TAX STRATEGIES IN THE SALE OF A BUSINESS WHAT THE NEW TAX LAW CAN DO FOR YOU

Transcription

1 TAX STRATEGIES IN THE SALE OF A BUSINESS WHAT THE NEW TAX LAW CAN DO FOR YOU William C. Staley Attrney Hllywd/Beverly Hills Discussin Grup Ls Angeles Chapter CALIFORNIA SOCIETY OF CPAS August 8, dc WS4.WHL :1315

2 TAX STRATEGIES IN THE SALE OF A BUSINESS WHAT THE NEW TAX LAW CAN DO FOR YOU TABLE OF CONTENTS Part One: Preliminary Analysis 1. Evaluating the Seller's Ptential Gain Planning fr the Seller's Gain Recgnitin The Seller's Charitable Cntributin f Sale Prceeds When t Use a Tax-Free Structure When t Use an ESOP The Buyer's Pre-Acquisitin Planning fr Unitary Tax Issues... 5 Part Tw: Asset Sales 7. Aviding the Duble Tax in an Asset Sale Sell Stck/Buy Assets Techniques t Minimize the Seller's Duble Tax and t Accelerate the Buyer's Deductin Structuring With the Asset Allcatin Rules in Mind Installment Sales Sales and Use Tax The Buyer's Liability fr the Seller's Other Taxes...19 Part Three: Stck Sales 14. Cmbining Stck Sales and Redemptins Using a Cash Merger t Acquire Minrity Shares The Buyer's Interest Deductin in a Stck Deal The Sectin 338 Electin: Opprtunities and Risks Aviding FIRPTA Traps Prperty Tax Reassessments Acquisitin Csts in a Stck Sale...26 Part Fur: When the Buyer r the Target is an S Crpratin 22. If the Buyer Will Cntinue the S Crpratin Electin If the Buyer Will Nt Cntinue the S Crpratin Electin Using the Interim Clsing f the Bks Electins t Eliminate Taxable Incme...28 Part Five: Other Issues 25. Using Net Operating Lsses dc WS4.WHL :1315

3 26. Acquisitin Csts fr Sellers and fr Deals that dn't Clse Shuld the Seller Liquidate After the Sale?...30 Cpyright 2003 All rights reserved William C. Staley (818) LAW OFFICE OF WILLIAM C. STALEY 6303 Owensmuth Avenue, 10 th Flr Wdland Hills, CA This article shuld be viewed nly as a summary f the law and nt as a substitute fr legal r tax cnsultatin in a particular case. Yur cmments and questins are always welcme dc WS4.WHL :1315 -ii- William C. Staley

4 TAX STRATEGIES IN THE SALE OF A BUSINESS WHAT THE NEW TAX LAW CAN DO FOR YOU 1 William C. Staley Attrney (818) Part One Preliminary Analysis Fr the seller, the initial tax planning fr the sale f a business invlves determining the amunt f gain that wuld be recgnized in a fully taxable transactins and then explring alternatives t minimize the resulting tax. 1. Evaluating the Seller s Ptential Gain What is the crpratin s tax basis in its assets (the inside basis ) and each sharehlder s basis in his stck (the utside basis )? In mst cases the utside basis f each S crpratin sharehlder must be analyzed separately. The Califrnia and federal bases ften will differ, especially if the crpratin has prperty, plant r payrll utside Califrnia r if the federal S electin was effective befre Hw much gain will the crpratin realize if it sells assets? What will be the tax n this gain if it is recgnized? Hw much gain will the sharehlders realize if they sell stck? Hw much gain will the sharehlders realize if the crpratin sells assets, pays tax and then distributes the balance f the sales prceeds t them as a liquidating distributin? 2 Use this as a benchmark fr yur tax planning. 1 The material in this utline is current as f August 8, 2003, and des nt reflect develpments after that date. 2 See "Aviding the Duble Tax in an Asset Sale" belw dc WS4.WHL :1315

