Selected Tax Considerations for - Coming...

9/17/2011

1

Selected Tax Considerations for the Sale of a Closely‐Held Entity

David W. HotesBethesda Law Group

4520 East West Highway, Suite 700Bethesda, Maryland 20814

Phone: 301‐469‐3352Email: [email protected]

MACPA Chesapeake Tax ConferenceSeptember 22, 2011

9/17/2011 1© 2011 Bethesda Law Group All rights reserved.

Focus:

● Seller is private and closely‐held

● Seller and/or Seller shareholders seek to sell either substantially all of their assets or all of their stock to a thirdparty

● Sale is for cash and/or promissory notes (i.e. no tax‐free mergers or reorganizations)

● Seller seeks to maximize after‐tax gains


9/17/2011

2

Part I: Seller Entity is a C Corporation


Structuring the Deal: Asset Sale vs. Stock Sale

A. Non‐Tax Issues ‐ General

● Sale of all or portion of assets

● Limiting assumed liabilities

● Ass’t of leases, contracts and third‐party

agreements

● Transfer of licenses


9/17/2011

3

B. Non‐Tax Issues – Stock Sale

● All shareholders willing to sell?

‐ “Drag‐along” provision

● All assets included at Closing

● All liabilities assumed (including contingent and unknown

liabilities)

● Rep’s and Warranties are critical for Buyer

‐Holdbacks and Setoff Rights may be

required

● Transfer of licenses, contracts and leases should be effective,

subject to any “change of control” provisions


C. Non‐Tax Issues – Asset Sale

● Corporation is Seller

● Generally, all or substantially all assets are sold and then

Corporation makes liquidating distributions to its shareholders

● Seller has ability to sell less than all assets (e.g. a division)

● Only select liabilities are assumed

Caveat: Certain liabilities may “follow” the assets (e.g.

environmental, tax and tort liabilities)

● Third‐party consents to assignment of licenses, contracts and

leases ‐ Critical to Buyer

● Retention of all Key Personnel of Seller – Also Critical


9/17/2011

4

D. Tax Issues in Stock Sale for Cash and/or Notes

Corporate Seller’s Perspective

● No tax ramifications to Corporation

● Corporation’s basis in its assets carries over



Shareholder Perspective

● Taxable income to each shareholder, based on amount of

consideration received less their basis in the stock

● Basis = Capital Contributed less Distributions Previously

Received

● Capital gains tax rate is 15% (through 2012)

● Exception: Small Business Stock (IRC §1202)


9/17/2011

5


Shareholder Perspective (Continued)

● Small Business Stock – Eligibility

‐ C corporation stock, acquired at original issuance

‐Active business, other than a professional service

business

‐ Gross assets < $50M

‐Held for at least 5 years




● Small Business Stock – Exclusion Amount

‐ Presently, for Stock acquired after 8/10/93 – 50%

Excluded and 7% AMT Preference (Resulting in

Maximum Effective AMT Rate of 15%

(28% AMT Rate x 57% of Gain Exposed))

‐ Stock acquired from 9/28/10 to 12/31/11 – 100%

Excluded and no AMT Preference (Planning Tip)

‐ Stock acquired from 2/17/09 to 9/27/10 – 75% Excluded

and 28% AMT Preference

● Rollover of Gain under IRC §1045 (60 days)


9/17/2011

6



● Notes Taken Back by Selling Shareholders?

● Installment Method will be available if:

1) Shareholder is a Cash‐Basis Taxpayer; and

2) The Note is not payable upon demand

● Under the Installment Method, gains will be reported as Note

is paid off (pro rata)



Buyer’s Perspective

● Buyer’s Basis in Stock = Purchase Price plus Acquisition Costs

● No Step‐Up in Basis of Corporation’s Assets

● Buyer obtains Tax Attributes of Corporation

– e.g. NOL’s (subject to IRC §382 limitations)

– Earnings & Profits


9/17/2011

7


Hypothetical:

● Shareholder bought 100 shares (comprising 100%) of Target, a C

corporation, for $100,000 in 1995.

