Buying or selling a business can give rise to some of the most important tax planning you may ever require. You, whether representing a buyer or seller, need to know that the tax consequences of the transaction will be those which were intended and which were assumed by the parties when negotiating the price. And since the price which the parties agree to will depend on the tax consequences of the structure chosen, it is important that you know the different structural choices as early as possible in the negotiation process.
Where a business is operated as a C corporation (meaning any corporation that does not elect to be treated for tax purposes as an S corporation), a buyer may either acquire the stock of the corporation (the “target corporation”) from its shareholders (a “stock deal”), or it may acquire the assets comprising the business from the target corporation itself (an “asset deal”). Either a stock deal or an asset deal may be designed as a taxable sale or as a tax-free reorganization.
A taxable sale of assets followed by a liquidation of the corporate seller normally results in a double tax. The corporate seller will pay a tax on gain recognized on the sale of its assets, and the shareholders will pay tax on gain recognized on the liquidating distributions that they receive. On the other hand, a taxable sale of stock avoids for the seller a double tax at the corporate and shareholder levels, resulting in a single tax to the selling shareholders on gain from the sale at capital gains rates.
The strikingly different tax consequences for the parties can be dramatic. For example, assume that the target corporation owns assets with a basis of $1 million and that the target corporation’s sole shareholder has a basis of $200,000 in the target corporation’s stock. Assume further that the target corporation sells its assets for $5 million and then liquidates.
If the target corporation is a C corporation in a 40% combined federal and state tax bracket, it pays corporate tax of $1.6 million on the recognized corporate gain of $4 million. And upon the target corporation’s distribution of the after-tax sales proceeds of $3.4 million to its shareholders in liquidation, the shareholder recognizes $3.2 million in gain on the distribution ($3.4 million liquidating proceeds less $200,000 stock basis). Assuming the shareholder is in a combined 25% federal and state tax bracket, the shareholder pays a tax of $800,000. Thus, the shareholder nets $2.6 million in after-tax liquidation proceeds on a $5 million sale of assets.
If, however, this transaction is structured as a stock deal with the shareholder selling his stock in the target corporation for $5 million, the shareholder pays a tax of $1.2 million and thus nets $3.8 million in after-tax sales proceeds on a $5 million sale of stock. In other words, the shareholder nets $1.2 million more by selling his stock in the target corporation rather than causing the target corporation to sell its assets and to then liquidate.
Therefore, the double tax cost to the seller’s shareholders will usually mean that the seller will prefer a stock deal to an asset deal. The converse is true for the buyer who, in a taxable sale of assets, acquires the assets comprising the business with a basis equal to the price paid (including any liabilities assumed).
For example, if the above transaction is structured as an asset deal, the buyer gets a stepped-up, fair market value, basis for the assets equal to $5 million, and will therefore get higher depreciation and amortization deductions than the target corporation was enjoying. Conversely, in a stock deal, the basis of the assets to the buyer after the sale generally remains the same as it was before the sale. As a result of the loss of increased depreciation and amortization deductions, the buyer will often be unwilling to pay as much for stock as it would for assets.
An election is available under IRC §338 to treat a stock deal as an asset deal for tax purposes, resulting in a stepped-up basis for the corporate assets, but the target corporation will then generally recognize gain as if it had actually sold its assets, resulting in a double tax as in an actual asset sale and liquidation. The IRC §338 election is thus generally advisable only if the target corporation has a large enough net operating loss to offset any gain on the deemed asset sale. A variation of the IRC §338 election is available under IRC §338(h)(10) when stock of an S corporation or a subsidiary in a consolidated group is sold; the 338 (h)(10) election also treats a stock deal as an asset deal for tax purposes, yielding a stepped-up basis, but only one level of tax is triggered.
