Top Tax Considerations in PM Business Sales
Biggest Tax Issues When Selling Your PM Company
Don’t Let Uncle Sam Step On Your Plans for the Future
Long before you try selling your property management company, you need to understand what costs are involved. I’ve seen over many years in business brokerage that some sellers have not taken the time to understand the tax implications of a sale.
Like any transaction that makes you money, the sale of a business is considered income and you are required by law to pay taxes on it. This income is usually a capital gain and it applies whether you’re selling the assets of a company or shares of company stock. (See accompanying post “Advantages & Disadvantages of Stock vs. Asset Sales”)
The tax consequences depend greatly on the deal structure. There are substantially different implications for an asset sale versus a stock sale versus a merger. So you need to know, going into any negotiation process with a prospective buyer, how the dollars in the deal will play out.
At ManageVisors we take a great deal of time and energy to help you understand the tax landscape you’re entering. Still, I can’t stress enough the importance of consulting your accountant or other tax advisor long before your business hits the market. I’ve had many entrepreneurs stop the sale process cold once they fully understood the tax implications.
Jason, a Ventura County property manager, told me back in 2018 “I just can’t afford to sell right now. It wouldn’t be worth it.”
C Corp. vs. S Corp vs. LLC vs Partnership
Any PM company operating as a C Corporation will be taxed two times on the sale. The first tax you’ll have to pay is the corporate tax which coincides with your commercial income tax return. Since corporations are considered separate entities from their owners, the IRS requires each entity to pay their share of taxes from it.
The corporation will pay whatever the current corporate tax rate is on longterm capital gains. Then, each shareholder of the company will be subjected to a capital gains tax on their personal income tax return. They won’t have to pay taxes on the full amount of the capital gains, though. The profits of capital assets get distributed equally among the shareholders of the company. Therefore, the amount that was distributed to each shareholder will get multiplied by the capital gains tax rate. The result is the amount that each shareholder must pay in personal taxes.
S corporations and partnerships have a similar tax structure in the sense that there is no double taxation like you have with C corporations. When you sell assets through an S corporation or partnership, the individual owners or shareholders are each responsible for paying the taxes on their personal income tax returns. The upside is they don’t have to pay another set of taxes on the commercial income tax return of the company.
This makes S corporations perfect for property managers who want to sell shares of their company while still maintaining a single tax rate for the profits. BE WARNED. C corporations are not allowed to change their corporate status to an S corporation, for the purposes of avoiding the double taxation. The IRS loves cracking down on this. The government requires C corporations to change their status many years before the sale of any assets takes place. This is their way of deterring owners from committing tax evasion.
Limited liability companies, LLC’s, are a bit dicier. In California, real estate law prohibits real estate brokerages and property management companies from being owned by an LLC. Current legislation is winding its way through the state Legislature to loosen this restriction but existing law has not changed. However, there are work-arounds to separate the licensed sponsoring broker from the majority owner selling the business.
The IRS usually considers LLC’s and sole proprietorships to be disregarded entities, treated as pass-throughs. This means that these companies won’t get taxed separately and you won’t have to file a commercial income tax return. Instead, any profits made from these capital assets will only have to be paid on the owner’s personal income tax form. Of course, you have the option of making your limited liability company a separate entity if you want to, but most people don’t because the tax benefits are so much better when keeping it as a disregarded entity.
Stock Sale vs Asset Sale
When a small business owner sells stock in their company, they are really selling the entity of the company to the buyer. Remember that selling a stock is like selling a portion of the ownership to your company. The more stock that is purchased, the bigger percentage of the company that your buyer owns. Of course, the buyer will assume the debts and liabilities that are attached to their ownership of the company as well.
That is why most buyers prefer an Asset Sale. They buy the assets of a company without incurring the debts and liabilities of your corporation. It is quite common for a business to be sold in an Asset Sale while the seller’s corporate entity continues on, long after the business has changed hands.
Sellers, on the other hand, generally prefer a Stock Sale because they will get taxed at a much lower rate than they would if they sold their capital assets. Buyers might not always like this idea, so sellers will typically lower their purchase price in order to make the offer more appealing to the buyer.
