As Published in “Success in Home Care”
By Don Cummins, guest editor
One of the most important financial components of selling an HHA may not be the price – it just may be the tax.
Done incorrectly, you could pay a tax of close to 50% of the proceeds. Done correctly, you could instead pay less than 20% in taxes.
Getting to the right structure to minimize the tax impact however isn’t simple – it usually requires serious negotiation. That’s because typically what is good for the seller in terms of tax paid usually has an adverse effect on the buyer’s future cash-flow.
In the sale of an established home nursing agency, we are usually dealing with one of the following structures:
The sale of the stock of the corporation is in many ways the simplest method of transferring ownership. And it usually is the more advantageous structure for the seller.
Items such as lease and license transfers are also made easier. But the real bonus to the stockholders is that most, if not all, of their proceeds from the sale passes to them in the advantageous long-term capital gains rate of 15% (if held for more than one year)….and even then, only the profit from the sale is taxed (that portion above the tax basis).
This structure however may negatively impact the buyer: in two important ways
Liability: The buyer assumes all of the liability from the past operations of the corporation. Items such as taxes, and Medicare liabilities will probably pass through in any event. However the buyer may be responsible for items from the sellers past operations, i.e. law suits, that they wouldn’t be in an asset sale.
Allocation: If the buyer purchases the stock he takes items on the balance sheet at the value they are currently listed at on the balance sheet (book value). For instance a piece of equipment may have been purchased for $20,000, and then depreciated to a value of $5,000. The buyer takes it at $5,000 and may have little depreciation left.
Sale of the assets of the corporation leaves the empty corporation in the hands of the stockholders (asset sale). This method is far more popular with buyers — for a couple of very good reasons.
First, it reduces the buyer’s exposure to past corporate liabilities.
Second, in an asset sale, the buyer can re-allocate the tangible assets to a higher figure and begin depreciating them all over again (step-up). The entire purchase price may be able to be written off in terms of taxes.
Now let’s move on to the most common structures used for the sale of home health agencies: the sale of the stock of both “S-Corps” and “C-Corps” and also the asset sale of both of those entities.
Asset Sale: The asset sale of a C-Corporation is the most problematic. Under this structure the assets are sold, leaving the corporation intact. Any profit on the sale (sale price less tax basis) is taxed at the corporate tax rate (graduated up to 35%), and then any cash disbursed to the stockholders is again taxed as either a dividend or a long term capital gain (both currently at 15%).
As you can readily see, a worst case scenario shows a tax of close to 50% on the profit.
Fortunately there are various methods to reduce this tax obligation. One such method is to have some of the assets allocated to personal service contracts such as non-compete agreements and consulting agreements.
Because these are personal agreements earned by the stockholder and not the corporation, the proceeds can be disbursed directly to the stockholder and by-pass the corporation. Unfortunately the taxes on these proceeds are then treated as ordinary income, which are then taxed at higher rates.
A better method: If it can be shown that the owner of the corporation is responsible for some of the goodwill (through her skill, ability, integrity or personal relationships) then it may be possible to allocate a portion of that goodwill directly to that individual stockholder (capital gain), by-passing the corporation. Because goodwill is probably a sizable portion of the value in the sale of a home nursing agency, this can provide great tax relief.
A buyer may also welcome this structure because goodwill can be amortized (written-off) over 15 years. Stock cannot be written off at all.
So, given the onerous treatment of stockholders in an asset sale of a C-Corp, why don’t more agency owners convert to an S-Corp before selling the company? Unfortunately Uncle Sam anticipated this thought and created Section 1374 of the tax code, which imposes a corporate tax rate of 35% if gains are recognized within 10 years of the conversion (subject to certain limits). Ouch!
For a more on the treatment of goodwill in the sale of a C-Corp, please refer to the following article:www.arne.com/The_Tax_Adviser_Article.pdf
Stock Sale: In a stock sale the C-corporation is the legal “owning entity” of the company and the purchase price may be allocated 100% to the sale of the stock. This results in capital gains treatment on the entire amount of the profit, which is very good for the stockholders.
As a practical matter however, since the buyer gets no step-up in his tax basis and also runs a higher risk of unforeseen liabilities, the price for the business may be negotiated lower.
Again, this is a negotiation for price and structure.
Asset Sale: Because the profits in an S-Corp pass through directly to the stockholders, the onerous corporate tax does not apply. The allocation of the assets now becomes very important to the stockholders, because the manner in which the assets are allocated will determine the tax rate.
This normally will result in a blend or combination of tax rates, capital gains, and ordinary income. Ordinary income that is earned may also carry self-employment taxes (a real ouch).
Again, what is good for the seller may not be good for the buyer. Usually give and take between the parties results in a fair deal.
Items that are normally allocated in the sale of a home health agency include the following:
Tangible Personal Property (trade fixtures, furniture, equipment), and Leasehold Improvements: The portion that is attributable to the depreciation is ordinary income. Any portion that is in excess of the original cost is capital gain.
Example:
Non-compete agreement: Comes as ordinary income to the stockholder. The buyer can amortize this over 15 years.
Training or consulting agreement: Ordinary income to stockholder. The buyer can expense it as it is paid out.
Goodwill: Comes as capital gain to the stockholder. The buyer can amortize over 15 years.
Inventory: To the extent that the allocation is over the tax basis it comes as ordinary income, otherwise, since there is no profit there is no tax. The buyer treats this as “cost of goods sold” upon the sale of the product.
The total amount allocated to the assets should equal the total selling price of the business. Because there are many creative ways to allocate these assets, the advice from a seasoned tax professional can be quite valuable.
Stock Sale: The same advantage of a stock sale in a C-Corp applies to an S-Corp……all of the profit is taxed as a capital gain, which we have learned is a big plus for the stockholders. However, because the onerous corporate tax on an asset sale does not apply to an S-Corp, we often see sales of S-Corps structured as asset sales.
In some cases, where issues such as license transfers or other contractual issues become a problem, it may be to the Buyers advantage to structure a stock sale.
An election under IRS Section 338(h) (10) may be useful here. This results in a sale of the stock, but allows the parties to treat the transaction as an asset purchase, i.e. a stock sale that allows the buyer to get their write-offs.
Note: This article is being distributed with the understanding that neither the author or Stoneridge Partners is rendering legal, accounting or other professional advice and assume no liability whatsoever in connection with its use. Please consult with a CPA or other tax professional for further information and advice
About the Author: Don Cummins is a senior partner with Stoneridge Partners (www.stoneridgeonline.com), a merger and acquisition firm that specializes in brokering home health agencies.. Don is the past owner of several businesses and has been involved in business sales for over 20 years, specializing in home care since 1997. He was awarded the prestigious designation “Master Merger & Acquisition Intermediary” (MMAI) in 2003.
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