Questions Answered in the Acquisition or Disposition of a Business
Strategies for Structuring Transactions and
Peter A. Karl III
What considerations are involved in an acquisition/disposition
of a business?
legal and tax issues are involved for both business buyers and
sellers. This is best illustrated by the fact that a purchaser
rarely wants to acquire an enterprise through an entity purchase
(i.e., by purchasing the ownership interest in the entity, such
as stock, directly from the seller). From a legal perspective,
the acquired business would remain exposed to the subsequent claims
of pre-acquisition creditors, even those unknown at the time.
In contrast, an asset purchase permits a buyer to choose which
specific assets will be purchased along with which, if any, of
the known liabilities will be assumed.
stock acquisition also presents tax disadvantages: The purchase
price becomes part of the tax basis of the stock purchased without
the benefit of the consideration paid being allocated for depreciation
or IRC section 179 purposes among the underlying assets to be
held by the entity (unless an election under IRC section 338 is
made by a corporate purchaser, as discussed in Question 13 below).
prefer a business (conducted in corporate form) that is being
sold to structure the transaction as a entity disposition in order
the stock transfer for capital gains tax rate;
the gain against any personal capital losses being carried forward;
- use installment
sale treatment (if seller financing is involved), which can
apply to the entire sale, unlike the asset version; and
- take advantage
of IRC section 1244 ordinary loss treatment, which is limited
to $50,000 per year for taxpayers filing singly ($100,000 for
of the form chosen, a prospective buyer should be required to
execute a confidentiality/nondisclosure agreement to discourage
misuse of proprietary information.
How is the lump-sum sales price of assets allocated for tax purposes?
transfer of a business involves a mixed property transaction encompassing
both tangible and intangible personalty (along with possibly realty),
a lump-sum purchase price without a specific allocation among
assets should never be used. Furthermore, IRC section 1060 requires
both the seller and the buyer of business assets to file Form
8594 (Asset Acquisition Statement). As a practical matter, a completed
version of this form can be incorporated as an exhibit to the
purchase agreement to ensure that both parties are consistent
in their tax reporting.
1, there are seven asset classes under this methodology (known
as the residual method of price allocation), each with varied
tax consequences to the seller and the buyer, as discussed below.
Because the IRS generally respects the negotiations between an
unrelated buyer and seller, there is some flexibility in the allocation
of the assets encompassing business realty and personalty (note
that a professional appraisal can be concurrently obtained if
In a disposition of business assets, what is the significance
of the various classifications to the seller?
perspective of the seller, the importance of asset allocation
among capital assets, IRC section 1231 assets, and assets with
ordinary income implications cannot be understated, as shown in
2. If the seller is a C corporation, the significance of this
is less because there is no individual capital gain rate to utilize.
What tax strategies are available for a seller to minimize the
tax implications of a disposition?
If the seller
is involved in an asset disposition, IRC section 1031 can apply
to both the realty and most of the business personalty. For example,
any allocation to inventory would be nonqualifying. While the
rules under section 1031 would allow the business real estate
to be reinvested in commercial or even investment realty (including
vacant land with or without a “build/rehab to suit”
feature), the regulations impose much tighter restrictions on
the rollover of the 1031 proceeds allocable to the personalty.
With regard to the latter, Revenue Procedure 87-56 and the North
American Industrial Classification System (NAICS) classify personal
property in various categories, which must then be matched within
exchange groups (i.e., comparing what is being disposed versus
what is being acquired). Intangible personal property, such as
goodwill, is ineligible for IRC section 1031 treatment. Nevertheless,
the IRS, in Private Letter Ruling 200035005, has shown some flexibility
with regard to intangible personal property by permitting the
proceeds allocable to a FCC radio license to be rolled over to
a television license.
