Tax Consequences
of Buying and
Selling a Business
January 2006
Presented by Douglas A. Dickey, CPA
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?
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
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 …
Basis

Adjusted Basis is
your original
cost plus certain
additions and
deductions, such
as depreciation
and casualty
losses.
Increases to
Basis
Decreases to
Basis
Capital
Improvements
Depreciation
Casualty Losses:
Restoring Damaged
Property
Sec. 179 deduction
Legal & Selling
Fees/Costs
Non-Taxable
Corporate
distributions
Delivery,
installation, zoning
costs
Rebates or refunds
from seller
IRS Pub 551
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
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
FMV of property received
Real estate taxes assumed by buyer
Mortgage assumed by buyer
Adjusted basis:
Cost of building
Improvements
Minus: Depreciation
Adjusted basis
Plus: Selling expenses
Gain on sale
$100,000
20,000
3,000
17,000
$70,000
20,000
(10,000)
$80,000
4,000
$140,000
$84,000
$56,000
Sale of Fixed Assets
7 Asset Classes
I. Cash
II. Short Term Investments
•
For Example: Stocks & CD’s
III. A/R
IV. Inventory
V. Land and PP&E
VI. Intangibles
VII. Residual Allocation (Goodwill)
Sale of Fixed Assets

Buyer and sellers allocations and valuations
generally match when reported on Form 8594
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
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.
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
Cost
Less Depreciation Taken
Basis
$150,000
$100,000
20,000
80,000
80,000
Gain on Sale
70,000
Taxed at Max Capital Gain Rate of 15%
Taxed at Unrecaptured Section 1250
Gain Rate of 25%
50,000
20,000
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.
Earnings & Tax Brackets


Different types of Assets have Various Tax Rates for
Different Entities
Partner in LLC or Partnership





Shareholder of S Corp


Short term capital assets or hot assets = Ordinary Income
Long term capital assets = max 15%
Unrecaptured Section 1250 gains = max 25%
Collectibles = max 28%
The rates are the same, but the rates for hot assets and Sec
1250 gains do not apply
C Corporations use Graduated Rates
Tax Brackets
Samples of Sales
Samples of Sales




Partnership
S-Corp
Sole Proprietorship
C- Corp
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
Assets
Adjusted Basis
FMV
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
$330,000
$110,000
Total gain ($690,000 – 360,000) divided by three =
$
-
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.
,
Section 751(a)”Hot Assets” ordinary income
from unrealized receivables,
inventory and depreciation
recapture on equipment …….......
Schedule C Inventory
Collectibles ……………………….
Unrecaptured 1250 gain from SL
depreciation on building …………
Residual long-term capital gain ..
C-Corp Gain………………………
Totals ……………………………..
Partnership
Inside Tax ………………………..
Outside Tax ………………………
Total Tax………………………….
S Corp
$ 45,000
$ 5,000
10,000
Prop
C Corp
Rate
0
10,000
$ 5,000
10,000
10,000
10,000
45,000
0
95,000
10, 000
75, 000
$110,000
$110,000
$110,000
0
0
110,000
$110,000
$ 27,800
0
$ 27,800
$ 18,800
0
$ 18,800
$ 21,800
0
$ 21,800
$ 26,150
$ 12,578 (230,000-26,150)-Basis*15%
$38,728
0
35%
35%
28%
25%
15%
see tables
**
**Section 179 maximum deduction is $108,000 for 2006
Quickfinder N-16
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
Sale of S-Corp Assets vs. Stock



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
Equipment
Subject to Sec. 1245…
Inventory…………….
Total Ordinary Income
Goodwill………….....
Total Cap Gains……..
Totals………………..
Basis
Gain
$ 310,000 $ 228,000 $ 82,000
40,000
20,000
$102,000
50,000
0
$ 50,000
$ 400,000 $ 248,000 $152,000
Tax
20,000
25,500
50,000
7,500
$33,000
Total Cash Received $367,000 from sale of Assets
(400,000 – 33,000 = 367,000)
Rate
25%
15%
S-Corp Stock Sale

Sale of Stock
Sales Price
less Basis
Cap Gain
Tax
$ 390,000
248,000
$ 142,000
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.
Sale of C-Corp Assets vs. Stock



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
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
Liquidating Distribution
$357,470
less Basis in Surrendered Stock
248,000
Cap Gains
$109,470
Tax
$ 42,530
$ 16,420.50
$ 58,950.50
Total Cash Received $341,049.50 from Sale of Assets
(400,000 – 58,950.50 = 341,049.50)
C-Corp Stock Sale

Sale of Stock
Sales Price
less Basis
Cap Gain
Tax
$ 390,000
248,000
$ 142,000
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.
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.
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.
Working to improve your future, not just account for the past.
2525 Bay Area Blvd., Suite 460
Houston, TX 77058
281-488-2022
1011 Tremont Street
Galveston, TX 77550
409-765-9311