In the lifecycle of every business, there will be a time that a business owner will have to contemplate either growing their business by acquiring another business, or to look toward retirement and will decide to sell their business. During this extremely delicate process, there are many aspects to consider depending on what side of the table the business owner is sitting and this article helps to shed a little light on the one of the more important topics. As this article just describes a few of the points to consider at this time, it is always very important to discuss the details of any of these transactions with a qualified CPA.
The first topic to consider is what exactly is being sold and purchased. There are generally two basic methods of acquisitions and each carries its pros and cons depending on whether you are the seller or purchaser. The first and more infrequent method is a stock sale. This is a transfer of one owner’s stock or ownership interest in a company to the purchaser. The company and its assets do not change in form and recorded value at the sale date as this transaction will just exchange the owners of that company. This treatment in most cases will benefit the seller. In the majority of cases, the seller can recognize capital gain on the excess of the sales price realized over the adjusted basis of the stock. There is an exception for partnership interest and “hot assets” that will be discussed later. The purchaser in a stock transaction will now have a value in the stock that was purchased that will serve as their beginning basis in the stock value. That value is not able to provide a current deduction for the purchaser and therefore does not provide any tax benefit until the newly acquired stock is sold or transferred to another party.
The second method of acquisition is the asset purchase agreement. This is the more commonly used method of recording the merger or acquisition of a company because it provides the purchaser an immediate tax benefit as to the assets value as well as gives some flexibility to the seller and how they will be taxed on the different classes of assets being sold. The total sales price must be allocated across all classes of assets being sold and reported on Form 8594, Asset Acquisition Statement Under Section 1060. This allocation will normally follow the rules of Section 338 and Regulation Section 1.338-6. In this situation, every asset being sold, both tangible and non-tangible, is valued at its current Fair Market Value (FMV) and sold accordingly. The purchaser records the value of the tangible assets received, and the remaining purchase price in excess of the tangible assets FMV is allocated to the Section 197 intangible assets. These assets include goodwill, customer list, covenant not to compete, and tradename to name a few. For the purchaser, there is a desire to push more value to the physical assets of the company as this allows for greater depreciation deductions and the ability in some cases to deduct the cost paid for these items in the same year. The value assigned to any asset cannot exceed that assets FMV, and if it does can be subject to IRS scrutiny and subsequent reclassification should it be examined. In most cases, the Section 197 intangible assets are also able to be amortized over several years allowing the purchaser to have tax savings associated with the values assigned. For the purchaser, this is much preferred as compared to the tax treatments of a stock purchase as the value assigned to stock is not able to provide any tax savings until the stock itself is sold or transferred.
As for the seller, they will want the value assigned to physical assets to be lower as a gain recognized on the sale of physical assets is usually taxed at ordinary income tax rates. The seller would want as much value as possible, again not to exceed FMV, to be applied to intangible assets as a gain on most of those assets is taxed as a capital gain. This is often the area for both sides of the transaction to find some common ground as it provides both sides with an acceptable tax treatment. The seller gets capital gain treatment on the gain associated with these assets while the purchaser is still able to take an ordinary deduction as the assets are amortized. The one exception to this rule is the value assigned to any covenant not to compete clause associated with the sale. This would be taxed as ordinary income to the seller as it represents income replacement. As a planning tool, there are cases associated with the sale of goodwill within a C-Corporation. These cases state that if the value assigned to goodwill can be proven to be associated with the individual owner and not the corporation itself, the sale of that goodwill can take place outside of the corporation and skip the double tax disadvantages imposed by C-Corporations.
Another important consideration is if the seller is a member of a partnership or LLC. In this case there are two common areas of concern that should be identified closely. A partner in an LLC carries an adjusted basis in his individual partnership interest. This basis is affected by the partnership’s liabilities at the time of sale. Liabilities of the partnership add to the basis of the individual partner and are called loan basis. If loan basis has been used by a partner to deduct losses of the company in any previous year, the payoff of those liabilities can create a taxable event. Also, the release of obligation to repay on those liabilities is considered part of the overall sales price and will add to the cash paid at closing and consequently affect the overall gain realized. The second factor to consider when selling a partnership or LLC interest is if the partnership contained any hot assets at the time of sale. A hot asset, Section 751 asset, includes inventory items and accounts receivable of a cash basis partnership if the asset were sold at FMV. The sale of these assets would trigger ordinary income tax treatment associated with the sale price. For example, if a purchaser is going to purchase the outstanding accounts receivable balance at the time of sale, that sales price is treated as if all of the outstanding accounts receivable at that time were immediately collected and is now included as a part of the taxable earnings of the company and subject to ordinary income tax rates.
As you can see, with so many variables to consider at the time of closing, it is very important to consult your tax advisor and make sure you are not caught off guard by the way the sale is structured. The sales price and its value after the sale, for both the seller and purchaser, can be drastically reduced if not handled properly.