If the new
business needs to be acquired before an existing one is disposed,
a “Reverse Starker” exchange may be appropriate in
either the “Exchange Last” or “Exchange First”
format. An Exchange Last involves the taxpayer lending money to
an Exchange Accommodation Titleholder (EAT) who uses the funds
to acquire the replacement property, which will be held in the
EAT’s name until the taxpayer is ready to close on the property
to be relinquished. The Exchange First also involves the taxpayer
lending money to the EAT to purchase the replacement property;
however, in this version, the EAT acquires and holds legal title
to the taxpayer’s property to be relinquished. The Exchange
First is often used when new financing will be involved in the
acquisition of the replacement assets, whereas the Exchange Last
is often used when the taxpayer is uncertain about which specific
property will be subsequently relinquished. (For further information,
refer to the author’s article “Twenty Questions Answered
About Deferred Realty Exchanges Under IRC Section 1031,”
The CPA Journal, May 2003.)
What are the alternatives to IRC section 1031 for a business seller?
of whether a stock or an asset disposition is being undertaken,
tax-saving opportunities exist. A charitable remainder trust (CRT)
can be an alternative to IRC section 1031 for a business disposition
or when installment sale treatment is not available (e.g., when
personal property such as equipment is being sold). This strategy
can provide a higher than normal income stream to the former business
owner because the payments from the trust are based on the pre-tax
disposition price received by the CRT (as the titleholder and
contract vendor of the property), along with the fact that a portion
of the income will initially be tax-sheltered because of the available
charitable deduction. This writeoff will be based on the value
of the remainder interest (using the IRS actuarial tables) and
is subject to the annual adjusted gross income limitations (the
five-year carryover period applies). This strategy requires the
CRT to be created and funded with the business prior to the execution
of the sales agreement. Because this arrangement does not provide
any benefit to the children after the death of the parents as
income beneficiaries of the CRT, a life insurance trust (funded
with a second-to-die term policy) known as a wealth replacement
trust can be used to replace what is “lost” to charity
as the remainder beneficiary of the CRT. The key factor is whether
the parents can obtain a reasonably priced policy, from an insurance
underwriting perspective. (For further information, see the author’s
article “Twenty Questions Answered About Trusts,”
The CPA Journal, September 1998.)
sale is another alternative, particularly when the seller receives
a down payment sufficient to cover the tax liability for the ordinary
income recognized in the first year stemming from the portion
of the sale related to the disposition of personalty (depreciation
recapture), accounts receivable, and inventory. The benefit to
the seller of “holding paper” that is executed by
individual signature or the purchasing entity (with the principals
as cosigners) is that the annual income received will be higher
than if there had been a taxable sale and an investment of the
after-tax proceeds into a certificate of deposit (CD). The reason
is that the interest rate negotiated between the parties is usually
higher than that offered by most financial institutions and is
earned on the pre-tax mortgage balance amortized over the length
of the obligation. In essence, a IRC section 453 transaction is
tantamount to the seller receiving a secured CD. The detriment
to holding paper, however, is that the seller of a business remains,
in many situations, as a quasi-partner whose future payments depend
on the success of the new owner, particularly when the business
being sold does not consist of any realty used as security.
As a result,
consideration should be given to incorporating additional protections
for the seller (in the supplemental role of a future creditor)
in the sales agreement, as a third-party financial institution
would require. This could include a credit report, the pledge
of other collateral, the signature of the spouse or other party
on the note, the receipt of periodic financial statements, and
even designation as a beneficiary under a term life insurance
policy. If the buyer proposes to pay cash (with or without bank
financing), restructuring the transaction using a third-party
institution as the initial recipient (and subsequent payor of
the buyer’s proceeds over time) will avoid actual and constructive
receipt by the seller of the closing funds. This commercially
available immediate annuity (which does not have any surrender
value) will allow gain to be deferred under IRC section 453.
stock is transferred in an installment arrangement, consideration
should be given to the stock being held in an attorney’s
escrow arrangement, because the public filings in an asset sale
of a mortgage or UCC-9 for realty and personalty, respectively,
legal advantage for a buyer (and disadvantage for a seller) would
be to use an offset provision within the debt instrument providing
that future payments be remitted to an attorney’s escrow
account in the event that any of the preclosing representations
by the seller are found to be inaccurate after the acquisition.
Earnout arrangements whereby the amount ultimately paid is contingent
on future financial performance protect a buyer.