● Shareholder sells entire interest in 2011 to Buyer for $500,000

cash.

●At time of sale, Shareholder basis = original investment

● Stock is “Qualified Small Business Stock”



Result:

●No Gain to Target

● Gain to Shareholder = $$$ Received less Basis = $400,000.

50% excluded as QSB stock. Other 50% is LTCG, with 7% AMT

preference. Net, net ‐ Shareholder will pay 15% tax on this gain =

$60,000.

● Buyer’s Basis = Amount Paid = $500,000

●What about §1045 rollover?


9/17/2011

8

E. Tax‐Free Exchange in a Stock Sale

● Stock for stock exchanges may be tax‐deferred under IRS §368

● “A” Reorg – Statutory Merger ‐At least 50% of Buyer Stock

● “B” Reorg – Stock for Stock – 80% Ownership

● “C” Reorg – Assets for Stock – Substantially all assets

● Taxable to extent of Boot (Cash or Other Property) Received

● Shareholder’s Basis Carries Over

● N.B. – Disregarded SMLLC’s may now be used


F. Tax Issues in an Asset Sale (C Corp Seller)


● Tax on Gain Realized by Sale

● Tax Based on Sales Price less Corporation’s “Inside” Basis, by

Asset Class

● Corporate Rate = 35% (No Cap Gain Preference)

●No tax effect to Corporation upon Distribution of Proceeds to

Shareholders following Sale


9/17/2011

9


Corporate Seller’s Perspective (Continued)

●Allocation of Purchase Price (Form 8594)

● Residual Method Must Be Used

ASSET CLASSES:

First, to Cash and General Deposit Accounts, then to:

I) Stock & Securities, CD’s

II) Accounts Receivable

III) Inventory

IV) All Other Assets (excluding IRC §197 Intangibles)

V) IRC §197 Intangibles

VI) Goodwill




● IRC §197 Intangibles

‐ Goodwill, Going Concern Value & Noncompete Cov’ts

‐Workforce in Place

‐ Information Base

‐ Patents, Copyrights and other IP

‐ Customer‐Based Intangibles (e.g. Customer Lists)

‐ Supplier‐Based Intangibles

‐ Governmental Licenses & Permits

‐ Franchise, Trademark or Trade Name Rights

● 15 Year Amortization


9/17/2011

10



● Receipt of Note?

● Installment Sale Reporting should be available to Corporation

EXCEPTIONS:

1) Inventory

2) Dealer Property

3) Stocks & Securities

* All gains related to these assets will be recognized

● See IRS Publication 537




● Taxable Income Recognized on Liquidating Distribution

● Basis = Consideration Received Less Shareholder’s Basis

● Taxed at Cap Gains Rate of 15% (if held for > 12 mos.)


9/17/2011

11



● Buyer’s Basis “Stepped Up” to Purchase Price paid PLUS

Assumed Liabilities PLUS Acquisition Costs

● Purchase Price Spread Based on Form 8594 Allocation



Hypothetical

● Seller sells assets to Buyer for $50,000, $25,000 cash down in 2011

and $25,000 by a Promissory Note due in 2012.

● Seller’s Basis in its assets is $30,000: $10,000 in Inventory,

$10,000 in Accounts Receivable and $10,000 in Equipment (assume

no depreciation recapture)

● Seller IS ELIGIBLE for Installment Sale Reporting

● Form 8594 Allocation

‐ Inventory ‐ $20,000

‐Accounts Receivable $10,000

‐ Equipment ‐ $10,000

‐ Goodwill ‐ $10,000 (plug)


9/17/2011

12


Result

● Seller has an overall gain of $20,000, of which $10,000 relates to

appreciated Inventory. The sale of Inventory is excepted from

installment sale reporting.

● For the installment sale, the contract price is $30,000 and

Seller’s related basis is $20,000. Hence, the gross profit % = 33%

(Gain of $10,000/Contract Price of $30,000).

