By Doug Gross
BrownWinick Law Firm
Once a business owner understands the goals motivating the succession planning process, it is helpful to understand the legal and tax implications of the business transfer.
This article discusses the steps required for transfer of assets and methods of sale for sole proprietorship, general partnership, corporation and other legal entities. This article also discusses the difference between an entity sale and an asset sale, and lump sum versus installment payments.
Contents |
Type of Entity
The steps required of a seller, and the tax implications of the sale, depend upon what type of entity the seller is.
Sole Proprietorship (and Single-Member LLCs)
Steps required for transfer
- Because the sole proprietor enjoys complete control over the business, the proprietor may freely transfer any or all of the assets comprising it, subject to normal restrictions, such as fraudulent conveyance laws. [5 Iowa Prac. 1:4]
Tax implications of sale
- Generally, a sole proprietor reports the income, gains, deductions, and losses from his business on his personal tax return. If the business is sold, the sole proprietor reports the gain or loss on his personal tax return. [5 Iowa Prac. 2:9]
- Individuals, unlike corporations, enjoy a preferential tax rate on long-term capital gains. Thus, the character of the income gained from the sale (e.g. ordinary income or loss vs. capital gain loss) has a substantial effect on the tax consequences. How the income is characterized depends upon how the sale price was allocated among the assets of the business – gain from some assets will be taxed as ordinary income, others will be taxed as capital gain. [Darby at 27; Steingold at 4/10]
General Partnership or Limited Partnership
Steps required for transfer
- The right of a partner to dispose of his interest in a partnership is limited. Unless the partnership agreement provides otherwise, a partner’s only transferable right is the partner’s share of the profits and losses of the partnership and the partner’s right to receive distributions. Addition of a new partner usually requires unanimous consent of the partners. [5 Iowa Prac. 1:5]
Tax implications of sale
Three methods of sale. The tax results are generally the same for each method.
- 1) Sale of assets
The partnership generally recognizes capital gain at the partnership level, and that gain is passed out to partners. If the partner is an individual, the partner will enjoy the preferential individual tax rate on capital gains. [Darby at 16]
- 2) Sale of partnership interests
Each selling partner generally gets capital gains tax treatment. If the seller is an individual, the partner will enjoy the preferential individual tax rate on capital gains. [Darby at 16]
- 3) Liquidation of partnership followed by sale of assets
The distribution rules that apply to a partnership are what amounts to a tax-free liquidation of the entity by causing gain to be recognized only by the partner and only to the extent that the amount of money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution. Moreover, in the case of a liquidating distribution, the tax basis of a partner in the distributed assets will be the adjusted basis of such partner’s interest in the partnership reduced by any money distributed in the same transaction. In certain circumstances, these distribution rules can result in a substantial benefit to the seller. [Darby at 234-35]
Limited Liability Company
Steps required for transfer
- Depends on what the articles of organization or operating agreement say regarding transferability. Default rule is that a member may assign his membership interest, but the assignee’s rights are limited to the member’s profits distribution. [5 Iowa Prac. 1:6]
Tax implications of sale
- Treated the same as a partnership
C-Corporation
Steps required for transfer
- Corporate shares are freely transferable. However, the articles of incorporation, bylaws, or an agreement among shareholders may place reasonable restrictions on the transfer of shares. [5 Iowa Prac. 1:5]
- Sale of assets will normally require approval by the board of directors and possibly shareholder approval. Whether the corporation’s shareholders will participate depends on whether the sale of its assets leaves the corporation with a “significant continuing business activity,” defined to mean business activity that represented at least 25 percent of the corporation’s assets as of the end of its most recent fiscal year and 25 percent of the corporation’s income for that fiscal year. [6 Iowa Prac. 35:3]
Tax implications of sale
- On a sale of assets, the C-Corporation pays tax on income and gain at the corporate level. There is no preferential tax rate for capital gains recognized by corporations. Money and other property distributed to shareholders on an asset sale is taxed as a dividend or, if the corporation has adopted a plan of liquidation, as capital gain. [Darby at 12]
- On a sale of stock, the selling shareholders get capital gains treatment. If the shareholder is an individual, the shareholder will enjoy the preferential individual tax rate on capital gains. The corporation does not pay a tax because it has sold nothing. [Darby at 13; Steingold at 4/8]
S-Corporation
Steps required for transfer
- S-Corporations are corporations for all non-tax purposes. Thus, the steps required for transfer are generally the same as the steps required for C-Corporations. [Darby at 215]
Tax implications of sale
- S-Corporations are pass-through entities, so the tax implications are essentially the same as those for partnerships.