453 requires any installment obligation longer than six months
to contain a provision for interest at the lower of 9% or the
applicable federal rate (AFR; the author recommends
as a reference). In addition, the payment of interest is required
on the tax being deferred for any obligation over $5 million.
A third alternative
is the use of an employee stock ownership plan (ESOP), which not
only provides a potential buyer for a corporate business, but
also offers significant tax benefits to a seller (including an
S corporation), such as the following:
- The sale
of the business’ shares to an ESOP will be tax-deferred
if the proceeds are reinvested in certain publicly traded or
closely held stocks and bonds.
the corporation’s stock to the ESOP will create a deduction
based on its fair value and could result in a carryback loss
and/or tax refund.
to the three alternatives discussed above, the tax benefits of
a private annuity trust have been eliminated by a proposed regulation
that would deny IRC section 453 treatment to an owner selling
property, including corporate stock.
How does a seller report the gain from mixed-use realty?
2005-14 addresses transactions with realty that has both personal
and business use, whether the business is conducted in one structure
or separate ones. The former is best illustrated by a home office
within a personal residence, while the latter includes a working
farm with a home on the land.
that a taxpayer has owned and used the real property as a personal
residence for at least two of the last five years, Revenue Procedure
2005-14 allows for the IRC section 121 gain exclusion to be first
used on the residential portion and then on the business segment
within the same structure (other than the gain attributable to
post–May 6, 1997, depreciation). On the other hand, if the
home and business are contained in separate buildings on the land,
the section 121 gain exclusion that is not used on the residence
may not be applied against the business portion. When realty contains
separate structures, in order to maximize the tax-free portion
of the gain related to the residence, an appraisal documenting
the value of the house and accompanying acreage (as compared to
the business realty) should be considered.
case, any gain related to the business portion of the realty which
is ineligible for the IRC section 121 exclusion may be deferred
by using IRC section 1031. While Revenue Procedure 2005-14 does
not outline the specifics of an exchange encompassing real property
with both personal and business use, the need for a four-party
deferred exchange format, utilizing a qualified intermediary,
is highly recommended.
How does a seller benefit from intrafamily gifting prior to a
kiddie tax applies to the unearned income of a child, the gifting
of assets or stock could result in the 0% capital gains rate being
used for that taxpayer’s portion of what is being sold (if
taxable income in 2008 is less than $32,550; $65,100 for joint
filers). The Small Business Work Opportunity Act of 2007 expanded
the application of the kiddie tax rules by increasing the age
to any child age 18 as of the last day of the tax year and certain
full-time students between the ages of 19 and 23 (i.e., having
earned income less than one-half of his or her annual support).
For individuals not affected by these limitations of the use of
the lower capital gains rate, there is also the advantage that
the IRC section 1250 unrecaptured gain rate of 25% (related to
the accumulated depreciation that exists when business realty
is disposed) is inapplicable.
What strategies can reduce taxes in a stock sale?
sale of stock held for at least a year guarantees long-term capital
gain treatment for the seller, the tax-free reorganization provisions
under IRC section 368 can defer taxation when corporate stock
of the buyer is part of the consideration received. Under IRC
section 368, the Type B format involves a stock-for-stock reorganization,
with the acquiring corporation exchanging its shares for those
held by the stockholders of a target. The transaction could also
be structured as a reverse triangular merger, whereby the buyer
forms a subsidiary which merges into the target corporation, with
this entity surviving as a subsidiary of the acquirer. These two
transactions will be taxable unless at least 80% of the stock
of the target is acquired or the seller receives consideration
that is not voting stock.
From a buyer’s perspective, what tax strategy should be
considered for personal property?
In the allocation
of a lump-sum purchase price, a buyer would be interested in obtaining
the fastest writeoffs, which means an allocation to the assets
with the shortest life for depreciation purposes, as outlined
3. The downside is that state and local sales taxes might
apply. If this is the case, one should determine whether any of
the assets are exempt from sales tax (e.g., if used in the production
or sale of future items that are sales-taxable). The IRC section
179 deduction, available for new or used business personalty,
is $128,000 in 2008, providing the most immediate tax benefit
to the purchaser.
