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o Asset Sale

o Stock Sale

o Tax Strategies on Disposition

TAX IMPLICATIONS OF ASSET VS. STOCK SALES

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Glen Birnbaum, CPAShareholder at Heinold Banwart, Ltd – CPA firm in East Peoria, Illinois – about 50 employees

Experience:• Valuation – in particular: working capital targets in the

context of M&A, due diligence, estate and gift tax valuation discounts

• Audit – in particular: manufacturing and agriculture• Tax – S corps, partnerships, LLC’s, & 263A inventory

capitalization

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1. Asset Sale

• S corp seller

• C corp seller

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Asset Sale: S Corp Seller• Seller (S corporation) recognizes gain based on tax rate

applicable for that asseto Cash basis receivables (ordinary income tax rates)o Equipment depreciation recapture (ordinary income

tax rates) - §1245o Real estate depreciation recapture (maximum 25%

federal tax rate) - §1250o Capital gain (15-20% federal tax rate) - §1221

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Asset Sale: S Corp Seller (cont’d)

• Sales price allocation matterso How the price is allocated amongst the assets

• The more proceeds which are allocated to ordinary income assets, the higher the tax liability

• Seller wants to skew sales price to capital assets which generate capital gain

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Asset Sale: C Corp Seller

• Seller (C corporation) recognizes gain based on C corporation bracketso No distinction between capital gain on land vs. equipment

depreciation recapture for exampleo No lower capital gains rate inside a C corporation

• Do not put appreciating assets (farmland, marketable securities, etc.) in a C corporation

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Asset Sale: C Corp Seller

• Double tax for an asset saleo First, when the assets are soldo Then, when cash is distributed to owners

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C Corp Double Tax Example

Asset proceeds = $1,125,000Tax basis in assets = $125,000Gain on sale = $1,000,000Corporate tax = $340,000

Liquidating distribution = $785,000 Capital gain on liquidation = $157,000 (double tax)

Net aftertax proceeds = $628,000Total taxes paid = $497,000

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Asset Sale: C Corp Tax Brackets

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Reporting An Asset Sale

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Reporting An Asset Sale

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Asset Sale: Buyer

• Buyer gets to start fresh and depreciate assets at what was paid for them (fair market value) - §1012

• Buyer prefers ordinary income assets because, generally, depreciable life is shorter

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Asset Sale: Buyer

Example Write-off Periods

o Inventory: 1 year (assume sold in the first year)o Equipment: 5-7 years o Goodwill: 15 years - §197o Building: 39 yearso Land: No depreciation allowed

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Asset Sale Allocation: Tug of War Between Buyer and Seller

• What is good for one is likely bad for the other

• Negotiation!

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Allocation of Sales Price• Both Buyer and Seller must report allocations

made pursuant to §1060 on Form 8594

• Residual allocation method described under Regs. §1.1060-1(e)

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Reporting : Form 8594

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Asset Sale: Form 8594

• Class 1 – checking & saving cash• Class 2 – CDs, publicly traded stock• Class 3 – trade receivables• Class 4 - inventory• Class 5 – property, plant and equipment• Class 6 – customer lists, trade names, etc.• Class 7 – goodwill

Regs. §1.338-6(b)(1),(2)(i)-(vii)

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2. Stock Sale

Assumption: An individual is selling the stock

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Stock Sale

• Seller recognizes capital gain on sale of stocko Capital gains usually taxed at a lower rate

• Proceeds - tax basis in the stock = gain

• §1221 defines a capital asset

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Stock Sale - Basis

• Basis in Stock – C corporation• Original investment “paid in capital” of company (usually

very low) • Amount paid for the stock

• Basis in Stock – S corporation - §1367o Original investment + share of income and losses

- distributions

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Stock Sale – Basis: C vs S

Basis does not increase when C corp retains profits

Basis does increase when S corp retains profits

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Stock Sale - Basis

KEY POINT:

• This basis increase for an S corporation shareholder is what avoids the “double tax” later when S corp assets are sold and cash distributed out.

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Stock Sale - Gain

• Gain on Sale– C corporation• Subject to net investment income tax - §1411

– 3.8% surtax, generally for individuals with Adjusted Gross Income (AGI) over $250,000

• Gain on Sale– S corporationo Not subject to net investment income tax generally if the

owner was a material participant in the business - §1411(c)(4)

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Stock Sale – §1202

• A partial exclusion may be available for Qualified Small Business Stock – essentially C corp stock held more than 5 years

• 50% exclusion for stock acquired after 8/10/1993

• 75% exclusion for stock acquired after 2/17/2009 and before 2/28/2010

• 100% exclusion for stock acquired after 2/27/2010 and before 1/1/2015

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Stock Purchase

• Buyer takes cost basis in the stock - §1012• Stock is a nondepreciable asset, however