● Of the aggregate purchase price, $30,000 qualifies for installment

reporting. Hence, 60% of each payment received relates to the

installment sale, while the remaining 40% relates to the sale of

Inventory.



Result (Continued)

● For 2010, Seller reports:

‐ The full $10,000 gain on Inventory, and

‐ $5,000 as installment sale gain

= $25,000 x 60% (Installment Sale Portion) x 33% (GPP)

● Gains will be taxed at 35%, totaling $5,250. In 2012, Seller will

have another gain of $5,000, and pay tax of $1,750.

● Thereafter, Seller makes liquidating distribution of $43,000

●No tax to Seller on distribution

● LTCG Tax of 15% to Seller’s shareholder on distribution less

outside basis. Assuming outside basis = $0, Net Proceeds =

$36,550 ($50,000 ‐ $7,000 Seller tax ‐ $6,450 shareholder tax)


9/17/2011

13


Planning Ideas:

● Buyer wants to BUY ASSETS / Seller wants to SELL STOCK

●What can be done for Seller locked into Asset Deal?

‐ Personal Goodwill?

‐ Consulting Agreement?

‐Allocate to Goodwill, Not to FF&E

‐ Noncompete Covenant – WRONG

‐ IRC §338 election? Not tax‐efficient



Personal Goodwill

● Does the Principal Shareholder’s reputation, expertise or

contacts give Seller its intrinsic value?

● Is the Seller’s business technical or specialized?

● Is there no employment agreement or noncompete covenant in

place with Principal Shareholder? (See, e.g., Larry Howard v. U.S.,

9th Circuit Court of Appeals, 10‐35768, Aug. 29, 2011)

● If YES, you may be able to allocate a portion of the purchase

price to Personal Goodwill (No change to Buyer; LTCG to Seller’s

Shareholder)

● For more analysis, see Ibrahim, Darian M., The Unique Benefits of Treating

Personal Goodwill as Property in Corporate Acquisitions. Delaware Journal of

Corporate Law, Vol. 30, No. 1, Winter 2005.


9/17/2011

14


Consulting Agreement

● Shift portion of purchase price to Consulting Fees for Seller

Principal – MUST BE REASONABLE

●No entity‐level tax on Consulting Fees

● Deduction to Buyer when paid

● Ordinary income to Seller’s Shareholder when received

● Recharacterization = §197 Intangible (15 Year Amortization)


Part II: Seller Entity is an S Corporation


9/17/2011

15

A. Tax Issues in an Asset Sale (S Corporation)


● No entity‐level tax on gain

● Corporate level gain flows through to Shareholders,

maintaining its character (i.e. cap gain vs. ord. income)

● Corporate level gain increases Shareholders’ basis in Corporate

stock, reducing or eliminating any tax on a liquidating

distribution following sale

●No tax to Corporation on distribution of assets




● Tax is based on entity level taxable income flowing through to

Shareholders

● Generally, no taxable income recognized by Shareholders on

liquidating distribution due to basis increase


9/17/2011

16



● Buyer’s Basis “Stepped Up” to Purchase Price paid PLUS

Assumed Liabilities PLUS Acquisition Costs

● Purchase Price Spread Based on Form 8594 Allocation

● Identical treatment for Buyer to C Corp. asset sale



Hypothetical

● Seller Corporation sells its assets to Buyer for $100,000.

●Assets include A/R, inventory, equipment and goodwill.

● Corporation’s basis in its assets is $50,000.

● Shareholder’s basis in his stock is also $50,000.


9/17/2011

17


Result

● No tax to Corporation on sale, $50,000 gain flows through

● Shareholder pays tax on gain based upon its character

(cap gain or ordinary income).

● Shareholder’s stock basis increases from $50k to $100k.

● No tax to Corporation upon distribution of $100,000 to

Shareholder.

● Shareholder pays no tax on distribution because his basis

equals the amount of the distribution.

● Buyer allocates purchase price among the assets (Form 8594).


