“I want to pay as little as possible under current tax laws and I’ll worry about the future impact of this decision later!”
Sound familiar? This is a common mindset when it comes to taxes, and it certainly is not a bad one. However, we recommend you keep at least an informal scorecard of the potential cash flow impact upon a “day of reckoning” event as a component of an effective long-term tax and wealth planning process.
For example, many small businesses adopt the cash method of accounting for tax reporting purposes, as it provides the business owner with greater perceived control over the timing of tax payments. This can be accomplished by managing the collection of accounts receivable along with the timing of year-end vendor payments to achieve a desired tax. Over time, the accumulated deferral of taxable income that would have otherwise been reported using the accrual method of accounting can grow to a substantial level. This is the good news.
The problem arises with a liquidation event such as a sale of the business. A buyer will not want to pay tax on the seller’s profits imbedded in the tax deferral arising from the use of the cash method of accounting and will likely demand an asset purchase or equivalent design to a purchase transaction. This can leave the seller with little positive cash proceeds after paying taxes on the gain arising from the transaction itself as well as the taxes previously deferred under the cash method of accounting. Potentially making matters worse, a seller will often be required to use a material portion of the sale proceeds to retire bank debt and other obligations, further reducing and, in some unfortunate cases, eliminating the seller’s net cash proceeds.
Similar outcomes can arise in equipment intensive businesses when the advantages of bonus tax depreciation and Section 179 deduction provisions have been used regularly. The good news is that taxes have been reduced by these favorable tax write-offs. The problem is that a buyer wants to take full advantage of tax write-offs going forward on the fair market value of these assets rather than a relatively modest amount of cost that the seller has yet to report at the time of a sale.
These scenarios, combined with the possible reversal of various other favorable tax deferral strategies, can add up to the feeling that you can’t afford to sell your business.
Unfortunately, there is no magic wand to make these circumstances vanish. There are limited opportunities to mitigate the reversal of favorable tax deferral strategies – for example, a sale of stock involving an ESOP purchaser which need not be concerned about the tax impact of its purchase decisions – and such opportunities should be explored where they exist.
Ultimately, though, owners should be mindful throughout the lifecycle of their businesses that there is a potential day of reckoning in connection with material tax deferral strategies. Keep some accounting or an informal scorecard of the potential economic magnitude of this event to avoid a bad surprise when planning for retirement or other business liquidation.