5 The seller ften must grm the business fr sale. Here is an verall strategy fr dispsing f unwanted assets f a C crpratin (r an S crpratin subject t the built-in gains tax). The seller shuld list the crpratin s assets and then rank them by the appreciatin in each asset. The ultimate gal is t leave the highly appreciated assets in the crpratin and t sell the stck f the crpratin with thse assets in it. T the extent that the lw-gain assets wuld reduce the marketability f the substantially appreciated assets, have the crpratin sell the lw-gain assets at a lw tax cst. The seller shuld als cnsider cmbining with anther business t achieve critical mass and higher multiples r t make the business mre attractive t a financial buyer. 2. Planning fr the Seller s Gain Recgnitin Shuld ne r mre f the sharehlders hld the shares until death s that their heirs can receive the step-up in basis t the fair market value at that time? If s, the sale shuld be deferred r a nnrecgnitin structure shuld be cnsidered. A sale t the next generatin is ne f several methds f freezing the value f the business in the seller s estate. The future appreciatin in value wuld be taxed at estate tax rates f 49% (the 2003 maximum rate). The anticipated present value f that tax must be balanced against the tax n currently recgnized gain at a cmbined federal and Califrnia maximum effective rates f apprximately 40% fr C crpratins, 46% fr individual s rdinary incme, 24% fr individual s lng-term capital gain (assuming the federal AMT applies and kncks ut the federal deductin fr Califrnia tax), and 47% and 24% fr rdinary incme r lng-term capital gain flwing thrugh and S crpratin (in each case, assuming that a duble incme tax and substantial sales tax can be avided). If the value f an asset held by an individual is less than his basis in the asset, the individual can benefit by recgnizing the lss during his lifetime. If the asset is held until death, the basis will step dwn t the fair market value at that time, with n incme tax benefit frm the adjustment. If the seller will realize gain n the sale, des he have capital lsses frm ther surces t ffset the gain? If the seller will realize a lss n the sale, des he have gain frm ther surces which he can recgnize and absrb the capital lss frm the sale? dc WS4.WHL : William C. Staley

6 If the seller des nt plan t hld ut fr the basis step-up at death and the sale will generate rdinary incme (as a result f depreciatin recapture r the tax benefit rule, fr example), it might make sense t use a taxable structure if the seller believes that tax rates n rdinary incme will increase. 3. The Seller s Charitable Cntributin f Sale Prceeds If the seller plans t dnate sme f the sale prceeds t charities, he shuld cnsider dnating sme f the stck t the charity and letting the charity sell it. If the step transactin prblem can be avided, the dnr will receive an incme tax deductin fr the dnatin and the charity will escape tax n the sale. 3 Anther alternative is t establish a private fundatin, cntribute the target stck t the fundatin, and let the fundatin sell the stck. The fundatin can hld the sale prceeds as an endwment, distributing nly the incme t ther charities. (The dnrs may als wish t use the fundatin in their estate plan.) Generally, the fundatin can hld the stck fr five years withut incurring penalty taxes. The deductin limitatins that apply t cntributins t private fundatins are mre nerus than thse fr cntributins t public charities and private perating fundatins. 4 Cnsequently, the seller shuld explre establishing a fund with a cmmunity fundatin t achieve better tax results with flexibility very clse t a private fundatin -- but a lt less hassle. The seller shuld cnsider using a charitable remainder trust ( CRT ) The incme tax deductin in the year f the initial dnatin can shelter gain frm the sale. The stream f lifetime payments frm the CRT can put the seller in clse t the same after-tax psitin as if he sld the stck and tk back a prmissry nte with level payments. If the seller and the 3 Making assumptins and running the numbers is the nly way t determine if the presale cntributin f stck will result in tax savings. The cntributin deductin limitatins shuld be reviewed t determine (1) whether the amunt f the cntributin will be measured by the value f the stck r the dnr's basis in it, and (2) the applicable percentage limitatin (50%, 30% r 20% f AGI, disregarding NOL carryfrwards). 4 The amunt f the deductin fr a cntributin f stck f a clsely-held business t a private fundatin is limited t the dnr's basis in the shares dc WS4.WHL : William C. Staley

7 seller s spuse utlive their actuarial life expectancies, they can actually d better with the CRT. By investing sme f their up-frnt tax savings in life insurance held in a wealth replacement trust, they can hedge the risk that they will nt utlive their actuarial life expectancies. The payments frm the CRT can cntinue fr the lives f the seller and his spuse, as cmpared with the shrter term f a prmissry nte. The undistributed assets in the CRT grw tax-free, like a qualified retirement plan r an IRA. The annual valuatin f the CRT assets prvides prtectin frm inflatin that is nt available with a prmissry nte. Nte: Transfers f shares t these entities cannt be undne. If the deal des nt clse, the seller cannt get the shares back. 4. When t Use a Tax-Free Structure Frm the seller s perspective, a tax-free rerganizatin r cntributin t capital f a crpratin (in either case with a basis carryver) will be attractive if: The seller wants t hld ut fr the basis step-up at death r wants t avid tax in the current year, and The seller will be satisfied with an equity interest in the buyer r the buyer s parent. Hwever, after the rerganizatin, the seller s assets remain at risk in the target business, which will then be perated by the buyer. In certain tax-free transactins the seller can receive sme cash in the frm f taxable bt. The seller can als receive funds pursuant t emplyment, cnsulting r deferred cmpensatin arrangements r cvenants nt t cmpete. 5 5 See "Techniques t Minimize the Seller's Duble Tax" belw dc WS4.WHL : William C. Staley