Anytime the seller makes a profit on the sale of their stock, they must pay a longterm capital gains tax, unless the business is less than a year old, which is rare. The difference is that stocks are usually held for a lot longer than capital assets, which means the seller will get a more generous tax break for selling stock that they’ve held for longer than one year.
Dealing wih Capital Assets
Property management businesses are typically sold with very little in the way of capital assets. The vast majority of a service company’s enterprise value is in goodwill, defined as all value after tangible assets. The common tangible assets in PM transactions include office equipment, software and hardware, furniture, tenant improvements, maintenance equipment and vehicles.
Capital assets are thrown into three categories by the IRS – real property, depreciable property, and inventory property. Some PM owners sell real estate along with their business. The real estate gets taxed as a separate capital asset unless the buyer was purchasing the entire entity of the company in a Stock Sale. If the buyer purchases the entity, it would allow the buyer to just take over all the real estate holdings of the company because those properties are under the company’s name. The only time this wouldn’t apply is if the original owner’s name was on the property. Then, the owner would have to actually sell the property through a real estate transaction to the buyer and pay a capital gain tax on the profit.
Depreciable property is the furniture, computers, vehicles and such whish gets treated as a gain or loss, based on the current value. This value is almost always lower than what the seller originally purchased it for. If you held the depreciable property for longer than one year before you sold it, then your tax rate will be considerably less than if you held the property for under a year. The current value versus the purchase price will be what decides the tax rate in this situation. Depreciation recapture is the term used to describe the amount of profit you made from selling the depreciable property.
Inventory sales is not relevant to property management companies and most service businesses.
One Way To Close a Deal Tax-Free
Property management sellers want to pay as little tax as possible. Is it possible to avoid paying taxes altogether? Yes and no. If you put cash in your pocket upon the sale of the company, you’re going to get taxed. But there are a few ways to close your deal on a tax-free basis.
One way is with stock exchanges. If a buyer has his own corporation and offers his company stock in exchange for stock in your company, it could qualify. As long as certain IRS provisions are met which pertain to a reorganization, you can conduct a stock exchange like this and not have to pay any taxes at closing.
The IRS states that the seller must receive 50%-100% of the buyer’s stock in order for it to be tax-free. As for asset transfers, you can make these tax-free as well if you receive 100% of the buyer’s stock. The only time you will be taxed is if the buyer gave you actual cash for your stock or assets. Otherwise, you can get away with a tax-free transaction by simply keeping it as an exchange of non-cash assets.
The benefit of seller financing
Business sellers love all-cash offers. Because property management is a highly-desirable category in business sales, all-cash deals are very achievable. But more often than not, buyers are not willing to pony up 100% cash to close the transaction.
Seller financing allows an owner to achieve a higher price by deferring payments from the buyer. The buyer makes monthly payments for 3, 5 or 7 years typically, with an interest rate added onto the monthly premiums. SBA lenders and local banks usually require some amount of seller financing in order to underwrite their loan. A seller carry note is usually the best way to bridge the gap in price expectations between a seller and buyer. It’s also seen as a way for the outgoing owner to still have skin in the game and actively assist the new owner in a successful transition.
Many sellers struggle with incurring this risk. What if the new guy makes a mess of things? Loses many of my clients or employees? If the business goes south and the buyer defaults, there is a chance you could lose your business and the money still owed on the note.
On the favorable side, the nature of PM’s recurring revenues and contracted fees makes this, thankfully, pretty uncommon. In a worst case of a default or BK, the seller can defer all taxes on the monthly payments until they’ve landed. You only pay taxes on the money the buyer has already paid you. Not only that, you get to retain ownership of your company while keeping the money the buyer already paid you.
This outcome can be great as long as the company has not lost a lot of its income potential. These are serious considerations you need to make before you offer seller financing to a buyer. But if you are just selling some of your assets through seller financing while retaining stock ownership of the company, then it may be a less risky transaction for you.