Tax Consequences of Buying and Selling a Business

1. Tax Consequences of Buying and Selling a Business January 2006 Presented by Douglas A. Dickey, CPA

2. How to Structure the Sale? A. Assets B. Stock C. Earn out D. Cash or Finance E. Merger or Acquisition What are the consequences of each option to the Buyer and Seller? How can you manage these consequences to get your deals closed?

3. How to Structure the Sale? A. What is a Gain or Loss? B. What Type of Gain or Loss is it? C. What is Basis? D. Types of Fixed Assets - Asset Classes

4. What is a Gain? Amount Realized – Basis = Gain / Loss • Amount Realized = Money Received + Debt Relieved + FMV of Property & Services Received + Notes Received • Basis: Starts with Cost … plus other items …

5. Basis • Adjusted Basis is your original cost plus certain additions and deductions, such as depreciation and casualty losses. IRS Pub 551

6. Basis – Special Cases • What is basis if you didn’t “buy” the items you are selling? • Property received for services • FMV of the property received (not the services) (83(b) election). • Changed from personal to business use • Lesser of FMV on date of change or adjusted basis on date of change

7. Gain Example You used a building in your business that cost you $70,000. You made certain permanent improvements at a cost of $20,000 and deducted depreciation totaling $10,000. You sold the building for $100,000 plus property having an FMV of $20,000. The buyer assumed your real estate taxes of $3,000 and a mortgage of $17,000 on the building. The selling expenses were $4,000. Your gain is as follows. Amount realized: Cash $100,000 FMV of property received 20,000 Real estate taxes assumed by buyer 3,000 Mortgage assumed by buyer 17,000 $140,000 Adjusted basis: Cost of building $70,000 Improvements 20,000 Minus: Depreciation (10,000) Adjusted basis $80,000 Plus: Selling expenses 4,000 $84,000 Gain on sale $56,000

8. Sale of Fixed Assets 7 Asset Classes • Cash • Short Term Investments • For Example: Stocks & CD’s • A/R • Inventory • Land and PP&E • Intangibles • Residual Allocation (Goodwill)

9. Sale of Fixed Assets • Buyer and sellers allocations and valuations generally match when reported on Form 8594

10. Sale of Business & Items to Consider • Balance Sheet • Sales Price & Terms • Basis in Asset or Stock • C Corp • S Corp or Partnership/LLC • Individual Earnings and Tax Brackets

11. Definitions • Hot Assets • Unrealized receivables and inventory items - Code Section 751(a) • Unrecaptured Section 1250 Gain • For sales of Section 1250 Property (Real Property), the part of long-term capital gain attributable to depreciation is taxed at a maximum rate of 25%. In general Section 1250 gain is the gain attributable to straight line (SL) depreciation.

12. Unrecaptured Sec 1250 Gain Harry sold rental property in December 2005 for $150,000. He paid $100,000 for the property several years ago and had depreciated $20,000 under MACRS(SL depreciation). Of his total $70,000 gain, $50,000 is attributable to appreciation (which is taxed at a maximum rate of 15%) and $20,000 is attributable to depreciation (which is taxed as unrecaptured Section 1250 gain at a maximum rate of 25%. Sales Price $150,000 Cost $100,000 Less Depreciation Taken 20,000 Basis 80,000 80,000 Gain on Sale 70,000 Taxed at Max Capital Gain Rate of 15% 50,000 Taxed at Unrecaptured Section 1250 Gain Rate of 25% 20,000

13. Definitions - Collections • Gains on the sale or exchange of collectibles is taxed at a maximum rate of 28%. • Gain is computed on a pass-through entity as if it had sold the collectibles in a fully taxable transaction immediately before the pass-through entity sale. • Losses on collectibles are not recognized. • Collectibles include works of art, rugs, antiques, metals (such as gold, silver and platinum bullion), gems, stamps, coins, alcoholic beverages and certain other tangible property. • Collectibles include any gain (but not loss) from the sale or exchange of an interest in a partnership to unrealized appreciation of collectibles.

14. Different types of Assets have Various Tax Rates for Different Entities Partner in LLC or Partnership Short term capital assets or hot assets = Ordinary Income Long term capital assets = max 15% Unrecaptured Section 1250 gains = max 25% Collectibles = max 28% Shareholder of S Corp The rates are the same, but the rates for hot assets and Sec 1250 gains do not apply C Corporations use Graduated Rates Earnings & Tax Brackets