8 Sellers shuld always use a triangular merger instead f a B rerganizatin (stck slely fr stck ); because any bt in a B will cause the exchange t be taxable. Big buyers like triangular mergers because they ften can avid the expense and delay f sliciting sharehlder apprval fr the transactin. A tax-free transactin is attractive fr the buyer because it allws the buyer t acquire the target business with a minimum cash cst. Hwever, the seller stays in the picture, sharing in the upside and having a say in hw the business is run. The like-kind exchange rules which permit tax-free swaps f investment prperty d nt apply t exchanges f stck, securities, ntes r partnership interests. Hwever, carryver basis treatment is available fr rllvers f publicly traded securities int Small Business Investment Cmpanies (SBICs) under Sectin 1044 and fr rllvers f qualified small business stck int ther qualified small business stck under Sectin When t Use an ESOP The seller shuld cnsider an ESOP as a way t cash ut f a C crpratin withut recgnizing any gain by selling the business t the emplyees, t achieve a tax-free cash-ut f minrity sharehlders as a prelude t the sale f the business, and/r t help t bnd the emplyees t the cmpany. The buyer shuld cnsider an ESOP t make the principal payments n the acquisitin debt (r n pst-acquisitin brrwings t capitalize the business) effectively deductible fr federal and Califrnia incme tax purpses The Buyer s Pre-Acquisitin Planning fr Unitary Tax Issues When acquiring a business which culd be unitary with ther businesses f the buyer, substantial tax savings can be realized in many cases by structuring the transactin with the unitary rules in mind. 6 Althugh S crpratins are nw allwed t have ESOPs (fr federal -- but nt fr Califrnia tax purpses), the best features f ESOPs are nt available t S crpratin ESOPs dc WS4.WHL : William C. Staley

9 The Unitary Methd. When a taxpayer derived incme frm surces bth within and withut Califrnia, it is required t measure its Califrnia franchise tax liability by its net incme derived frm r attributable t surces within this state. If the taxpayer is engaged in a unitary business with ne r mre affiliated crpratins, the amunt f business incme attributable t Califrnia surces must be determined by applying an apprtinment frmula t the ttal incme derived frm the cmbined unitary peratins f the affiliated cmpanies. If the Califrnia business generates a lss, but the wrldwide unitary business is prfitable, Califrnia franchise tax will be due under the unitary methd. Many find this unfair. There are tw alternative tests t determine whether a affiliated entities are part f a unitary business: A unitary business is cnclusively established by the existence f: (1) unity f wnership; (2) unity f peratin as evidenced by central purchasing, advertising, accunting, and management divisins; and (3) unity f use in a centralized executive frce and general system f peratin (the three unities test). A business is als unitary when the peratin f the business within Califrnia cntributes t, r is dependent upn, the peratin f a cmmnly-wned business utside the state (the dependency test). The existence f a unitary business may be established if either the three unities r the dependency test is satisfied. Structuring Cncerns. Prjectins shuld be made fr each business which the buyer grup will wn after the acquisitin. Then determine which businesses shuld be unitary, which shuld nt be unitary and in which years. Fr example, it may be helpful t arrange fr the separatin f certain businesses frm the unitary grup at a future time. T keep a business utside f the unitary grup, it shuld be segregated in a separate entity. The easiest unitary factr t manipulate is the wnership factr, but the ther factrs can als be used. The Water s Edge Electin. Fr a buyer grup which will be eligible fr the water s edge electin as a result f the acquisitin, the electin shuld be carefully cnsidered befre the clsing. If the electin is made, mst freign crp dc WS4.WHL : William C. Staley