What else should a buyer acquiring business realty consider?
consider whether a cost segregation study will be beneficial.
Cost segregation separates property into components, providing
shorter depreciable lives for categories such as personal property
or land improvements (with its 150% declining-balance depreciation).
The disadvantage is that the buyer is subsequently exposed to
IRC section 1245 recapture, or may need to roll over the nonrealty
proceeds in a section 1031 exchange with replacement personalty
that qualifies under the stricter like-class standard (which is
not applicable to realty).
From a legal
perspective, one of the most important contract contingencies
when real property is part of a business acquisition is environmental
testing. A buyer may otherwise face liability emanating from the
misdeeds of the predecessor owners.
If the seller
does not own the business realty, the buyer (prior to signing,
or as a contract contingency) must carefully review the lease
for provisions that address assignability and the ability to renew,
as well as any purchase option or right of first refusal in the
Is goodwill a favorable category in the allocation of an asset
seller’s perspective (other than a C corporation), any asset
allocation to goodwill qualifies for capital gains treatment.
To the extent that any accumulated amortization from intangible
assets exists, IRC section 1245 recapture is applicable. The Energy
Bill of 2005 closed a loophole in the law whereby a taxpayer needed
only to acknowledge the section 1245 recapture stemming from the
goodwill and could avoid recapture associated with other intangible
asset categories. Now all of the intangibles must be lumped together
in order to first recognize the ordinary income attributable to
the accumulated amortization.
also benefits from the goodwill allocation because it is not subject
to sales tax. To the extent that the value of any business realty
included in the transaction can be reduced correspondingly, this
will provide a shorter writeoff period (i.e., 15 years rather
than 39), along with lower annual realty taxes.
can be treated as an asset of the shareholders and not the corporation
is addressed in cases such as Martin Ice Cream v. Comm’r
(110 TC 189, 1998) and Norwalk v. Comm’r (TC Memo
1998-29). The relevant factors include the extent of the shareholder’s
personal relationships in developing and retaining business; in
a sale, this is usually addressed via post-closing contractual
involvement by the former owner, possibly encompassing payouts
based on future sales or retention of existing business.
be noted that if a tax-deferred exchange is being contemplated
for the realty and tangible personalty, any allocation of the
business purchase price to goodwill is not eligible for an IRC
section 1031 rollover.
When should a covenant not to compete be used?
of a business should always incorporate a covenant not to compete
within the transfer documentation. Courts will generally respect
this provision if the wording is reasonable in terms of duration
and geography. For example, a buyer purchasing a local restaurant
might restrict the seller from competing during a five-year period
within a radius of 25 miles, whereas a larger business with a
statewide clientele could have broader geographic restrictions.
When reviewing these clauses, courts attempt to strike a balance
between protecting the buyer’s interest and not depriving
the former owner of the right to earn a living. From a tax perspective,
a deduction (amortized over 15 years) is created, while offering
another opportunity to slightly reduce the future assessed value
of any realty which may be part of the business acquisition.
many businesses would benefit after an acquisition by the presence
or cooperation of the former owner for a period of six to 12 months,
a consulting arrangement between the parties should also be considered
by the buyer (noting the ordinary income and self-employment tax
implications for the seller).
the use of a covenant not to compete, a consulting agreement,
and even goodwill payable to the individual as discussed in Question
11 above can be used in structuring the payment package for a
C corporation selling its assets. Reducing the allocation to the
entity will limit the proceeds subject to double taxation.
What elections are available under IRC section 338?
IRC section 338 election permits a corporate stock transfer to
be treated as an asset acquisition by the buyer; however, the
disadvantages of this election arguably outweigh the advantages.