B. S Corp Stock Sale with IRC §338(h)(10) Election

● Treats Seller Corporation and Buyer as if asset sale

occurred. Best of both worlds for Buyer.

● Buyer must be buying at least 80% of Corp’s stock

● Joint election to step up basis of assets (Form 8023)

‐must be made by 15th day of 9th month following

month of acquisition

● Corporation’s basis in its assets is stepped up to

= Purchase Price for stock + Corporation’s liabilities +

acquisition costs


9/17/2011

18

B. S Corp Stock Sale with IRC §338(h)(10) Election

● Corporation taxed as if it sold its assets in a “deemed

asset sale” to itself

● Tax is based upon excess of FMV over Corporation’s basis

● Corporation’s NOL can generally be used to offset gains

● Corporation’s gain passed through to Shareholders,

giving them a corresponding basis increase in their stock

● BEWARE OF:

‐ Depreciation Recapture (§1245 & 1250)

‐ BIG’s if Corporation used to be a C corp.


C. S Corp Stock Sale – Less than 50% of Stock Sold

● Consider a “closing of the books” election under

§1377(a)(2)

● Prevents manipulation of books for balance of tax year by

surviving, non‐selling shareholders

● Caveat: All shareholders must consent


9/17/2011

19

Part III: Seller Entity is a Partnership


Overview

Tax treatment of disposition of a partnership interest depends on:

1) Redemption/Liquidation vs. Sale of Interest;

2) Types of Assets Owned by Partnership;

3) If Redemption/Liquidation, Types of AssetsReceived by Partner;

4) Sale by Partnership Itself


9/17/2011

20

Focus:

● Sale vs. Redemption of an Interest

● Cash Consideration

● Not Covering:‐Mergers & Divisions‐ Disguised Sales‐ Partnership Liquidations

● Asset Sale by Partnership – See prior Section II(a)


A. Sale or Exchange to a Third Party

Seller’s Perspective

● Generally, gain or loss recognized on sale

● Partnership interest is a Capital Asset

● Hence, Capital Gain Rules apply

● Installment Rules apply


9/17/2011

21



EXCEPTION #1 ‐ IRC §751 “Hot Assets”

‐ Unrealized Receivables

(includes §1245 personalty and §1250

realty, and certain intellectual property)

‐ Inventory

‐ Ordinary Income & Immediate Recognition




EXCEPTION #2 – Relief of Liabilities

‐ To extent Seller is relieved of Partnership

liabilities

◦ Constructive receipt of cash payments

= Assumption of Seller’s share of

Partnership Liabilities

◦Must be recognized immediately


9/17/2011

22



● Outside Basis

= Purchase Price

+

Liabilities Assumed

(of Transferor and of Partnership)




● Inside Basis – Steps into Seller’s Shoes

● Unless IRC §754 Election Made

‐Made by Partnership, Not Partners

‐Made with Annual Return

‐ Continuous & Largely Irrevocable


9/17/2011

23



● Effect of §754 Election

‐ Step‐Up of Inside Basis to Purchase Price

‐Allocation governed by §755

◦ Between capital assets and §1231

property and any other property

◦ Reduce difference b/w FMV and basis

‐ Great Opportunity for Buyer where Ptn. holds

substantially appreciated, depreciable assets


B. Redemption of Partnership Interest

● §736

● Either:

‐ “§736(a) Payments” – Pro‐Buyer (Ptn.)

[Distributive Share / Guaranteed Payment]

or

‐ “§736(b) Payments” – Pro‐Seller

[Taxed as a Distribution]

● Significant flexibility may exist to structure


9/17/2011

24


● §736(b) – Default Setting

● Exception, if:

(a) Payment in exchange for unrealized

receivables or goodwill;

(b) Capital not a material income‐

producing factor (i.e. service partnerships); AND

(c) Seller was a general partner.