10 ratins are excluded frm the unitary grup and the Califrnia crpratin is required t pay a deductible annual fee based n its Califrnia prperty and payrll. Part Tw Asset Sales Selling the business assets (including gdwill) -- as ppsed t the stck r partnership interests -- raises special tax cncerns fr the seller. This is ften the best structure fr the buyer. 7. Aviding the Duble Tax in an Asset Sale T the extent reasnably pssible, in an asset sale the seller shuld allcate the purchase price away frm assets held by a prfitable C crpratin (r an S crpratin which is subject t the built-in gains tax). Instead, allcate the purchase price t payments directly t the individual sellers, such as persnal gdwill, salary, rent and payments fr cnsulting and, if necessary, cvenants nt t cmpete. The seller s gal is t achieve a single level f tax, which wuld be the result if an individual sld a sle prprietrship. 7 The Duble Tax Prblem The sale f a business (r ther appreciated asset) by a C crpratin and the distributin f the sale prceeds t its sharehlders -- whether in liquidatin r therwise -- will almst always result in tw levels f tax: ne at the crprate level resulting frm the sale, and a secnd tax at the sharehlder level when the balance f the prceeds are distributed. The extent f the duble tax depends n the selling crpratin s basis in its assets (the inside basis ) and its sharehlders basis in their stck (the utside basis ). 7 If the business wner r spuse f the business wner recently died, the gal changes t aviding gain entirely by using the basis step-up dc WS4.WHL : William C. Staley

11 Example 1: Using Inside and Outside Basis. In 2003, X Crp, a C crpratin, sells its business fr $1,000,000, recgnizing gain f $800,000 and liquidates. Dave and Ed, the sharehlders, have an aggregate basis f $10,000 in their X Crp stck. At an effective cmbined federal and Califrnia tax rate f 40%, X Crp will incur a tax f $320,000 ($800,000 x 40%) n the sale, leaving $680,000 ($1,000,000 - $320,000) fr distributin t Dave and Ed. Since the liquidating distributin will be treated as a sale f their stck, Dave and Ed will recgnize gain f $670,000 ($680,000 - $10,000) n the distributin. At an effective federal and Califrnia tax rate f 24% fr lng-term capital gain, they will pay tax f $161,000 ($480,000 x 24%). The tax n the sale and distributin will ttal $481,000 ($320,000 + $161,000) -- ver 48% f the sale price. If the selling crpratin has a tax lss frm peratins in the year f the sale r a net perating lss (an NOL ) carryfrward t that year, the crprate-level tax may be reduced r eliminated. 8 Example 2: Wrst Case. If X Crp had a zer basis in the assets which it sld and the distributin was a taxable nn-liquidating distributin, then X Crp s gain wuld be $1,000,000, subject t a tax f $400,000; the amunt f the distributin wuld be $600,000; if the sharehlders had a zer tax basis in their shares, then the tax wuld be $144,000; the ttal tax wuld be $544,000, r 54% f the sale price -- the current maximum duble tax rate n dividend distributins f C crpratin earnings and prfits. 8. Sell Stck/Buy Assets Sell Stck/Buy Assets If the buyer is cnsidering the purchase f a business currently cnducted by a crpratin, it rdinarily will be in the buyer s interest t buy the business assets, nt the stck, f the crpratin, even if the buyer plans t incrprate the business. (The buyer can rganize a new crpratin, which wuld buy the assets frm the selling crpratin.) By purchasing assets: It is easier t minimize the buyer s ptential liability fr claims against the business which arise befre the acquisitin date; 9 8 See "Using Net Operating Lsses" belw dc WS4.WHL : William C. Staley

12 The buyer gets an aggregate tax basis fr the assets equal t his purchase price, which is generally greater than the existing aggregate tax basis f the assets; The buyer can tailr a new crpratin s capital structure and tax electins (including the S crpratin electin) t his wn needs; and The buyer s new crpratin will nt be burdened with the seller s undistributed C crpratin earnings and prfits r negative S crpratin accumulated adjustments accunt. The buyer amrtizes ver 15 years the prtin f the purchase price in an asset deal that is prperly allcated t gdwill, but cannt deduct r amrtize any f the purchase price fr stck (until the stck is sld r becmes wrthless). The buyer can arrange t use the seller s trade name and crprate name even in an asset deal. In cntrast, the seller wants t sell stck, achieving a single level f tax at favrable lng-term capital gain rates (a 24% cmbined rate vs. the 54% wrstcase cmbined rate nted abve fr an asset sale), and dispsing f the crprate shell alng with the business assets. Befre deciding t prceed with an asset sale, the seller shuld determine whether sales tax will apply. If the seller agrees t an asset sale t accmmdate the buyer, the seller shuld insist that the buyer bear the resulting sales tax, if any. 10 Purchasing assets requires a review f all leases and ther cntracts, and transferring certain assets r large quantities f assets may present prblems. Smetimes ther cnsideratins frce the buyer t acquire stck f the crpratin cnducting the target business. The crpratin may have favrable 9 An asset deal is ne f several ways t minimize the buyer's risk. The parties shuld agree n risk allcatin principles befre the agreements are drafted. 10 See "Sales and Use Tax" belw dc WS4.WHL : William C. Staley