15. Tax Brackets

16. Samples of Sales

17. Samples of Sales • Partnership • S-Corp • Sole Proprietorship • C- Corp

18. Example: Able, Baker and Charlie are equal owners in ABC Company, a cash basis business formed 10 years ago. Able sells his interest in the entity to Deanna on June 1, 2005, for $230,000, which represents one-third of the FMV of the assets. (Basis $120,000) ABC Company – Assets on date of sale AssetsAdjusted BasisFMV 1/3 gain Cash ………………………………………………. $ 15,000 $ 15,000 $ - Unrealized receivables ………………………….. 0 90,000 30,000 Inventory ………………………………………….. 100,000 130,000 10,000 Collectibles ……………………………………….. 30,000 60,000 10,000 Equipment ………………………………………… 50,000 35,000 5,000 Accumulated depreciation ………………………. (30,000) Building ……………………………………………. 200,000 320,000 50,000 Accumulated depreciation (SL) …………………. (30,000) Land ……………………………………………….. 25,000 40,000 5,000 Totals ………………………………………………. $360,000$690,000 $110,000 Total gain ($690,000 – 360,000) divided by three = $330,000 $110,000 The following illustrates the different gains that must be recognized by Able (one-third) interest in assets) depending upon whether ABC Company is a partnership, S corporation, Proprietor, or C-corporation. Assume Able is in the top 35% tax bracket in 2005. , Partnership S Corp Prop C Corp Rate Section 751(a)”Hot Assets” ordinary income from unrealized receivables, inventory and depreciation recapture on equipment ……....... $ 45,000 $ 5,000 $ 5,000 0 35% Schedule C Inventory 10,000 35% Collectibles ………………………. 10,000 10,000 10,000 0 28% Unrecaptured 1250 gain from SL depreciation on building ………… 10,000 0 10, 000 0 25% Residual long-term capital gain .. 45,000 95,000 75, 000 0 15% C-Corp Gain……………………… 110,000 see tables Totals …………………………….. $110,000 $110,000 $110,000 $110,000 Inside Tax ……………………….. $ 27,800 $ 18,800 $ 21,800 $ 26,150 Outside Tax ……………………… 0 0 0 $ 12,578 (230,000-26,150)-Basis*15% Total Tax…………………………. $ 27,800 $ 18,800 $ 21,800 $38,728

19. ** **Section 179 maximum deduction is $108,000 for 2006 Quickfinder N-16

20. Sale of Assets vs. Stock • Seller • Stock Sales pay Less Tax than Asset Sales • Stock Sales are easy to report on Schedule D • Buyer • Stock has a Greater Risk of Successor Liability • Assets can be Depreciated for Ongoing Deduction Benefits unlike Stock

21. Example: Jan and Simon are shareholders in an S-Corp. They have received 2 offers for their business; $390,000 for their stock or $400,000 to purchase the assets of the business Sale of Assets: FMV Basis Gain Tax Rate Equipment Subject to Sec. 1245… $ 310,000 $ 228,000 $ 82,000 Inventory……………. 40,000 20,000 20,000 Total Ordinary Income $102,000 25,500 25% Goodwill…………..... 50,000 0 50,000 Total Cap Gains…….. $ 50,000 7,500 15% Totals……………….. $ 400,000 $ 248,000 $152,000 $33,000 Total Cash Received $367,000 from sale of Assets (400,000 – 33,000 = 367,000) Sale of S-Corp Assets vs. Stock

22. S-Corp Stock Sale • Sale of Stock Sales Price $ 390,000 less Basis 248,000 Cap Gain $ 142,000 Tax 21,300 @15% Total Cash Received $368,700 from sale of Stock (390,000 – 21,300 = 368,700) Difference in cash received is only $1,700 more for sale of Stock. However, finding a purchaser for the stock may be more difficult then finding a purchaser for the assets.

23. Example: Jan and Simon are shareholders in a Corporation. They have received 2 offers for their business; $390,000 for their stock or $400,000 to purchase the assets of the business Sale of Assets: FMV Basis Gain Tax Equipment………… $ 310,000 $ 228,000 $ 82,000 Inventory………….. 40,000 20,000 20,000 Goodwill…………... 50,000 0 50,000 Totals……………… $ 400,000 $ 248,000 $152,000 $ 42,530 Liquidating Distribution $357,470 less Basis in Surrendered Stock 248,000 Cap Gains $109,470 $ 16,420.50 $ 58,950.50 Total Cash Received $341,049.50 from Sale of Assets (400,000 – 58,950.50 = 341,049.50) Sale of C-Corp Assets vs. Stock

24. C-Corp Stock Sale • Sale of Stock Sales Price $ 390,000 less Basis 248,000 Cap Gain $ 142,000 Tax 21,300 @15% Total Cash Received $368,700 from sale of Stock (390,000 – 21,300 = 368,700) Difference in cash received is $27,650.50 more for sale of Corporate Stock.

25. Determining the Difference • The buyer and seller cannot both structure the sale entirely to their advantage. The greatest risk is generally to the buyer of stock who may not have adequate information to quantify the risk. Sellers may receive higher prices for assets rather then stock sales.

26. Earn Out • Generally, earn outs are structured only in deals in which the original owners will stay with the company and thus can have some impact on future performance. • Most earn-out clauses are tied to sales and earnings performance over a three-to-five-year period –generally the same time frame as any employment contracts negotiated with former management. • Earn outs can be structured in any number of ways, depending on the priorities of sellers and buyers.

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