Tax Consequences in the Sale of a Business
The Bullet Points
As one may imagine, the sale of a business entails tax consequences which may be larger than any other single issue faced in the negotiations. It is best to understand these consequences before price negotiations start, so that the price takes account of them. Mistakes made early may be difficult to correct later.
Most businesses are owned by entities, frequently corporations. Generally, the corporation may sell its assets, or its owners may sell their shares. The tax consequences can differ greatly.
There are taxable sales and non-taxable sales (whether of assets or of stock). Speaking very generally, non-taxable1 sales require, among (many) other things, that the seller receive stock in the purchaser in exchange for the stock or assets sold. To the extent cash or other nonstock consideration is received, the transaction is taxable.
Taxable sales, on the other hand, involve the receipt of cash, notes, and other types of consideration, or for other reasons do not qualify for tax-free treatment.
Sellers love tax-free treatment, but buyers suffer a detriment in that seller’s old basis in the underlying assets is carried over to the buyer. This will reduce the buyer’s depreciation deductions in the future. In a taxable transaction, the buyer receives a “stepped up” basis in the assets acquired, though the seller receives a tax bill.
In viewing the parties collectively, it is a choice between paying a capital gains tax now (the seller’s) or receiving a (possibly ordinary) deduction later (the buyer’s). It has always been my approach to minimize the aggregate of taxes being paid, in the belief that making the pie larger should result in larger pieces for everyone. 2
II. The Tax Consequences of a Taxable Transaction
A. Sale of Shares
The seller’s ideal transaction is a sale of shares. In this event, there will be one level of capital gains tax, which the shareholders will pay. For 2010, the maximum capital gains rate for most people is 15%. This is considered so low that some sellers in this position eschew tax-free sales, preferring to receive cash, which they can receive in a taxable transaction, rather than receiving stock, with its attendant risk, which they must receive in a tax-deferred transaction.
There is another reason for sellers to prefer a sale of stock. A non-corporate seller may currently exclude 100% of the gain, up to the greater of $10,000,000 or ten times its value of the stock sold attributable to the sale of “small business stock” held more than five years under Internal Revenue Code Section 1202. 3
B. Sale of Assets
A corporation’s taxable sale of its assets may represent a worst case scenario for the seller. A corporation is not entitled to preferential capital gains rates under federal or California tax laws. Accordingly, the corporation will pay taxes on its gain on sale at ordinary rates: a maximum of 39% for federal purposes and about 10% for California purposes.
It does not end there. There may be California sales taxes to pay on any tangible personal property sold in the transaction, and perhaps a Proposition 13 impact on any real property involved in the transaction.
It does not end there. Another level of taxation may be incurred when the sales proceeds are distributed from the selling corporation to its shareholders. This distribution to the shareholders may be taxed as a dividend at a federal rate of 15% and a California rate of 10%.
III. Tax-Free Transactions
As mentioned above, a tax-free transaction requires an exchange of stock or assets solely for stock of the acquiring corporation. To the extent anything other than stock in the acquirer is received, the transaction will be taxable. Thus, the seller must be satisfied with retaining its investment in an illiquid and non-diversified portfolio. As soon as the shares which the seller receives are sold for cash, tax will be triggered. Since the shareholders’ old basis is retained for the new shares, the gain will include the amount previously unrecognized.
Only corporations can participate in tax-free reorganizations under Internal Revenue Code Section 368. The transactions can take several forms, and each has its own requirements and consequences. Without getting into the nomenclature used by the Internal Revenue Code, these forms include:
• a statutory merger
• a stock-for-stock exchange
• a stock-for-assets exchange
• triangular mergers in which a transitory subsidiary merges into the target and the parent’s stock in the subsidiary is converted into the target’s outstanding stock
• various other permutations and combinations of the above
Requirements contained in the Internal Revenue Code are complex but crisply defined (for the most part). However, courts have consistently held that the requirements of the Internal Revenue Code are not the only requirements. Rather, a long line of cases that predate the Internal Revenue Code provisions retain their vitality. Thus, there are judicially imposed requirements in addition to those of the Internal Revenue Code. These requirements include:
• a valid business purpose
• a continuity of business interest (the successor corporation must continue the historic business of the seller)
• a continuity of shareholder’s interest (the shareholders must have a continuity of equity interest in the surviving corporation.)