13 cntracts which cannt be easily assigned; the type r quantity f assets invlved may make transfers impractical; r the seller s tax situatin r bargaining pwer may preclude an asset sale. If the buyer acquires stck f a crpratin with undistributed earning and prfits, the purchase price shuld reflect the eventual tax cst which the buyer will pay t distribute thse earnings Techniques t Minimize the Seller s Duble Tax and t Accelerate the Buyer s Deductin Persn Gdwill. Sme f the gdwill f the business is attributable t its name, lcatin, trademarks, phne number and dmain names. Hwever, sme f the gdwill f the business may be persnal gdwill f the business wners wh are active in the business. If the custmers will fllw the wner t whatever business hme he may find, the gdwill is persnal and the wner individually may be able t sell it, aviding a duble tax. This is ften the case in service businesses. Emplyment and Cnsulting Agreements and Cvenants Nt t Cmpete. Emplyment and cnsulting agreements and cvenants nt t cmpete can allcate the purchase price t the sharehlders -- where it is taxed nce, and away frm the crpratin -- where it subject t a secnd level f tax. Nw that the maximum effective tax rates n lng-term capital gain and rdinary incme are 24% and 46%, respectively, the seller will prefer lng-term capital gain t rdinary incme -- unless the buyer reduces the purchase price. The buyer can deduct currently the payments under the emplyment r cnsulting agreement (subject t leveling rules in sme cases if the payments are unequal ver time), can deduct ver 15 years the prtins f the purchase price allcated t the cvenant and gdwill, and can deduct the amunt paid fr depreciable r amrtizable assets wuld be deducted ver the life f the asset. Hwever, the entire amunt paid fr stck must be capitalized. The buyer will almst always prefer t allcate t amrtizable r depreciable assets, rather than t stck. 11 See "Aviding the Duble Tax in an Asset Sale" abve dc WS4.WHL : William C. Staley

14 The Service can require either party t shw that rendering the cnsulting services was a reasnable pssibility at the time that an availability agreement was made and/r, if the agreement requires actual services, that they were perfrmed. Fr payments under a cvenant, the Service can require a shwing that cmpetitin was a real threat. Accrdingly, these techniques shuld be used nly fr sharehlders wh are active in the business prir t the sale. Als, the seller shuld allcate between the cvenant and the sale f persnal gdwill, since the frmer will be taxed at rdinary incme rates and the latter has a sht at being taxed at capital gains rates. An emplyee s duty f lyalty during emplyment prhibits the emplyee frm cmpeting with the emplyer, unless the emplyment agreement expressly prvides therwise. In cntrast, a cnsultant has n duty t refrain frm cmpeting with a client, unless the duty is impsed by law (as it is fr attrneys) r by cntract. If a cnsulting agreement includes a cvenant nt t cmpete, the Service might require an allcatin f the payments between the cnsulting services and the cvenant, with the latter deductible ver 15 years. If the gal is t prevent cmpetitin, an emplyment arrangement is better than cnsulting; if emplyment is nt feasible, the prhibitins shuld be stated in terms f prtecting the target cmpany s trade secrets rather than prhibiting cmpetitin. The parties must als be prepared t shw that n mre than a reasnable amunt was paid fr the seller s services r his prmise nt t cmpete. An appraisal r the pinin f an investment banker can be helpful. Allcate t Assets Held Outside the Crpratin. If sme f the assets being sld are held utside the crpratin (fr example, real estate, equipment, designs, patents r the stck f brther-sister crpratins), the seller shuld allcate the highest reasnable amunt t thse utside assets that generate lngterm capital gain, reducing the prtin f the purchase price allcated t inside assets (that is, thse held by the crpratin) and t utside assets that will generate rdinary incme (fr example, frm depreciatin recapture). The gain n the utside assets is taxed nce, but the gain n assets held inside the crpratin might be taxed at bth the crprate and the sharehlder level. Reminder: Appreciating assets shuld never be held by a crpratin (whether an S crpratin r a C crpratin), absent a cmpelling reasn t d s dc WS4.WHL : William C. Staley

