Classify a Seller as Management Consulting (1099)

Posted On: 01-25-2008

When buying a business, minimize your total cash outlay and future tax liability by carefully classifying the efforts of the seller post-closing.

 

In most instances, when buying a business, you will require the seller to remain with the business in some capacity and for a specified period of time while you become acclimated to the inner workings of the operation.  As you know, this training will not be free and will come at a cost to you.  However, by properly accounting for the time purchased, you can realize a subtle positive effect on both your current cash outlay and future tax liability.

From greatest after-tax value to least, your options for structuring future training/consulting are: 

By utilizing the seller as a consultant, or an independent 1099 contractor, your cash outlay is strictly the value of the consulting agreement.  The seller (independent contractor) is responsible for the full value of all payroll taxes (12.4% for social security tax plus 2.9% for Medicare totaling 15.3%)  For federal income tax purposes, all amounts you pay to the seller are fully deductible in the year in which they are incurred.

If you elect to retain the seller’s services through a traditional employment agreement rather than a 1099 consulting agreement, you again would offset your income in the year incurred.  However, your total cash outlay would be greater than with the 1099 contractor agreement as a result of payroll taxes.  In a traditional employment arrangement, you the buyer (employer) are responsible for the employer portion of the seller’s (employee) payroll taxes (employer portion of FICA).  This additional expense of 7.15%, although fully tax deductible (in the period incurred) proves an additional drain on cash flow.

The third (and in my opinion least attractive option) to a buyer would be to include the seller’s compensation for services rendered with the value of the non-compete agreement.  Although from a buyer’s perspective it can be argued that the inclusion of the value of seller services with the non-compete is preferential to the previously discussed employment agreement (there are no employer payroll taxes associated with the non-compete) the negatives outweigh the positives in the long term.

A covenant not to compete can only be expensed (amortized) by the buyer over a 15 year period regardless of the term of the agreement.  For example, let’s assume a seller has agreed to a 5 year non-compete agreement at a value of $150,000 which includes a 6 month transition period whereby the seller remains with the business.  Although you have avoided paying payroll taxes on the amount for services rendered (like when using a 1099 consulting agreement), you can only offset business income, over the next 15 years.  This means with a $150,000 non-compete you will be able to offset taxable income by $10,000 a year over a 15 year period.  Although only a small portion of this $10,000 will be attributable to seller services rendered with the majority attributable to the non-competition clause, there remains a very slight negative time value of money tax effect to you compared to the previously discussed options of using a 1099 consulting agreement or a traditional employment agreement.

Remember as stated in our seller’s perspective piece regarding this same issue the cost/benefit to each party is completely different and there will be a need to negotiate.  It will probably not be worth your time, energy and money to argue with the buyer over traditional employment versus including the value of future services in the non-compete.  However, simply being aware of the different treatments may allow you to realize a benefit here as an offset to giving in another area.  As always, keep your accountant actively involved in negotiations.  They are tax experts.

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