Structuring the Sale of Your Alarm Company

Selling your stock at a lower recurring monthly revenue multiple may leave more money in your pocket than selling assets at a higher multiple. That is why smart sellers look beyond the purchase price and ask how much will be left after income taxes.

Recently, the consolidation of alarm companies has caused you to consider what you might receive if you sell your company. But in deciding whether to sell the company’s assets or to sell your company stock, you find variables that you hadn’t previously considered. Although it is easy to simply focus on the multiple of recurring monthly revenue (RMR) and the gross purchase price that results, a smart seller looks beyond these two factors.

Instead, the smart seller wants to know what will actually be left after paying taxes on any gain realized from the sale. Did you know that a seller might wind up with more in his or her pocket from a sale of stock at a lower multiple of RMR than from a sale of the company’s assets at a higher multiple? When deciding how to sell a security company, understanding income taxes can help you choose the best deal.

All Companies Not Taxed Equally

Many alarm companies, particularly older companies, are classified as C corporations for income tax purposes. A C corporation is a taxpaying entity separate from its owners, known as “shareholders,” and, thus, pays income tax on its own income from year to year.  A C corporation also carries certain state income tax consequences, which must be determined by reference to applicable state law.

Distributions made by a C corporation to its shareholders (other than those representing reasonable compensation to shareholder-employees) are generally not deductible by the corporation and are taxed to the shareholders as dividend income when received.  Thus, a C corporation’s income is subject to double taxation – once at the corporate level when the corporation earns the income and again at the shareholder level when the income is distributed to the shareholders as a dividend.

Partnerships, limited liability companies and S corporations, on the other hand, are essentially “passthrough” entities that do not pay income taxes at the entity level. Instead, the owners of such companies are taxed directly on the company’s income (e.g., the income is passed through to the owners), whether or not such amounts are paid out.

Subsequent distributions of income to the company’s owners are not taxed a second time. Converting from a C corporation to another form of business, however, can carry undesirable income tax consequences. Thus, many businesses that were established years ago as C corporations are still faced with this form of business entity and the double taxation that goes along with it.

Double taxation may also occur when a C corporation sells its assets. A C corporation that is for sale may own highly depreciated assets or other assets that have a very low income tax basis. Upon the sale of such assets, the corporation must generally recognize taxable capital gain equal to the purchase price received for the assets less their tax basis. If the corporation’s tax basis in its assets is zero, the entire purchase price may represent capital gain that is taxable to the corporation at regular corporate income tax rates.

Upon the liquidation of the corporation, the subsequent distribution of the remaining purchase price to the shareholders will represent capital gain to the shareholders to the extent the distribution exceeds the shareholders’ basis in company stock.

Buyers Pay More, Sellers Get Less

The effect of income taxes on the sale of an alarm company may be illustrated by the following example. Assume that the selling company is a C corporation with RMR of $100,000 and a tax basis in its assets of zero. The company’s stock is owned by a single shareholder whose income tax basis in the stock is zero. (This simplified example is for illustration purposes only and does not reflect all possible variables that may affect the tax consequences of alarm company sales.)

After many years of building the company, the sole shareholder wishes to sell the company and retire. Although there is no established formula, the current market trend is for sellers to pay three to six multiples of RMR lower for a stock sale than for an asset sale. Consistent with this trend, the company recently received the following two offers for its business:
• 38 times RMR for assets, for a gross purchase price of $3.8 million
• 35 times RMR for stock, for a gross purchase price of $3.5 million
On this basis, the shareholder is prepared to accept the offer for an asset sale, but first calculates the net proceeds from the asset sale.

Stock Sale Avoids Double Taxation

Because the double taxation present in a sale of assets can be avoided with a stock sale, the shareholders of a C corporation generally prefer a sale of stock. The purchase price is not paid to the corporation itself, but is instead paid directly to the shareholders.

Therefore, the corporation makes no disposition of its assets and does not recognize capital gain on the sale. Instead, the shareholders simply pay capital gains tax on the amount by which the purchase price exceeds their income tax basis in their stock.

Buyers, on the other hand, generally prefer to purchase assets rather than stock. If a buyer purchases stock, the buyer will not receive an increase in the depreciable basis of the business assets nor the ability to amortize acquired goodwill and other intangible items (such as customer lists) as it would in an asset sale. Furthermore, in a typical asset sale, the buyer assumes only specified liabilities, whereas in a stock sale, the buyer assumes all of the liabilities of the acquired company by operation of law. For these reasons, buyers will pay less to acquire a business through a stock sale.

Upon considering the income tax rules applicable to a stock sale, the shareholder in our example calculates the net proceeds from the stock sale. Even though the buyer will pay a multiple of three times RMR less for a stock sale, the shareholder finds that he will net $886,500 more from the stock sale than the asset sale.

Consulting With Advisors Is Key

Although the shareholder in our example found that a stock sale was a better deal than an asset sale, the opposite may be true in other cases, depending on the nature of the offer, the seller’s income tax basis and other tax laws that may apply.

Before seeking buyers for your alarm company, be sure to consult with both tax and legal advisors to determine the best method of structuring the sale.

Samuel J. Goncz (412-562-1381; [email protected]) is an attorney and member of Buchanan Ingersoll Professional Corp.‘s Tax Group.

John M. Wilson (412-562-1884; [email protected]) is an attorney and member of Buchanan Ingersoll Professional Corp.‘s Security Alarm Group.

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