- On a sale of assets, the S-Corporation generally recognizes capital gain at the corporate level, which passes out to shareholders and if shareholders are individuals, is taxed at the preferential capital gains tax rate for individuals. Shareholders in turn get a step-up in tax basis in their shares as a result of corporate gain recognition. [Darby at 13]
- On a sale of stock, the selling shareholders get capital gains tax treatment, and if they are individuals, they will enjoy the preferential capital gains tax rate for individuals. The corporation doesn’t pay a tax because it has sold nothing. [Darby at 13; Steingold at 4/8]
Structuring the Deal
Selling the Business
Entity sale vs. asset sale generally
- Buyers typically prefer an asset sale because they are able to begin getting depreciation benefits sooner, and often can avoid acquiring an entity’s liabilities. [Steingold at 3/5]
- Sellers typically prefer an entity sale because the seller will pay taxes at the low long-term capital gain rate, whereas in an asset sale some of the tax may be computed at the higher ordinary income tax rate. [Steingold at 3/5]
Lump sum vs. installment payments
Lump sum
- Advantageous to seller because it brings the risk of nonpayment to zero. [Steingold at 9/10]
Installment payments
Rules of thumb:
- Aim for a two or three year payment period to reduce potential problems. [Steingold at 9/11]
- Seek a large down payment [Steingold at 9/12]
- Always charge interest [Steingold at 9/13]
Means of reducing the risk of nonpayment:
- Obtain personal guarantee by buyer, buyer’s spouse, and/or third party [Steingold at 9/14 – 9/16]
- Obtain security interests in the business, buyer’s personal real estate and other property [Steingold at 9/16 -9/17]
- Require buyer to obtain term life insurance with seller as the beneficiary [Steingold at 9/17]
- Include acceleration clause and attorney’s fees clause in promissory note [Steingold at 9/17 – 9/18]
Tax implications:
- When property is sold in an installment sale, the selling taxpayer is not required to report the full gain on the date of the sale, but rather is permitted to report gain on a deferred basis. [Darby at 262]
Selling the Business to the Business (or to Co-Owners)
Details regarding share transferability are often included in a company’s Articles of Organization, By-Laws, or a separate Shareholder Agreement (a.k.a. Buy-Sell Agreement) [Darby at 351]
“Redemption” – purchase by the corporation
vs.
“Cross-purchase” – purchase by the shareholders
It is almost always better for the shareholders to purchase the stock because a cross-purchase acquisition results in valuable outside tax basis in the purchased shares. A redemption by the company causes the tax basis to “disappear” in the redeemed shares. [Darby at 353]
- The tax consequences of a redemption are affected by whether the redemption is treated by the IRS as a sale rather than a dividend distribution. If treated as a sale, the shareholder gets capital gain tax treatment. If treated as a dividend, the income to the selling shareholder will be treated as dividend income. The IRS has complex rules for determining whether the redemption is a sale or a dividend distribution. [Darby at 335]
Selling the business to employees
Three common methods:
1) Installment sale (see description above)
2) Leveraged Buyout
Employees use borrowed capital to acquire a business that, following acquisition, will produce a strong enough cash flow to service the debt. The result is that old shareholders are bought out using mostly borrowed funds and employees own all or most of the business. [Darby at 388]
- Depending on the structure of the sale, employees may be financed by a third party, or by the seller itself. If employees are financed by the seller, the IRS may deem the transaction an installment sale, and the transaction will be subject to those rules. [Darby at 389]
Congress, in response to perceived abuses, has formulated extremely complicated tax rules for leveraged buyouts – whether these rules apply can affect the tax consequences of the transaction. The specific structure of the deal will affect what rules are applicable. [Darby at 389-94]
3) Employee Stock Ownership Plan (ESOP)
Though an ESOP has many different purposes (e.g. retirement plan for employees), it is also a mechanism for financing a leveraged buyout by employees. [Darby at 394]
Benefits to seller:
- Seller can essentially “invent” a buyer for the employer stock. Selling to an ESOP may be a good option if the business is struggling to find a serious buyer. [Darby at 402-03]
- Seller can avoid capital gain on the stock sale by reinvesting in qualified replacement property, such as publicly traded stocks. [Darby at 403]
Practical limitations on selling to an ESOP:
This option may be effectively unavailable to employers with only a small number of employees contributing to the plan. This is because most ESOPs are leveraged and must be able to pay the loan – it is more difficult to meet such obligations with a small number of employees contributing to the plan. [Darby at 403]
May not be very beneficial to employees due to the concentration of risk when the employee’s retirement benefits and current job and financial future are so closely tied to the employer’s success. [Darby at 403]
Gift
With a few limited exclusions, gifts are taxed. The most relevant exception is the annual exclusion:
- In 2008, for gifts of $12,000 or less to any amount of people, the donor does not have to pay any gift tax and the recipient does not have to pay any income tax
A donor, totaled over his/her lifetime, can give up to $1 million over the annual limit before being subject to the gift tax. Gift tax is normally paid by the donor.
References
- Matthew Dore, Business Organizations, IOWA PRACTICE SERIES, Vols. 5-6 (2007).
- Joseph Darby, Practical Guide to Mergers, Acquisitions, and Business Sales (2006).
- Fred S. Steingold, The Complete Guide to Selling a Business (2005).