This election is available only to corporations as purchasers
of at least 80% of the target corporation. There will be gain
recognition by the target corporation (which does not have to
be dissolved), resulting in its assets being stepped up to their
fair market value because of the deemed sale. Because of the ensuing
tax liability, this election makes more sense when the target
has offsetting losses or tax-credit carry-forwards.
under 338(h)(10) is appropriate when the stock of the target is
owned by another corporation, when S corporation stock is being
acquired by another corporation, or when the target is a member
of a consolidated group. Double taxation is avoided under this
provision when the target is a C corporation, because of the tax-free
liquidation concept under IRC section 332, which results in the
sale of the target stock being disregarded although its assets
are stepped up to fair market value.
In an asset purchase, what type of notification is required to
Uniform Commercial Code no longer requires notice to creditors
in a bulk sale transfer of assets, the New York State Department
of Taxation and Finance, for example, does require notice when
a business having sales tax obligations is to be transferred.
Form AU 196.10 must be filed with the NYS Sales Tax Department
20 days prior to settlement in order to obtain a clearance, without
which the purchaser would be liable for any of the seller’s
sales tax arrearages.
If the purchase of a business includes realty, should it be segregated
from other assets?
real estate is involved, this should first be separated from the
business operations in order to be individually owned or held
in a LLC, depending upon whether there are tort liability concerns
and adequate insurance is available. Single-owner LLCs can also
be used with multiple owners, each holding title as co-tenants
(as opposed to one multi-member LLC). This allows for each individual
to have the option of either a taxable sale or an IRC section
1031 exchange when they go their separate ways. With regard to
the business operation itself, this could be held in a separate
entity to provide legal insulation to the realty in the event
the enterprise is subsequently sued. For example, the operation
of a restaurant and bar could have the business personalty owned
by a corporation and the building being leased on a triple-net
basis by the shareholder in his individual capacity (or his singly
owned LLC). The tenant would also be required to undertake capital
improvements, which are tax-free to the lessor, and this arrangement
would provide FICA-free income to the realty’s owners.
the use of a C or S corporation for the holding of real property
is ill-advised given the tax effects (i.e., potential double and
single taxation, respectively, as discussed in the author’s
article “Twenty Questions Answered About the Selection of
a Business Entity,” The CPA Journal, August 1999).
When should a buyer use a C corporation to operate an acquired
the tax advantages of the C corporation have diminished over the
years, in certain situations this form should still be considered.
Note that the legal protection afforded a stockholder in a closely
held corporation is diminished because:
no entity (including an LLC) can shield an owner from personal
liability if he is the one who committed (or to whom is attributed)
- A creditor
usually will require a personal guarantee with respect to liability
for the entity’s major contracts (e.g., a bank loan or
- The IRS
may consider an individual to be the responsible party for unremitted
trust taxes (e.g., payroll withholdings or state sales tax).
If the business
owner will be required to reinvest profits in the operations,
a C corporation allows for income-splitting between the W-2 of
the officer/shareholder, while retained earnings are taxed at
the corporate level (i.e., the first $50,000 at 15% and the next
$25,000 at 25%). In addition, IRC section 1202 provides a 50%
gain exclusion upon the sale of up to $10 million of stock held
for at least five years, which makes it an excellent vehicle for
corporations involved in an active business (such as technology).
Excluded corporations under this provision include those involved
in service, farming, and tourist-related activities (e.g., hotels
Upon a subsequent
sale of a business that has been operated as a C corporation,
one of the following three outcomes is possible:
- No taxation,
if an IRC section 368 reorganization is accomplished (i.e.,
Type A merger/consolidation, Type B stock for stock, or Type
C stock for assets).
gains taxation, if a stock sale is involved.
taxation, if structured as an asset disposition.
IRC section 368 reorganization is most common when a publicly
traded company is the acquirer, the dispositions of closely held
corporate businesses are more often structured as an asset sale
because of the issues addressed in Question 1 above. Alternatively,
a stock purchaser of a business would be advised to discount the
purchase price for the eventual built-in gains.
If a business
held by a C corporation might be sold in the future, the conversion
of the entity to a S corporation should be investigated. Because
IRC section 1374 imposes a C level double taxation for the preconversion
gain during the succeeding 10-year period, an appraisal of the
assets at the time of conversion is recommended to establish the
postconversion appreciation, because this portion will avoid the
two levels of taxation.
