Business owners contemplating a sale of their business should carefully evaluate the state tax implications of various transaction structures. Several states, particularly New Jersey and New York, have individual income tax rates approaching 11%, which can significantly increase an owner’s tax bill upon the sale of their business. Due to these high tax rates, many owners consider relocating to a low- or no-tax state prior to an exit, with the idea that this change in residency will help save state income taxes. While this is certainly a viable option, as with many tax savings strategies, the actual benefit depends on several factors, the two most important of which are deal structure and timing of the relocation.
Asset Sales vs. Equity Sales: Understanding the Difference
In transactions structured as asset sales, the selling price is allocated across all transferred assets, including goodwill. In the case of multistate businesses, the allocation and apportionment of gain from asset sales, particularly goodwill, for state income tax purposes is a complex issue. Each jurisdiction has its own rules governing the apportionment and taxation of gain from the sale of assets, thus the complexity of multi-state sourcing warrants careful attention. Most states require gain to be apportioned across the states where the business operates. As a result, relocating to a more tax-friendly state before a transaction may not provide the tax benefit many business owners anticipate.
In transactions structured as equity sales, the gain is generally taxed based on the seller’s state of residence. As a result, a relocation prior to the closing of an equity sale may provide a more meaningful tax benefit if the change rises to the level of a change in domicile, and not just a change in residency.
A Change of Domicile Requires Careful Planning
A successful change of domicile is far more involved than most business owners initially anticipate. Establishing residency in a new state is not simply a matter of purchasing a home in Florida or spending a few additional months in a low-tax jurisdiction. High-tax states such as New Jersey and New York have become increasingly aggressive about challenging domicile changes made shortly before a liquidity event. Residency audits in these situations are common. A defensible change of domicile generally requires substantive lifestyle changes such as moving your personal effects, moving your professional and social affiliations, updating estate planning documents, changing your driver’s licenses and voter registration. Essentially, you must demonstrate a genuine intent to make the new state your permanent home. It also requires meticulous documentation. Business owners contemplating this planning strategy should generally plan to establish their new domicile at least 18 months before closing. Ideally, the earlier the relocation occurs, the stronger the position you have to defend yourself in the event of a state audit.
The structure of the transaction, whether as an asset sale or equity sale, and the nature of the business are key variables to consider when assessing the tax benefit of any pre-sale relocation strategy. Business owners considering this strategy should consult with their WG advisors well in advance of a transaction to model the state tax impact under each structure to ensure both compliance and optimal tax outcomes.