15 Management Cntracts. T avid the secnd level f tax in an asset sale by a C crpratin (r an S crpratin subject t the built-in gains tax), the seller shuld cnsider arranging a management agreement with the buyer, pursuant t which the buyer will perate the business and receive mst f the prfits. 12 Amng several drawbacks t this arrangement is the rdinary incme character f the amunts received by the seller. S Crpratin Electin. The preliminary review discussed in Evaluating the Seller s Ptential Gain abve is critical when the seller is an S crpratin. The seller f a business cnducted by an S crpratin ften can accmmdate the buyer s request fr an asset sale -- withut incurring a secnd level f tax n the seller. If there is n built-in gain prblem, they shuld be willing t sell assets, the buyer gets a basis step-up and the seller has ne level f tax in either a stck deal r an asset deal. If the seller incurs mre tax by selling assets and liquidating, the buyer might prefer t increase the purchase price rather than d a stck deal and keep the lw inside basis. 13 A primary reasn t make r retain the S electin is t avid a duble tax in an asset sale and t minimize the gain in a stck sale. The S electin is still ne f the best tax planning techniques fr a business that is held by a C crpratin, if the business is increasing in value and is being held fr a pssible sale. 14 If the target qualifies fr the S crpratin electin, cnsider making the S electin in cnnectin with a plan t minimize the built-in gain tax and t avid the excess passive receipts tax, especially where the target crpratin has NOL carryfrwards generated in C crpratin years r will incur lsses r zer ut 12 Nte that this will nt generate "passive receipts" (which wuld subject an S crpratin with C crpratin earnings and prfits t the excess passive receipts tax). In cntrast, ther techniques such as leasing, licensing r franchising t the "buyer" wuld prbably generate passive receipts. Nte: Fr a well-advised S crpratin with sme cash, the excess passive receipts prblem is ften manageable. 13 See "When the Buyer r the Target is an S Crpratin" belw. 14 Fr business that is nt in a crpratin, a limited liability cmpany is ften a better alternative than either a C crpratin r an S crpratin. See page 31 fr the utline Structuring Businesses fr the 21 st Century dc WS4.WHL : William C. Staley

16 in the 10 tax years fllwing the electin. The C crpratin NOLs may be carried frward t reduce the built-in gain, which is recgnized nly t the extent that the crpratin has taxable incme. The unrecgnized prtin f the built-in gain is carried frward, but nt after the tenth S crpratin year. Nte that the S crpratin electin fr a prfitable business will increase the basis in shares by the amunt f the undistributed S crpratin incme. Cnsequently, the S crpratin electin benefits the sellers whether they sell stck r the crpratin sells assets. 10. Structuring With the Asset Allcatin Rules in Mind The buyer and the seller shuld allcate the purchase price amng several categries which may be applicable. A particular allcatin which has favrable tax cnsequences fr the buyer usually -- but nt always -- has unfavrable tax cnsequences fr the seller, and vice versa. Summarized belw are the federal incme tax cnsequences t the buyer f allcating the purchase price t each f several cmmn categries: Accunts receivable: csts capitalized and the buyer has gain r lss if the amunt cllected varies frm the amunt capitalized. Inventry: csts capitalized and deducted against sales as cst f gds sld. Equipment: csts capitalized and depreciated. Sales tax may apply t the amunt allcated t the equipment. 15 Franchises and the right t use trade names and trademarks: generally, payments are currently deductible if the amunt f the payments is cntingent n the use, prductivity r dispsitin f the franchise, trademark r trade name. If the amunt f the payments is nt cntingent, the deductins are spread ver 15 years. If the buyer acquires all f the seller s significant rights in the franchise, trademark r trade name, the buyer cannt deduct the amunt paid fr these items unless the buyer can shw that they have a limited useful life. 15 See "Sales and Use Tax" belw dc WS4.WHL : William C. Staley

