Buyers and sellers: tax strategies for buying and selling businesses

California CPA, March-April, 2005 by Robert Briskin

Among its many provisions, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduces the tax costs of selling a business.

CPAs can maximize the tax benefits for their clients through careful tax structuring of the selling entity; transferring the selling entity's assets; and properly allocating the purchase price among sold assets, intangibles and employment agreements.

The following are some available tax strategies for buying and selling a business.

AVOIDING DOUBLE TAXATION

Many businesses that are sold are owned by C corporations, which produces two levels of taxation in an asset sale: first at the corporate level on the assets' sale and second at the shareholder level when the net sales proceeds are distributed to the shareholders in a corporate liquidation.

Even after the 2003 Tax Act's tax reductions, this double taxation of the purchase price paid to a C corp in an asset sale produces a 53 percent tax rate after taking into account the effect of California tax. This combined tax rate will increase after the federal capital gain rate increases to 20 percent in 2009. This current combined 53 percent rate on an assets' sale gain should be contrasted with a stock sale where the one level of tax on the gain produces a low combined 21 percent federal and California capital gain rate.

These tax rates assume that there is no federal individual alternative minimum tax, which is at a maximum 28 percent federal rate. Because of California's high income tax rates, many clients will be subject to the AMT where they have a large amount of taxable gain from the sale of their business.

Selling Shareholders Will Prefer to Sell Their C Corp Stock Instead of Doing an Asset Sale to Produce Only One Level of Taxation. To avoid two levels of taxation, C corp clients selling their businesses will want to have a stock sale and not an asset sale, since a stock sale produces only a shareholder-level tax at low capital gain rates. However, the business' buyer may desire an asset sale to receive a stepped-up tax basis in the acquired assets. An asset sale also allows the buyer to avoid being obligated for potential tort and contract liabilities of the selling corporation. Additionally, an asset sale may have a California sales and use tax imposed on the sold assets.

The corporate buyer of stock could make a Sec. 338 election to receive a step up in the selling corporation's assets' tax basis, but the buyer would then have to pay a corporate-level income tax.

If Selling C Corp Has Operating Losses, It Can Avoid Gain on an Assets Sale. If the selling C corp has operating losses, it may be able to use these losses to shelter the gain on an asset sale, while still giving the buyer a stepped-up asset tax basis.

Avoid the Double Level of Taxation to a C Corp By Having Part of the Purchase Price Paid to the Selling Shareholders as Compensation or as Payment for a Covenant Not to Compete. An asset sale can be structured to treat some portion of the purchase price as payment to the selling corporation's shareholders for compensation or for a covenant not to compete, provided these payments are "reasonable" for tax purposes.

Consulting or employment agreement payments are immediately deductible when paid by the buyer, and are included as ordinary income by the selling shareholders when received. Salaries, however, will be subject to the FICA tax to both the paying (employer/buyer) and receiving (employee/selling shareholder).

Payments paid by a buyer under a covenant not to compete are ordinary income to the selling shareholders, but must be amortized by the buyer (and cannot be expensed) over 15 years, even though the covenant may be for a shorter period of time than 15 years. [Sec. 197(d)(1)(E).]

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Use Qualified Plans to Defer Income Tax. Selling shareholders can set up qualified compensation plans to defer the tax on an employment agreement's payments.

Avoid the Double Level of Taxation to a C Corp by Treating Part of the Purchase Price as a Payment for Assets Owned by the Shareholders. Avoid the C corporate-level tax by paying the selling business' shareholders directly a license fee for shareholder-owned trademarks, trade names or franchises. License fees are taxed to the receiving selling shareholders at ordinary income rates. Shareholders owning real estate used by the business can either sell that real estate to the buying company (receiving capital gain treatment with the exception of recapture income) or the shareholders can rent that real estate to the buying entity (where the rents will be taxed to the receiving shareholders at ordinary income rates).

USING PASS-THROUGH ENTITIES

Owning the business in a limited liability company or S corp avoids the double level of taxation. California imposes an annual franchise tax of $800 on limited liability companies, plus an annual fee on income (before deductions) of $900 on income of $250,000, which maximizes at $11,790 annually on $5 million of income.

Convert Seller to an S Corp. If an S corp has been in existence for 10 years or more (or was initially formed as an S corp), then the asset sale will not produce a federal tax at the corporate level under Sec. 1374. An S corp will still have the 1.5 percent California tax on its earnings, including gain on an asset sale. [California Revenue and Taxation Code Sec. 23802(b)(1)]. If a C corp is converted to S status, then there is potential built-in gains tax under Sec. 1374, loss of net operating loss carry-overs, and the inventory LIFO recapture tax.