IV. The Purchaser’s Considerations
While the seller is concerned about avoiding tax on gains and income, the buyer may be concerned about maximizing its post-closing tax deductions. There are certain rules a purchaser needs to be aware of.
A. Amortization of Intangibles
Internal Revenue Code Section 197 requires that amounts allocated to goodwill, non-competition covenants purchased in the acquisition, and various similar items, such as going concern value, know-how, information base, licenses, permits or other governmental grants, in-place value, franchises, trademarks or trade names must be amortized on a straight-line basis over a 15 year period regardless of the actual useful life of the intangible. That sure takes the fun out of these kinds of assets.
B. Merger and Acquisition Expenses and Fees
Who does not want to deduct legal fees? Unfortunately, under Internal Revenue Code Section 263, transaction fees and costs must be capitalized rather than deducted if incurred to facilitate an acquisition.
C. Net Operating Loss Carry-Forwards
Buyers also want to preserve net operating loss carry-forwards and any tax credits of the acquired corporation. Generally, the rules in this area are found in Internal Revenue Code Section 381 and sections thereafter. The carryover of such losses and credits after an acquisition is substantially limited.
In general, no carryover is available if assets are purchased.
If corporate shares are purchased, and there is an ownership change entailing any increase of more than 50% by one or more of 5% shareholders, taxable income against which the net operating loss may be used in any later year is limited to the fair market value of the loss corporation’s stock immediately before the ownership change multiplied by the “long- term tax-exempt rate” published periodically by the IRS. However, this assumes the business enterprise is continued for at least two years after the ownership change.
V. Excluding Certain Assets From the Sale
This is no problem when the transaction is structured as a taxable asset sale. There is tax to be paid on the gain on assets sold. Assets retained do not result in any tax consequences.
Retained assets can be a problem in certain tax- free reorganizations in which substantially all of the properties of the seller must be acquired. Disposing of unwanted assets or withholding assets which the seller wishes to retain might violate this requirement.
Tax-free divisions under Internal Revenue Code Section 355 (e) have always been possible. However, if this is part of a plan under which 50% or more of either corporation is acquired by another party, the distribution is no longer tax-free. The gain is recognized to the distributing corporation. And there is a rebuttable presumption that the separation is part of a plan if the disposition of 50% or more occurs either within two years before or two years after the split up.
The tax consequences to the seller of business assets can range from zero to almost 50% of the sales proceeds. The buyer’s situation will also be affected by the tax structure of the transaction. In fact, there may not be any other single issue with as large an impact on the transaction. Accordingly, tax considerations should be considered early in the negotiating process so that neither party makes a pricing mistake which could prove difficult to correct.
1 At this point, I had better make an important correction to the terminology I have been using. “Tax-free” is really tax-deferred. The basis in the assets given up (in a “tax-free” sale) will be “carried over” to the assets acquired. The assets acquired will take the lower basis of the assets disposed of, so that at some time in the future, if those assets are sold in a taxable transaction, the gain presently going unrecognized will then be taxed. Accordingly, it is more technically accurate to refer to these transactions as tax-deferred rather than nontaxable.
2 It may be that, upon weighing these two tax alternatives, one of them outweighs the other. For example, for reasons unique to seller’s situation, the seller may be relatively capital gain indifferent, perhaps because of capital loss carry-forwards from other sources, or perhaps the seller is a tax exempt entity or is confronting very little gain on the transaction. In such an event, the sale should be structured to maximize the buyer’s benefits, with the seller sharing in those benefits, based on their negotiations.
3 This represents a limited time offer. At the end of 2011, the 100% exclusion reverts to 50%, as it has stood until recently. Generally, this applies to domestic subchapter C Corporations with aggregate gross assets of not over $50,000,000 actively conducting a qualified trade or business. (However, 42% of the exclusion will be treated as a tax preference item for the alternative minimum tax. I did not say this was easy.)