Taxes, loans and acquisitions: How outstanding loans are treated in a business sale

Whenever a small business entrepreneur is negotiating with a seller, the topic of the seller’s take-home proceeds will inevitably come up. Typically, the seller is referring to how much he or she will net from the sale of the business after paying any business broker fees, outstanding debt, and taxes.

While a self-funded search entrepreneur cannot be responsible for running that math for a business owner, it is important to understand how outstanding loans are treated in a business sale.

Can an owner lessen his tax liability with debt repayments after a business sale?

Unfortunately, repayments of outstanding loan principal will NOT offset any gains from a business sale. Said another way, a business owner will not be able to deduct paying off principal for auto, property or business loans from the proceeds to lessen the taxes he or she will owe from the sale of a business.

Repayments of debt principal need to occur with after-tax cash. 

How do you calculate the gain or loss from a sale?

The gain or loss commonly refers to the total proceeds after paying transaction expenses such as a business broker’s commission, CPA fees, and legal fees.

Proceeds - Transaction Expenses = Gain/Loss

How should an owner calculate after-tax proceeds?

This best approach to estimate after-tax proceeds is to work with a tax attorney or CPA who can give you tailored advice. We highly recommend Mike Baker from Baker Tax Law, but please consult fellow small business entrepreneurs and advisors to find the provider best for your needs.

With that being said, the high-level approach to determining after-tax proceeds depends on whether the deal is an asset-sale or a stock-sale.

For a Stock Sale…

If it’s a stock sale, which is favorable to business owners, the gain from a sale is most likely taxed as long-term capital gains. In the state of Texas, the owner would simply owe federal capital gains tax. At 20%, that would mean $200K on a sale resulting in a $1M gain after expenses.

After taxes have been paid, then the owner would repay any outstanding debt to generate net after tax proceeds (or take-home proceeds).

For an Asset Sale…

An asset sale is more complicated as the purchase price allocation and other tax rates will come into play. A purchase price allocation refers to what a buyer is purchasing for a transaction. For instance, what amount is for FF&E, what amount is for goodwill, etc.

Certain assets are taxed at ordinary income. By way of example, if you sold a business for $1M with $300K of ordinary income assets, you would owe long-term capital gains (20%) on the $700K of goodwill but you would owe ordinary income gains (10-37%) on $300K of assets.

Because an asset sale often leads to a higher tax burden for a business owner, they would need to argue for a higher purchase price to result in the same take-home proceeds.

Don’t Forget About State and Local Governments!

The above hypothetical examples do not take into account various state and local taxes and fees that may come into play. 

A Hypothetical Example

To play out the above, let’s assume that a business is being sold for $3M. The owner will owe a 10% business broker commission and $50K of legal and tax expenses, for a total of $350K of transaction expenses.

The business is based in Texas, which has no individual tax rate, but given the size of the business, the owner will be subject to the highest federal income tax bracket (37%).

Additionally, let’s assume that as part of the $3M sale, the owner has $500K of ordinary income assets and $1M of outstanding loans to pay down.

Tips for Negotiating with a Business Owner:

If a business owner starts to tip his or her hand that they are concerned about their after-tax proceeds, here are a few tips for negotiating and driving to a business acquisition that works for both parties.

1. Understand the owner’s ideal take-home proceeds from a sale: There are cases where a buyer and seller are worlds apart and it’s most efficient to walk. Other times, creative structures can help bridge a gap, whether it’s hiring the owner as a consultant or allowing them to roll some equity and be a minority shareholder in your company.

2. Consider the type of transaction: asset vs. stock sales: A separate post could be dedicated to the pros and cons of asset vs. stock sales. For the purpose of this post, it’s important to understand the transaction type so that you can get in front of an upset seller if there is serious amounts of fixed assets involved.

3. Understand how much debt is outstanding on the business: If you are doing a cash-free, debt-free transaction, you should get a sense of how much debt is outstanding. Not only will that help you gauge after-tax proceeds but it will also help you understand the working capital needs of the business.

4. Understand how the timing of the sale may impact the owner’s tax liability: Some owners will want to push a sale to the beginning of the next tax year, if doing so will allow them to have a lower federal income tax. This is especially true of smaller businesses.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.