Successful restaurant companies are a hot commodity in today’s marketplace with existing operators looking to diversify segments served or leverage economies of scale through acquisition – and let’s not forget the private equity group interest. If you’re thinking of selling your restaurant, it’s important to know the value of your company to get top dollar and it may be necessary to obtain an independent valuation. Once you know the value, you need to understand the tax considerations of selling your restaurant to maximize after-tax cash proceeds.
Asset versus stock sale
There are two types of sale transactions that will dictate the tax consequences:
- Asset sale – for example, a prospective buyer will purchase the restaurant’s kitchen equipment, tables and chairs and all interior design work.
- Stock sale – the owner sells his or her membership interest. In this case, the sales price typically includes the assumed liabilities.
Allocation of purchase price
In an asset sale, the seller and buyer negotiate how the purchase proceeds are allocated amongst the assets, which has a significant impact on the federal tax liability.
- Seller’s perspective – The seller’s desire is to allocate more of the purchase price to capital gain assets. This is because the tax rate for capital gains is generally 20%. Compare that rate to the top ordinary income tax rate of 37%. Generally, capital gain assets include the goodwill of the restaurant, which is the intangible property that can include the name brand, recipes, customer base and other similar items. Goodwill is recorded when the purchase price is higher than the amounts allocated to all identifiable assets purchased.
- Buyer’s perspective – The buyer will want to allocate more of the purchase price to the physical assets of the restaurant because they depreciate over a shorter life, which reduces the buyer’s income. Let’s say part of the assets acquired include kitchen equipment and goodwill. The buyer will want to allocate as much is reasonably possible to kitchen equipment because the typical life for that is five years compared to goodwill, which is taken as an expense over 15 years.
In a stock sale, there is no allocation of a purchase price. This is because nothing changes for the entity of the seller. For example, if a buyer purchased stock for $1 million, the cost of the kitchen equipment, tables and chairs and other assets remains the same. This can be a disadvantage for the buyer in that paying $1 million for the stock, while providing tax basis, does not provide immediate depreciation or amortization advantages. The buyer continues to depreciate the existing fixed assets over their remaining useful life. This is the reason most sales of businesses are structured as asset sales.
Sometimes there are restrictions on the transfer of assets that cause the buyer to acquire stock. There are options for a buyer using certain elections within the tax code when they purchase the stock for legal purposes. That would keep the existing entity intact, preserving non-transferable assets. Those elections also allow the buyer to acquire the assets for tax purposes. This would provide the tax benefits a buyer typically wants. Another method to mitigate the harsh results to a buyer of stock is to negotiate a covenant not to compete, which allows the buyer to amortize costs associated with the non-compete agreement to be expensed over 15 years. The amount allocated to the non-compete will be ordinary income to the seller, however.
Often overlooked in the sale of a restaurant are the state tax consequences. Each state has its own varying rates. Generally, at the state level, there is no differentiation between an ordinary gain or a capital gain. In addition, some states may impose a sales tax on the transfer of tangible personal property in an asset sale. This may come as a surprise to the seller after the deal is done.
We highly recommended you review various tax scenarios during the negotiation of the sale to understand the tax consequences and maximize after-tax cash proceeds. Due to the complexities of selling your restaurant, it’s important to work with your attorney and tax advisor in anticipation of a sale to get you the best result.
Kelly Lynch, CPA