When should a buyer use an S corporation to operate an acquired
If the business
being purchased has income stemming from business capital (and
not merely from services being rendered), using an S corporation
can be an alternative to the increasingly popular LLC. This is
because S corporation dividends (after payment of reasonable compensation
to shareholder-employees) will not be subject to Social Security
taxes. Because it is a pass-through entity, an S corporation should
also be considered when initial business losses are anticipated,
in order to offset other income on an individual’s Form
1040, or be used to split income associated with the enterprise’s
capital among family members not subject to the provisions for
the taxation of a child’s unearned income as discussed in
Question 7 above.
If the business
acquisition arrangement involves an S corporation being partially
acquired by nonqualifying shareholders (such as a C corporation),
the transaction could be restructured, with the S corporation
contributing its assets to an LLC tax-free under IRC section 721
(subject to concerns by the transferor about the adjusted basis
of the assets being exceeded by the associated liabilities). As
a result of this restructuring, the members of the LLC would be
the S and C corporations.
What legal considerations should be implemented when a purchaser
of the type of entity in which the operations will be conducted,
one of the most important legal considerations before commencing
a business with others (even if related parties) is a buy-sell
agreement that includes restrictions on the transfer or pledge
of any ownership interest. This is essentially a “prenuptial
arrangement” for a business marriage, which negotiations
in the marital context usually require separate advisors. This
may be a relevant consideration with respect to the representation
of the various parties involved in the buy-sell agreement. This
document should address issues such as the valuation and funding
for any subsequent buyout, which could be structured as an entity
redemption, a cross-purchase by the owners, or a hybrid of the
for the value could be based on a predetermined formula (as discussed
in Question 19, below), or a binding determination by a third
party. Rarely should a fixed value be used; ideally, the value
should be adjusted annually by the principals. Similarly, the
valuation should not be based solely on book value, because often
this will not accurately reflect the current fair market value.
A unique approach is the “push-pull” method, whereby
the departing owner sets the value and the remaining owners can
either accept this price or require the offerer to buy out the
offeree. In any case, the agreement should specifically define
its terms, using “income,” for example, in the context
of a formula using a multiplier of earnings.
funding source should be life insurance if the co-owners are insurable
at standard rates; a whole life policy is preferred to term life
because the former also provides liquidity (i.e., cash value)
in the event of a nondeath withdrawal. It is also very important
to distinguish between the policies issued by a stock company
and a mutual company. The policy dividends (used to reduce future
premiums) payable to mutual company policyholders significantly
exceed that payable to stock life company policyholders. This
is because the latter’s profits must also be shared with
stockholders whose ownership classification does not exist in
the rarer mutual companies owned by policyholders. As confirmed
by the major insurance rating reference sources (A.M. Best, Fitch,
Moody’s, and S&P), only two companies are available
to the general public, New York Life and Northwestern Mutual,
which rated in the highest category in each of these four services,
both of which are mutual companies. When insurance is being considered,
a separate policy covering disability (which should be specifically
defined in the buy-sell agreement) should be reviewed. To the
extent the policy’s cash value or face value is inadequate
for a buyout during life or death, respectively, the agreement
should specify provisions with respect to the financing between
the parties (i.e., fixed or adjustable interest rate, balloon
payment, and security).
in the author’s article “Twenty Questions Answered
About Business and Family Asset Protection” (The CPA
Journal, February 2000), if the co-owners are family members,
a family limited partnership (FLP) might be used for the asset
protection and potential transfer tax savings due to valuation
discounts. In addition, the FLP is the only entity where the super-minority
owners can have super-majority control (e.g., parents as 2% general
partners and the children as 98% limited partners).
having a husband and wife as co-owners (each filing a separate
Schedule C as a qualified joint venture arrangement as established
by the Small Business Opportunity Act of 2007), one spouse could
own the business assets and the other own the nonbusiness assets
(see the author’s article “Twenty Questions Answered
in Business and Family Asset Protection,” The CPA Journal,
February 2000.) In addition to sheltering personal assets in the
event of the business’s failure (including a responsible
party trust tax assessment), the splitting of the assets’
title between the spouses will result in potential FICA savings.