17 Land: csts capitalized and nt deducted r depreciated. Real estate imprvements: csts capitalized and depreciated. Favrable lease: csts allcated t the lease are amrtized ver the remaining lease term. (Nt subject t the 15-year amrtizatin rule fr ther intangibles.) Cnsulting agreements, emplyment agreements: payments generally deductible ver the term f the agreement. Cvenants nt t cmpete: capitalize and deduct ver 15 years (capitalize each payment and amrtize it ver the balance f the 15-year perid, as ppsed t taking 1/15th f the aggregate cvenant payments in the first year). Custmer lists, patents and secret frmulas: amrtize ver 15 years. Gdwill (i.e., the excess f the ttal purchase ver the amunt allcated t assets): amrtize ver 15 years. Payments made by the buyer will als have significant tax cnsequences: Interest payments in an asset deal: When the buyer is a C crpratin, the interest payments are deductible. (If the indebtedness is attributable t a passive activity, nte that the passive activity rules will prevent a clsely-held C crpratin frm using passive lsses t ffset prtfli incme.) When the buyer is an individual, the interest payments are generally deductible, subject t the passive activity, at risk and investment interest limitatins. When the buyer is a partnership r an S crpratin, the interest expense is currently deductible by the partners r sharehlders wh materially participate in the business, but nly (a) t the extent that the interest is nt allcable t prperty held fr investment r passive activities f the buyer, r (b) if s allcable, t the extent deductible under the investment interest and passive activity limitatins. If the buyer is a dc WS4.WHL : William C. Staley

18 partnership r S crpratin, the at risk rules and basis limitatins n lsses must als be cnsidered. Lease payments: generally currently deductible. Licenses t use patented inventins: payments deductible ver the term f the license. Investigatin and due diligence: deductible immediately if the buyer is in the target s business already; deductible ver 60 mnths as startup expenditures if the buyer is nt in the target business. Acquisitin Csts (legal, accunting, investment banking, finder s fees, escrw csts, etc.): added t the basis and allcated amng the assets purchased. Deductible t the extent the asset s basis is subject t depreciatin r amrtizatin deductins. Allcatin Methd. The residual methd is the nly way t determine the amunt allcated t gdwill in an asset sale. Reprting Requirement. Frm 8594, Asset Acquisitin Statement, must be filed in any transfer f assets which cnstitutes a trade r business. This prvides a substantial incentive fr the buyer and seller t agree n the allcatins. 16 The parties must disclse whether they have agreed n the allcatins and whether they have entered int an emplyment agreement r a cvenant nt t cmpete. If the buyer and seller agree n the allcatins, they are bund by them -- but the Service is nt bund! 16 The 1990 Tax Act extended the reprting requirement t stck sales if a 10% sharehlder r a related persn enters int any agreement with the buyer in cnnectin with the transactin, including the fllwing: an emplyment agreement a cvenant nt t cmpete a ryalty agreement r a lease agreement. Frm 8594 has nt been revised t reflect this 1990 statute dc WS4.WHL : William C. Staley

19 Penalties apply fr failure t file this infrmatin return Installment Sales Installment sales can be used t push the recgnitin f gain -- and the bligatin t pay tax n that gain -- int a future year. Using the installment methd is n lnger as straightfrward as it was nce was, and alternatives shuld be cnsidered in sme cases. The installment methd is nt available t accrual methd taxpayers with grss receipts ver $1 millin. Hazards f Using the Installment Methd. Using the installment methd might defer the gain int a year in which the federal r state tax rate n that gain exceeds the current rates. Depreciatin recapture cannt be deferred under the installment methd. Gain frm the sale f a partnership interest cannt be deferred under the installment methd t the extent that it is attributable t the partnership s substantially appreciated inventry which wuld nt be subject t the installment methd if sld directly. T the extent that the face amunt f the liabilities arising in a single year exceeds $5 millin at year-end, interest must be paid n the deferred tax. The time value f the deferral must be weighed against this tax in each case in which it applies. Pledging installment bligatins accelerates the gain. An installment bligatin cannt be secured by cash r cash equivalents (C.D.s, T-bills). Installment sales are subject t the imputed interest and riginal issue discunt rules. The passive activity and investment interest limitatins may apply t the buyer s interest expense deductin. 18 If a C crpratin has deferred gain frm an installment sale that is nt subject t the interest charge, the deferral is an AMT ACE adjustment. If the seller is a freign persn, the buyer must withhld tax n the interest payments. Installment bligatins held by a decedent d nt enjy a step-up in basis at death. 17 I.R.C See "Structuring With the Asset Allcatin Rules in Mind" abve and "The Buyer's Interest Deductin in a Stck Deal" belw dc WS4.WHL : William C. Staley