● Treatment – Capital Gain

‐ Caveat: §751(b) appreciated inventory



● §736(a) – Non‐Default Setting

● Guaranteed Payments

‐ Ordinary Income to Seller; Deduction to

Partnership

●Amounts Determined based on Income of

Partnership

‐ Distributive Share to Seller; Reduction of

Partnership Income to Remaining Partners


9/17/2011

25


● Default Allocation of §736 Payments – where no

contractual agreement reached:

◦ Fixed Amounts – Pro Rata

◦ Variable Amounts – First to §736(b) Payments

and then to §736(a) Payments

●Assumption of Liabilities by Partnership –

treated as constructive cash payments (§736(b)

Payments) – recognized at end of any installment

period.




● Basis of property (other than money)

= Adjusted Basis – Money Distributed

◦Allocated first to ordinary income property (to

extent of its inside basis) and then to other

property.


9/17/2011

26


Partnership’s Perspective

● No Gain or Loss to Partnership, UNLESS

◦ Non‐pro rata distribution of §751

property or other property

● If §754 Election is in force, adjusted basis of

Partnership property must be adjusted

◦ Generally, by amount of gain recognized

by Seller PLUS any decrease in adjusted

basis of distributed property


C. Deemed Termination of Partnership

● Sale or Exchange of at least 50% of Partnership

Capital and Profits Interests within 12 months

● Gifts, Bequests, Inheritances and Liquidations

DO NOT COUNT

● Date of Termination = Date of Trigger Event


9/17/2011

27

C. Deemed Termination of Partnership

Effect of Termination

● Partnership Tax Year Closes for All Partners

● Depreciation Lives Restart

●Mechanics:

◦ Old Partnership transfers all assets to New

Partnership in exchange for interests therein;

◦ Old Partnership distributes interests in New

Partnership to the Partners in liquidation

◦ New Partnership continues


D. Sale vs. Redemption ‐ Planning Pointers

(1) If Installment Arrangement proposed, Sale provides

basis increase immediately to Partnership, whereas Seller’s gain is

deferred.

(2) However, where Partnership assumes Liabilities of

Seller, Seller’s gain recognized immediately in Sale transaction, but

deferred in a redemption transaction

(3) Tradeoff between character and amount of gain to Seller

versus character and amount of step‐up and deductions to

Partnership.


9/17/2011

28

Part IV: Ancillary Tax Considerations


A. Bulk Sales and Use Tax Returns

● Due from Buyer by 20th of Month following Closing● 6% of Tangible Personal Property● Includes:

Furniture & FixturesComputer SoftwareBusiness RecordsCustomer ListsGoods and Supplies

● Excludes:Real PropertyInventoryListed AssetsManufacturing EquipmentIntangibles (including Goodwill)


9/17/2011

29

B. Bulk Sales Law (Comm’l Law Article §6‐101, et seq.)

●Applies to Transfers Outside the Ordinary Course of Business

● Buyer Required To:‐ Request Affirmed List of Creditors‐ Prepare Schedule of Property Sold‐Make List of Creditors Available for Inspection for 6 Months Following Closing‐Notify Each Creditor at least 10 Days Pre‐Close‐ Ensure Application of Purchase Price to Creditors

● Failure to Comply – Buyer At Risk to Extent of Value of Purchased Property

● Benefits – Shortened Statute of Limitations (6 Months)


C. MD Recordation and Transfer Taxes

Controlling Interests in a Real Property Entity(Tax‐Property Article §§12‐117 & 13‐103)

● “Controlling Interest” = 80% of the: (i) value of stock in a corporation; (ii) capital and profits interests in a pass‐through entity; or (iii) beneficial interests in a trust. 12 month test.

● “Real Property Entity” = any entity that: (a) directly or beneficially owns realty which constitutes 80% or more of its value; and (b) has a value of at least $1M. Value determined without regard to mortgages. Not included: (i) leases for 7 years or less; (ii) security interests in realty; and (iii) farms.

● Tax due within 30 days of final transfer.


9/17/2011

30

Thank You!

David W. HotesBethesda Law GroupPhone: (301) 469‐3352

Email: [email protected]


Selected Tax Considerations for - Coming...

Documents

Transcript of Selected Tax Considerations for - Coming...