• Target corporation retains various attributes including net operating loss carryforwards, credit carryforwards, accounting methods, etc.• Attributes may be limited however - §382/383/384

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Stock Purchase

• Buyer generally does not prefer stock sale, because old tax basis in assets of corporation carries overo Basis not stepped up to true asset valueo Carryover depreciation

• Impact: Buyer will typically demand a discount if buying stock

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§338(h)(10) Election

• A bilateral election under §338(h)(10) permits a step up in the assets for a buyer while purchasing the stock of a target corporation

• Legally the deal is a stock transaction, but treated as a deemed sale of assets for tax purposes

• Generally desirable for a target S corporation with high value and low basis such as goodwill or other intangibles

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Stock Purchase: Buyer Caution

• Buyer buys stock and pays $400,000 more than “inside basis” of the assets of the S corporation

• Pays the Seller $400,000 “extra” for goodwill (internally generated)

• This $400,000 difference is not depreciable by the Buyer because it is a purchase of stock.

• $400,000 in “lost” amortization for the Buyer

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Stock Purchase Caution

Several years later S corporation sells all assets in a taxable transaction and the corporation liquidates in the same year.

• What if goodwill was sold for:A. $500,000?B. $300,000?

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A - $500,000

$500,000 long term capital gain at entity level -

$400,000 long term capital loss at individual level=

$100,000 net long term capital gain

Federal taxes paid of $20,000 (20% of $100,000)

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B - $300,000

$300,000 long term capital gain at entity level -

$400,000 long term capital loss at individual level=

$100,000 net long term capital loss (only deductible at $3,000 per year)

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Stock Purchase Caution

Lesson #1

• Paying $400,000 more than inside tax basis means a guaranteed $400,000 loss on liquidation

• Try to ensure there is at least $400,000 capital gain generated at the entity level if selling assets (negotiate favorable allocation)

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Stock Purchase Caution

• What if the corporation is not liquidated until the year after sale?

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Stock Purchase Caution

$500,000 long term capital gain at entity level taxed in year 1

$400,000 long term capital loss at individual level recognized in year 2

Taxes paid year 1 = $100,000 ($500,000 x 20%)

$80,000 more taxes paid than A example previous!

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Stock Purchase Caution

Lesson #2

• Make sure you time the liquidation of the corporation in the same year as the gain on sale of assets.

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Reporting a Stock Sale

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Asset vs. Stock: Tax Comparison

• Buyer prefers asset sale because it gets to depreciate the purchase priceo Higher tax depreciation = Taxes saved = More cash o Able to put more cash toward paying down the purchase

debt incurredo Particularly helpful in the early years when cashflow may

be tight already

• Seller prefers stock sale because taxes are generally lower (lower capital gains rates)

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Tax Strategies On Disposition

• Non-compete Agreements

• Personal Goodwill

• Consulting Agreements

• Installment Sales

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Non-Compete Agreements

• Seller (shareholder) receives ordinary income as payments are received - income not subject to self-employment taxes

• Buyer deducts over 15 years under §197

• Avoids second layer of tax by paying directly to owner and not the C corporation (asset sale)

• Seller needs to be able to compete. The younger the seller, the more value that can be allocated to the agreement

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Personal Goodwill

• Seller (shareholder) receives capital gain income as payments are received

• Buyer deducts over 15 years under §197

• Avoids second layer of tax by paying directly to owner and not the C corporation (asset sale)

• Facts and circumstances (Martin Ice Cream case)

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Consulting Payments

• Seller (shareholder) recognizes ordinary income as payments are received, self employment tax generally applies

• Buyer deducts as paid – not over 15 years

• Avoids second layer of tax by paying directly to owner and not the C corporation (asset value)

• Beware of family attribution rules on C corporation redemptions

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Installment Sales

• Seller does not receive proceeds all in one year, and instead, takes “Seller Paper”o Finances part of the purchase price for the buyer

• Can be combined with some sort of earnout where if Company customers are kept, seller gets more money

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Installment Sales

• Ability to spread out income prorata as payments are received by the Seller (lower tax rates) - §453

• Primary Exceptions:o Depreciation recapture on equipment

• Gain all triggered in year 1, even if being paid over 5 years, for example

o Cash basis receivables

• Be careful of related party rules—may not be able to defer gain on related party sales

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Takeaways

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• There is no (lower) capital gain rate inside a C corporation• There is a double tax if assets are sold inside a C corporation

and cash is later distributed to stockholders • Be careful when buying stock and paying more than “inside

tax basis”• Carefully consider when corporation liquidation should occur

after a sale of corporate assets• Several strategies exist to plan for the “double tax”

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Questions?

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Thank You!

Glen Birnbaum, CPAgbirnbaum@hbcpas.com

201 Clock Tower Drive, Third FloorEast Peoria, IL 61611

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