Buying or Selling a Small Business: Deal Structure, Tax Allocation and Closing

The first structural decision is whether the buyer acquires the assets of the business or the ownership interests in the entity — shares of a corporation or membership interests in an LLC. The choice is driven by tax and by liability, and the two sides usually start in opposite corners.

In an asset purchase the buyer's new entity acquires the equipment, inventory, contracts and goodwill, and the price becomes its tax basis in each: equipment is depreciated, goodwill amortized over fifteen years. Liabilities not expressly assumed stay with the seller, subject to the successor-liability rules below. The seller recognizes gain asset by asset — ordinary income on inventory and depreciation recapture, capital gain on goodwill — and a C-corporation seller is taxed at the corporate level and again on distribution, which is why C-corporation sellers resist asset deals.

In a stock or membership-interest purchase the buyer acquires the entity with everything in it — assets, contracts, licenses, employees, and all liabilities, known and unknown. The seller has a single capital gain; the buyer's basis in the underlying assets does not change, so the asset-deal write-offs are lost unless a special election is available. Contracts and licenses that cannot be assigned — a lease without a consent clause, a liquor license — sometimes make a stock deal the only practical route.

The firm's approach is to price the structure: estimate each side's after-tax result under both forms, and let the difference inform the negotiation over price, indemnities and escrow.

Diligence is where the attorney-CPA combination earns its keep. The list for a typical small-business purchase in Cook County:

• Three years of federal and Illinois tax returns, financial statements and bank statements, reconciled to each other.
• Sales-tax returns and MyTax Illinois standing; payroll returns and the IDES account.
• The lease: term, options, assignment and consent clause, personal guaranty, and whether the landlord will consent to the buyer.
• Customer and supplier contracts and their assignment and change-of-control clauses.
• Licenses and permits, and whether each transfers (a City of Chicago business license and any liquor license are the usual issues).
• A UCC search and a judgment and lien search against the seller and its owners.
• Employees: agreements, non-competes, accrued vacation, pending claims.
• Equipment and vehicle titles, and leased equipment.
• For a stock purchase, the minute book, ownership ledger, operating or shareholder agreement, Secretary of State standing and S-corporation acceptance letter.
• Pending or threatened litigation and insurance claims history.

The output is a list of what the agreement must address: representations to be made, items to be fixed before closing, liabilities to be excluded, and price adjustments.

In an asset purchase, both the buyer and the seller file Form 8594, Asset Acquisition Statement, with their returns for the year of the sale, allocating the price among seven classes under the residual method: cash, actively traded securities, receivables, inventory, tangible property such as equipment, section 197 intangibles other than goodwill, and finally goodwill and going-concern value. For the seller, amounts allocated to inventory and to depreciation recapture on equipment are ordinary income, and amounts allocated to goodwill are capital gain. For the buyer, equipment is recovered through depreciation, while goodwill and other section 197 intangibles are amortized over fifteen years. Because the buyer wants more in equipment and the seller more in goodwill, the allocation is negotiated and written into the agreement so the two forms match; an allocation left to each side's accountant after closing invites an IRS inquiry.

Many small-business sales close with part of the price deferred. Seller financing is a promissory note from the buyer, secured by a lien on the assets, usually with a personal guaranty from the buyer's owner; the seller reports the gain on the installment method as payments come in. Earn-outs pay the seller additional amounts if revenue or profit targets are met after closing; the drafting questions are how the target is measured, what the buyer must and must not do while the earn-out runs, and how a dispute is decided.

A non-compete from the seller is standard and is usually what the buyer is paying for in goodwill. The Illinois Freedom to Work Act, which restricts employee non-competes by earnings threshold and notice requirements, expressly excludes covenants given by a person selling the goodwill of a business or an ownership interest, so a seller's covenant is judged on reasonableness in duration, geography and scope. The amount of the price allocated to it is ordinary income to the seller and a fifteen-year intangible for the buyer — another reason the allocation is negotiated.

At closing the parties sign the bill of sale, the assignments of contracts and the lease with the landlord's consent, the note and security documents if applicable, the non-compete, and the resolutions authorizing the deal; liens are paid off and UCC terminations filed. The buyer's entity should already be formed, with its EIN, bank account, MyTax Illinois and IDES registrations and license applications in progress, so payroll and sales-tax collection continue without a gap. After closing, Form 8594 goes in each side's file for the year's return, the seller's entity files its final returns or is dissolved, and the operating or shareholder agreement of the buying entity reflects any new owners who came in to finance the purchase.

1. Before the letter of intent

   Week one · before you sign anything

   A call to settle structure, price mechanics and the binding terms, then a reviewed or drafted letter.

2. Diligence and term sheet

   Usually two to four weeks · set by how complete the seller's records are

   The firm reviews the records, reads the returns, and lists the issues the agreement must address.

3. Agreement and allocation

   Usually three to six weeks · the other side's pace counts

   Drafting or negotiating the purchase agreement, schedules, allocation, note and security documents, and the bulk-sales notices.

4. Closing and after

   Closing day, then the first thirty days

   Signing, funding, lien releases, license and lease transfers, and a post-closing checklist for both sides' tax reporting.