is best illustrated by an operation conducted as a sole proprietorship
(or single-member LLC). This business will realize a $204,000
net profit in 2008. This would result in $18,564 of FICA taxes
for the sole owner, compared to $31,212 if the business were conducted
by husband and wife as a partnership or LLC. There may be a reason
to have the spouse as a bona fide employee (which wages are not
subject to FUTA taxes), in order to ensure eligibility for the
minimum Social Security benefits upon retirement (40 quarters
of lifetime employment). In addition, fringe benefits, such as
a written medical reimbursement plan, long-term care policy, or
health insurance, would be available. By deducting the health
insurance on the proprietor’s schedule C instead of from
AGI, self-employment taxes would be reduced.
What are the valuation methods for a closely held business?
business enterprises are valued as a multiple of gross revenues,
other businesses might be valued based upon their assets. This
can be done by taking the fair market value of tangible assets
and then determining if there are excess earnings that may be
attributable to goodwill (pursuant to Revenue Ruling 68-609).
A third valuation alternative, the capitalization method, uses
the following formula:
Value = Net
Operating Income (NOI) or Net Cash Flow (NCF)/
revenue minus related expenses) or NCF does not include any financing
expense or depreciation. EBDITA (earnings before depreciation,
interest, taxes, and amortization) can also be substituted in
the numerator. If the calculations encompass multiple years of
past business activity or future business projections, these can
be weighted or discounted, respectively. Adjustments usually need
to be made to owner’s compensation by factoring in the labor
of the departing business executive or key person; that is, what
it would take to compensate someone else for that same work. In
contrast, the owner might be receiving excess compensation or
employee benefits that could be understating NOI or NCF. The capitalization
rate generally ranges from 5% to 20%, depending on the riskiness
of the business (i.e., the riskier the business, the higher the
stock is being purchased, the price should be discounted for the
subsequent double-taxation potential upon liquidation in the case
of a C corporation, or the remaining 10-year period under the
IRC section 1374 built-in gains tax for an S corporation.
What tax traps exist when the buyer and the seller are related?
parties in a business disposition and acquisition are related
(the definition of the term varies in the IRC), as addressed below,
the following tax concerns need to be considered:
- The fair
market value of the transfers can be scrutinized by the IRS
and be recast as part sale, part gift.
- If an
IRC section 1031 exchange is involved, IRS Revenue Ruling 2002-83
disallows a qualified intermediary from using the impounded
funds to acquire replacement realty that is owned by a party
related to the exchangor. Such a disposition by the related
party (who is “cashing out” with funds received
from the qualified intermediary) is deemed a sale under IRC
section 1031(f). In contrast, Private Letter Rulings 20044002
and 200616005 permitted a related-party exchange when both parties
took advantage of IRC section 1031 using a qualified intermediary
and each party was required to retain the replacement realty
received for at least two years.
- The portion
of the consideration allocated to depreciable realty or personalty
will be deemed ordinary income.
- If property
that had been sold in installments is resold again in the two
years following the acquisition, the first seller will be required
to realize the sale proceeds from the initial sale.
- If a corporate
redemption of stock is involved because the owner’s children
are acquiring the business, a waiver should be filed stipulating
that for the succeeding 10-year period the redeeming shareholders
will not have any interest in the corporation other than as
a landlord or creditor; that is, the children are prohibited
from acting as an employee, officer, or board member. This will
avoid the family stock attribution rules and ensure that the
distributions are not deemed to be a dividend. Though the 15%
capital gain rate applies in any event, there must be a complete
termination by the stockholder in order to use the basis in
the stock being redeemed as an offset against the proceeds.
A. Karl III, JD, CPA, is a partner with the law firm of
Paravati, Karl, Green & DeBella in Utica, N.Y., a professor
of law and taxation at the State University of New York–Institute
of Technology (Utica–Rome), and a member of The CPA Journal
Editorial Board. He is also the author of the informational