Selling a business can be both exciting and frustrating. Whether you’re planning to retire or moving on to your next project some big changes are ahead. The amount of tax you pay on the sale, if any, will have a huge impact on the amount of cash you walk away with after the sale. As such, it’s important you are clear on the outcome you want prior to entering the negotiation process.
We will break the analysis up into a number of articles to avoid overloading you with tax jargon! In this first article lets focus on the choice between selling a business itself and selling the shares in the company which owns it. It might surprise you to learn that these options result in very different tax outcomes.
Selling a business or selling the Shares
As a general rule most purchasers would prefer to buy the business (the stock and and other assets) as opposed to the shares in the company. Why? Because if they buy the business assets they can start fresh and make their own decisions about structuring. Purchasing the shares in your existing company brings with it potential risk from the company’s trading history.
On the other hand vendors prefer to sell the shares in the company because it is much easier to extract the profits from the sale as well as allowing them easier access to a number of Capital Gains Tax (CGT) concessions.
Perhaps the easiest way to show the difference between selling a business and selling shares is with a live example..
Selling a business or selling the Shares – Tax Differences
Stuart owns 120 shares in ABC Party Hire Pty Ltd which is 100% of the company. The company hires party equipment to retail customers on hourly/day rates as well as selling party consumable items.
The Financial Statements for ABC Party Hire Pty Ltd show:
|Cash on hand||$ 120|
|Plant and Equipment||$ 100,000|
|Share Capital||$ 120|
|Retained earnings||$ 150,000|
For the purpose of this example we are assuming:
1. The business has been valued at $400,000 which means we are selling $250,000 of Goodwill.
2. Stuart pays tax at resident margin income tax rates and has no other source of income in the business;
3. Stuart purchased the shares in the company for $120.00, 5 years ago.
4. The company has sufficient franking credits to fully frank all dividends.
Option 1: Stuart sells the shares in ABC Party Hire Pty Ltd for $400,000
|Sale proceeds||$ 400,000|
|Less: cost base of shares||$ (120)|
|Gross capital gain||$ 399,880|
|Less: 50% Capital gains tax discount||$ (199,940) (owned shares for over 12 Months)|
|Taxable income||$ 199,940|
|Tax payable||$ 67,204|
If Stuart sold the shares in the company for the full $400,000 market value he would pay tax of $67,204.
Option 2: Stuart sells the business assets from ABC Party Hire Pty Ltd
Rather than selling the shares in the company, this time lets map out the tax calculation should Stuart choose to sell the business assets out of the company.
|Sale proceeds||$ 400,000|
|Less: Stock at Cost||$ (50,000)|
|Less: Equipment at Written Down Value (WDV)||$ (100,000)|
|Profit on Sale||$ 250,000|
|Tax on Profit (27.5%)||$ 68,750|
The issue then becomes how does Stuart get his money out of the company? Generally, he would do this via a fully franked dividend.
ABC Party Hire Pty Ltd now has retained earnings of $331,250. After adding franking credits at a rate of 27.5% (2018 financial year) Stuart would have taxable income of $456,897 when the dividend is paid.
|Cash dividend to Stuart||$ 331,250|
|Plus franking credits||$ 125,647|
|Taxable income||$ 456,897|
|Gross tax payable||$ 187,973|
|Less franking credits||$ (125,647)|
|Personal income tax payable||$ 62,327|
Total tax payable on the sale $131,077
Comparing the two methods
So, the total tax paid in each scenarios is:
The sale of shares: $67,204
Sales of Business assets: $131,077
In this example the sale of the shares results in a much better outcome for vendor than selling the assets from the business. However, the moral of story is not that you should always sell the shares. Remember, the purchaser will rarely commit to buying the shares to avoid the risk associated with your trading history. This is a very simple example and it seeks only to show you that planning is crucial. Just a few points that could also effect the analysis are:
- The tax paid on Scenario 2 could potentially be reduced had Stuart planned ahead and cleared some of the retained earning out of the company in prior years;
- Stuart may be able to gradually draw the retained earning out of the company over a number of years after the sale rather than all at once;
- Rather than having Retained earnings the company may have carried forward losses prior to the sale which would have a significant impact on the tax calculations.
- This example also ignores the Small Business CGT Concessions. We will cover these concessions under both scenarios in a future article.
What if i want to give my company to a family member for free?
This type of transfer is known as a non-arm’s length transaction. That is, the parties are not dealing with each other on a purely market basis. In these situations the ATO ignores the actual sale proceeds paid (if any) and uses the Market Value Substitution rules.
These rules essentially impose Capital gains tax on the vendor as if they had received full market value for the shares even if no money has actually changed hands. This can result in a situation where the vendor has a considerable tax bill to pay and no cash to make the payment!
If you’re planning to sell your business the first thing you should do is call your accountant! While you will likely engage a business broker and a legal advisor once you move forward with your plans your accountant should at least know what’s happening in case they see something you’ve overlooked.
The ATO has a helpful list of things you should discuss with your accountant as part of the planning process.
If you don’t have an accountant feel to contact us.
We will cover the Small Business Capital Gains Tax Concessions in a later article so watch this space.