Certain tax benefits may be available to an individual who sells stock in a small business corporation. IRC §1244 allows up to $100,000 of loss on the sale to be treated as ordinary rather than capital loss, which may be utilized only to offset capital gain and up to $3,000 of ordinary income in any taxable year, with any excess loss carried forward to future taxable years. IRC §1202 allows 50% of the gain on the sale of qualified small business stock to be excluded from income, resulting in federal tax of only 14% on the gain. And IRC §1045 allows the seller to avoid recognizing gain on the sale of qualified small business stock to the extent he reinvests the proceeds of sale in other qualified small business stock. Each of these provisions has stringent eligibility requirements as to the size and operating of the business and, for IRC §§ 1202 and 1045, the seller’s holding period for the stock.
Whether the sale of the target corporation’s business is cast in the form of an asset deal or a stock deal can also have strikingly different non-tax consequences. For example, unlike an asset deal where the buyer selects which liabilities, if any, it will assume, a buyer in a stock deal takes the target corporation with all its liabilities (whether known or unknown) in place. Moreover, unlike an asset deal where the buyer selects which assets it will purchase, a buyer in a stock deal acquires, through its stock ownership, all of the target corporation’s assets (whether wanted or unwanted).
Other non-tax factors affecting the decision to cast the transaction as a stock deal or an asset deal include the simplicity and convenience in arranging for the purchase, possible difficulties in transferring contracts, leases and similar assets, stockholder approval and appraisal rights, loan agreement and mortgage restrictions, collective bargaining agreements, employee benefit plans, and unemployment worker’s compensation insurance ratings.
Strategies for avoiding the double tax cost resulting from a taxable sale of assets are limited. Five come to mind. Of these, two are seldom employed, two are almost always used, and the fifth, through somewhat controversial, is probably the best under the right facts.
One seldom-employed strategy is to keep the corporation in existence after the asset sale until the shareholder’s death, at which time the stock passes to his estate or heirs with a stepped-up basis in their hands. In this way, all appreciation in value of the stock before death, including pre-sale appreciation, will escape income tax on a later sale of the stock or liquidation of the corporation by the shareholder’s estate or heirs. However, a principal disadvantage of this strategy is that personal holding company problems can arise for the corporate seller, if the corporation is not liquidated after the sale. If the corporation retains and invests the proceeds of sale of its assets, it may be classified as a personal holding company and subjected to penalty tax on its undistributed personal holding company income.
The other strategy that is rarely used involves the use of a charitable remainder unitrust (a “CRUT”) Here is how the strategy works. The shareholder creates a CRUT, pursuant to the provisions of which the trustee agrees to pay to the shareholder and his spouse during their lives and to the survivor of them during his or her lifetime an amount equal to, say, 7% of the fair market value of the trust assets, and at the death of the survivor of them, the remainder of the trust assets to the shareholder’s designated charitable beneficiary (which the shareholder may from time to time change). The shareholder then contributes his stock in the target corporation to the CRUT, and, soon thereafter, the target corporation sells its assets and then liquidates. While the target corporation pays tax on the gain recognized on the sale of the assets, no income taxes shall be payable upon liquidation because of the CRUT’s tax exempt status. Moreover, the shareholder receives a substantial income tax charitable deduction for the actuarial value of the charity’s remainder interest in the CRUT.
Of course, the disadvantage of this strategy is that the trust assets will ultimately pass to the designated charitable beneficiary upon the surviving spouse’s death rather than to the shareholder’s children or other loved ones. But that disadvantage can be negated by the purchase of a survivorship or second-to-die policy of life insurance on the lives of the shareholder and his spouse, the premiums on which could be paid from the income tax savings resulting from the charitable deduction for the actuarial value of the charity’s remainder interest in the trust and the excess income resulting from having been able to reinvest the entire liquidation proceeds. All premiums would be paid by the shareholder’s children or other loved ones, or by a life insurance trust established for their benefit, through annual exclusion gifts of the shareholder and his spouse. By so doing, the death proceeds will be received by the shareholder’s loved ones free of income and estate taxation.
The frequently-used strategies for negating the double tax cost to the shareholders involve the allocation of as much of the purchase price as can be reasonably justified to noncompetition and consulting agreements with the shareholders of the target corporation. While payments to the shareholders under those agreements will only be taxed once at the shareholder level, those payments constitute income to the shareholders taxable at ordinary income-tax rates. Moreover, payments made under consulting agreements will probably be subject to employment taxation as well.
