Q: A prospective buyer of my travel agency wants to pay just a few thousand dollars for my agency's assets and then pay me a very large consulting fee equal to the total value of my agency. Why would the buyer want to structure the payments this way? Is it good or bad for me to receive the payments as consulting fees? If it is bad, how should the payments be structured to minimize my taxes on the buyout?
The buyer probably prefers to allocate as much of the payments to consulting fees for you because the buyer is able to deduct the payments as an ordinary business expense in the year in which the buyer makes the payments.
Conversely, if the buyer must allocate the payments to the purchase of assets, then almost all of the payments will be deductible over a 15-year period at the rate of 6.66% per year.
Say the buyer is willing to pay you $500,000 for your agency. If the buyer pays you $20,000 for the tangible assets of your agency, such as your furniture and equipment, the buyer would deduct the latter amount over five or seven years, depending on what tangible assets you have.
Then, the buyer would typically want to accelerate the remaining $480,000 by characterizing it as consulting fees (or even a salary for you), so that the buyer can deduct the payments in the year paid.
If you do not agree to accept the $480,000 as consulting fees, then the buyer would be forced to allocate that amount to your agency's intangible assets. Then the buyer could deduct only 6.66% per year, or about $32,000 per year for 15 years.
Since both the buyer and the seller need to agree on the allocation of all payments and file their tax returns accordingly, there is often a tug of war over how to allocate the payments.
From the seller's point of view, allocation to consulting fees is usually terrible because consulting fees are ordinary income to you, as opposed to long-term capital gain income for the purchase of assets.
For example, if you own an S corporation (also known as a Subchapter S corporation), $480,000 in consulting fees paid to you or the corporation will result in a federal tax rate of about 39.6% if paid in one year and just a little less if paid over two or three years, depending on your other income and deductions.
On top of that percentage, you would owe state taxes on the income if you live in one of the 40-plus states with a state income tax.
On the other hand, if the buyer agrees to allocate all $500,000 to the purchase of assets, the payments will ordinarily be long-term capital gain income to your corporation and you, taxable at just 20% or less at the federal level, plus any state taxes on capital gains.
So allocating payments to consulting fees is bad for you, and the huge difference in tax treatment can easily justify the decision not to sell your agency to a buyer that insists on characterizing the payments as consulting fees.
Like all tax situations, there are exceptions to the rules, and you should consult a knowledgeable lawyer or certified public accountant before agreeing to any allocation of payments. Mark Pestronk is a Washington-based lawyer specializing in travel law. To submit a question for Legal Briefs, email him at firstname.lastname@example.org.