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Myths about selling assets or shares when you sell your business

Most of us who have at least considered selling a business are told by our accountants plain and simple: “Sell the shares of your business (not the assets) whenever you can because you will pay less tax.” (You can take advantage of your one-time personal capital gains exemption that comes with selling the shares of a Privately Controlled Canadian Corporation.)


February 14, 2011
By Victor Harding

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The same accountants tell us selling assets will be expensive. You will pay a large amount of income tax on the proceeds of the sale. (Selling “assets” here means selling your accounts and perhaps your inventory but generally keeping and collecting your own receivables and looking after all your own liabilities.)

The truth is that selling shares whenever you can is good advice. However, many buyers simply will not buy shares. The same buyers will tell you that they assume too much liability in buying shares, that share deals have substantially higher legal costs and finally they cannot write the purchase of shares off against income.

I maintain that only the third reason (they can’t write off the purchase price) will make a difference to a deal and even that can be overcome. Secondly, I maintain that if you account for the sale of “assets” properly, the taxes you pay should not be that great.

Doing “share” deals is not as risky or costly as many buyers say.

Let’s deal with the first myth – that share deals are much more risky and expensive to do. I have been buying and selling alarm companies for 15 years and working a great deal on the buy side where I would have heard about any problems with buying shares. I have not experienced that share deals were more risky or expensive to do. If shares deals are more risky, why were the buyers that I have worked for never “burned” on any undisclosed liabilities in buying shares? I am not saying it has never happened; only that you don’t hear much if anything about any such disasters from buying shares. I think one reason why there are not disasters from buying shares is that most alarm dealers do not have big employee bases or large supplier lists and it is relatively easy to determine what liabilities  a particular seller will have.

Buying shares should also not be that much more risky if a buyer does proper due diligence on what he or she is buying. That means doing a credit and background check on the company you are buying, and the seller. Secondly, smart buyers of shares will make the seller turn the company over to you with only the assets in it that you want to buy (i.e. the accounts) and no liabilities except deferred revenue. All other assets and liabilities are taken out.

Nor should it cost that much more legally to do a share deal. As a buyer you are going to do a background check on the company and its seller whether you are buying shares or assets. Both asset and share deals are going to make the seller responsible for anything that goes wrong with an account or an installation up until the time of sale. So why should the legal cost of doing a share deal be that much more.

As for the fact that a buyer of shares cannot write the share purchase off that is true and can make a difference. But this is easily overcome by just paying a slightly lower multiple when you are buying shares — better than not offering to buy shares at all.

I maintain that the smart sellers push their buyers for share deals. And the smart buyers are the ones that buy shares. Instead of grossly disadvantaging themselves, a buyer of shares will attract more sellers and distinguish themselves from all the “nervous Nellies” who say they cannot buy shares.



Selling “assets” does not attract as much tax as you might think

So imagine you are a seller and you can only sell assets. What about the tax on such a deal? I would suggest that if you treat the sale of accounts or assets as laid out below the tax is not as great as you might think:

  • Selling alarm accounts — often the major asset of your business — should be treated for tax purposes as a capital transaction not as regular business income. Many owners and their accountants do treat the sale of assets this way. They make the seller include the full purchase price into the business income of the year that the transaction took place.
  • Secondly, you should make sure your accountant uses the net purchase price after deferred revenue in his calculations of the capital gain on the sale of accounts.
  • Thirdly, it is possible, depending on how you sold your alarm accounts in the first place, that you might be able to deduct any “adjusted cost base” of any of the accounts from the purchase price. What does this mean? Many alarm dealers today don’t recover all their costs from the sale of an alarm system. That uncovered cost (if it has not been expensed against income already) can be deducted from the sales price of the alarm account when it is sold. So instead of looking at a capital gain of, say, $800 for the alarm account (being what you were paid per account) you might be looking at a capital gain of $500 because you had $300 of unrecovered cost on that account.
  • Next, the big win. Once you have the true capital gain on the sale of your accounts, you have to divide that capital gain in half because only one-half of your capital gain is taxable, not the whole gain. Fifty per cent of the capital gain is not taxable at all.
  • Now it is true that the taxable part of your capital gain (50 per cent of the capital gain) will be taxable at about 48 per cent but this tax can paid over the time period you receive the sale funds.
  • Finally, most importantly the non-taxable part (the other 50 per cent) of the capital gain goes into what it is called a “capital dividend account” and can be paid out to the shareholder tax-free. Many sellers do not realize this.

As a example of the above, let’s say you sell 600 alarm accounts for a gross sales price $500,000 to be paid out over three years and the deferred revenue is $75,000. That means the net purchase price is $425,000. Let’s also say you have $50,000 of unrecovered cost on setting up the accounts in the first place. Then your net capital gain is $375,000.

Now half of this gain or $187,500 is taxable at 48 per cent giving rise to $90,000 of tax. Nothing to be happy about but sellers should remember that they can elect to pay the income tax payable over the period that they receive the funds from the sale. Secondly, if there was a hold back on the deal and the seller did not get all of that paid to him that the capital gain can be re-calculated to reflect the lower sales price. Finally to offset the capital gains tax to be paid and to offset the gain that the buyer gets from being able to write the purchase off, smart sellers of assets will often ask for a higher multiple (say two to three times RMR more) when selling assets than if they were selling shares.

Summary

Where does this leave us in regards to the tax aspects of selling your business? Well the first rule is to search out buyers that will buy your shares. In almost every market across Canada there are buyers who will do so. Secondly, if you do end up selling assets make sure you calculate your tax payable in the proper way.

Victor Harding is president of Harding Security Services Inc. He can be reached at Victor@hardingsecurity.ca


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