The fifth, and perhaps the best, strategy is to allocate a portion of the purchase price to the personal goodwill of the shareholders. This strategy has three advantages. First, the amounts paid the shareholders are taxed at capital gain rates (rather than at ordinary income rates as is the case with respect to payments received under noncompetition agreements). Second, double taxation is avoided since the shareholders are the sellers of these assets. And, third, the buyer gets a stepped-up, fair market value, basis in these assets equal to the amount paid.
But for this strategy to work it must be demonstrated that the shareholders (rather than the target corporation) are the owners of the business goodwill, represented by the excess earning power over a fair return on the capital invested, that the buyer is acquiring. The question therefore is: Is the business goodwill and other intangible assets owned by the target corporation or do these assets actually belong to the shareholders?
In Martin Ice Cream Company v. Commissioner, 110 T.C. 189 (1998), the Tax Court examined this question in connection with the purchase and sale of intangible assets of an ice cream distributing business and ruled that, under the facts presented, the assets belonged to the shareholder and that ownership thereof could not be attributed to the corporation because the shareholder had never entered into a covenant not to compete with the corporation or any other agreement—not even an employment agreement—by which any of the intangible assets became the property of the corporation. In so ruling, the Tax Court stated as follows:
“This Court has long recognized that personal relationships of a shareholderemployee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate assets of corporate goodwill. See, e.g., Estate of Taracido v. Commissioner, 72 T.C. 1014, 1023, 1979 WL 3837 (1979) (where sole shareholder was sine qua non of corporation’s success, corporation’s goodwill did not include the personal qualities of its sole shareholder); Cullen v. Commissioner, 14 T.C. 368, 372, 1950 WL 142 (1950) (personal ability, personality, and reputation of sole active shareholder not a corporate intangible asset where there is no contractual obligation to continue shareholder’s services); MacDonald v. Commissioner, 3 T.C. 720, 727, 1944 WL 121 (1944) (‘We find no authority which holds that an individual’s personal ability is part of the assets of a corporation by which he is employed where * * * the corporation does not have a right by contract or otherwise to the future services of that individual.’); Providence Mill Supply Co. v. Commissioner, 2 B.T.A. 791, 793 (1925).”
In prior and subsequent decisions, courts have repeatedly recognized that the value of goodwill attributable to the personal abilities and relationships of the shareholders and employees of a corporation are not the property of the corporation absent some contractual obligation such as an employment agreement or noncompetition agreement that transfers these intangibles to the corporation. See MacDonald v. Commissioner, 3 T.C. 720 (1944); Mayme C. Sommers, Administatrix, 22 B.T.A. 1241 (1931); Wickes Boiler Co, 15 B.T.A. 1118 (1929); Estate of Taracido v. Commissioner, 72 T.C. 1014 (1979); Cullen v. Commissioner, 14 T.C. 368 (1950) and William Norwalk, et al v. Commissioner, T.C. Memo. 279 (1998).
The strategy for selling personal goodwill outside of a target corporation works best if the target corporation is not capital-intensive. Examples include sales of incorporated professional practices such as medical, dental, law and accounting firms. See O’Rear v. Commissioner, 28 B.T.A. 698 (1933); Schilbach v. Commissioner, T.C. Memo 1991-556 (1991); Miller v. Commissioner, 56 T.C. 636 (1971); Richard S. Wyler v. Commissioner, 14 T.C. 1251 (1950); Merle P. Brooks v. Commissioner, 36 T.C. 1128 (1961); Wilmot Fleming Engineering Co. v. Commissioner, 65 T.C. 847 (1976); LaRue v. Commissioner, 37 T.C. 39 (1961); and Braunwarth v. Commissioner, 22 B.T.A. 1008 (1931).
But even in the best of circumstances, it cannot be overemphasized how important it is to establish facts which can support a finding that the goodwill and other intangible assets belong to the shareholders and not to the target corporation. Unless carefully planned, the IRS may deem the sale of intangible assets by the shareholders as a fiction. Nevertheless, the opinion in Martin Ice Cream Co. certainly supports the position that shareholders can do so when the facts are right.
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