatic happens to the liquor license market in that particular county.)  Then what remains on the balance sheet is $200,000 ($75+75+50) less $100,000 or $100,000.  And further assume $40,000 of Goodwill is amortized and the non-compete has been expensed to the income statement.  So here is what the Seller’s balance sheet looks like at the time of sale:

SELLER’S CURRENT BALANCE SHEET

1. Equipment                                     $35,000

2. Leaseholds                                    $35,000

3. Furniture                                         $30,000

4. Liquor License                              $10,000

5. Covenant not to compete             $0

6. Goodwill                                         $40,000

Total                                                    $150,000

RESTAURANT IS SOLD

The restaurant sold for $400,000.

The purchase price allocation agreed upon by Buyer and Seller is as follows:

1. Equipment                                     $50,000

2. Leaseholds                                    $50,000

3. Furniture                                         $25,000

4. Liquor License                              $25,000

5. Covenant not to compete             $20,000

6. Goodwill                                         $230,000

Total Purchase Price                        $400,000

 
TAX CONSEQUENCES

Now total FF&E value is $125,000.  In this example the Seller paid $200,000 for the Equipment, Leaseholds and Furniture, but the book value is now $100,000.  In this case, Seller depreciated $25,000 more on his taxes than book value.  In other words, Seller in prior years got a tax benefit of $25,000 reducing his tax liability; hence since the assets are now worth $125,000 instead of the book value of $100,000, the Seller must “re-capture” $25,000 of tax benefits he received in prior years. This is taxed at the Seller’s ordinary tax rate.

Liquor license is taxed if it where valued at a higher amount than what they paid.  If the business was held for a year, there is a capital gains tax.  That rate today is 15% federal and in California it is 9%.  Of course, if they sold it for less than what they paid, there is a loss on the sale of the liquor license on their taxes.

On the one side, when the Seller purchased the restaurant, he paid $10,000 for a covenant. He also amortized it on his tax return over the life of the covenant and has no remaining value.  Covenant not to compete is treated as ordinary income to the Seller, usually amortized as income over the life of the covenant.  So if it were 5 year in this case, the client takes $4,000 a year to ordinary income.

As for goodwill, it is treated as a capital gain or loss depending on whether the amount received from the sale is greater than (gain) or less than (loss) the book value.  In this case goodwill started at $80,000 but they amortized it to $40,000.  So book value is $40,000 and the sale price received is $230,000 or $190,000 greater.  This triggers a capital gains tax of 15% for Federal and 9% for State.

Of course, these are mere guidelines to help a client understand the tax situation.  They must go to a TAX CPA or TAX ATTORNEY familiar with business sales transactions when they are in contract to sell the restaurant to determine the best mix of values to minimize taxes.

One can determine the Buyer’s tax situation by thinking through the above examples in reverse.