20 Structuring Hld-Backs. Buyers are ften cncerned abut adverse events (such as a decline in sales r a big prducts liability lawsuit) which may ccur after the clsing. If neither party will entirely accept the risk, there are tw chices: Pay the purchase price at the clsing and require the seller t give part f it back if adverse events ccur; r Use installment payments which are subject t a right f ffset. If the purchase price is paid and then part f it is given back, the seller will pay tax n the sale and capital lss n the give-back, which may nt be immediately useful. The secnd alternative limits the amunt f gain recgnized initially and has n negative tax cnsequences fr the seller when the adverse event ccurs. Accrdingly, the seller shuld use the installment sale/ffset alternative where he des nt need the cash immediately. Example 1. Seller sells his business in 2000 and prmises t indemnify Buyer fr any prducts liability claims arising befre The entire purchase price is paid in Seller s gain n the sale is capital gain. A prducts liability claim arises in 2003 and Seller indemnifies Buyer in The amunt paid by Seller in 2004 is a capital lss. Unless Seller has substantial capital gain in 2004, Seller s ability t use the capital lss t ffset ther incme will be limited; the unused capital lss will be carried frward and, if Seller is a crpratin, will be lst if nt used in five years. Example 2. Same as Example 1, but a prtin f the purchase price is paid by a five-year balln nte and the Buyer is entitled t ffset claims fr indemnity against the amunts due under the nte. The nte bears interest payable annually at a market rate. Using the installment methd, Seller defers recgnitin f a prtin f the gain until the principal prtin f the nte is paid. When Buyer satisfies the claim, Buyer reduces the amunt due under the nte. There is n tax cnsequence t Seller at that time. When Seller receives payment f the reduced amunt under the nte, Seller is taxed n the deferred gain -- but the amunt f gain recgnized is reduced in prprtin t the principal reductin n the nte. If the prducts liability claim exceeded the principal due under the nte, Seller s deferred gain wuld be eliminated and, t the extent that Seller was required t dc WS4.WHL : William C. Staley

21 make an indemnificatin payment t Buyer in 2004, Seller wuld incur a capital lss -- with the pssibly adverse tax cnsequences described abve. Earn-uts (used when the purchase price will increase if specified targets are reached) raise similar issues. 12. Sales and Use Tax Unless the business being sld is a service business, Califrnia sales tax prbably will apply t amunts allcated t equipment and certain ther tangible persnal prperty in an asset sale. Sales tax des nt apply t ccasinal sales. T qualify fr this exemptin, the seller must nt be required t hld a resale permit (that is, the seller must nt regularly engage in sales f tangible persnal prperty); and the seller must nt engage in mre than tw ther sales in any 12-mnth perid which includes the clsing. The third sale will cause all sales within the 12-mnth perid t be taxable. 19 N sales tax applies t sales f stck, which is nt tangible persnal prperty. (This is anther reasn why sellers prefer stck sales t asset deals.) Nte: When grming the business fr sale, and befre signing a letter f intent, the seller shuld cnsider drpping the equipment int a single-member LLC s that the buyer can buy an LLC interest (prbably nt subject t sales tax), rather than the taxable equipment. The buyer, as the new wner f the single0member LLC, shuld be treated fr tax purpses as the wner f the equipment and the LLC shuld be disregarded, putting the buyer in the just as favrable an incme tax psitin as if the buyer had bught the equipment and nt the LLC interest. Sales tax des nt apply t mergers. This rule prvides planning pprtunities fr minimizing sales tax in asset deals. Inventry held fr resale will be exempt frm sales tax if the seller btains a cmpleted and executed resale certificate frm the buyer. 19 A special rule applies when a single entity cnducts bth a service business and a sales business dc WS4.WHL : William C. Staley

22 There are several ther exemptins t the sales tax. Until an applicable exemptin is identified, assume that each item f tangible persnal prperty in an asset sale will be subject t the sales tax. Either party can bear the sales tax r they can split it. The purchase agreement shuld specify wh is respnsible. The seller will be required t file the sales tax return and t make payment t the State Bard f Equalizatin. The buyer shuld withhld a prtin f the purchase price until the buyer btains a certificate f release frm the State Bard f Equalizatin stating that n sales r use tax (whether incurred as a result f the sale f the business r therwise), interest, r penalties remain unpaid. The buyer shuld file with the lcal ffice f the State Bard f Equalizatin a written request fr a certificate f release as sn as pssible -- recgnizing that ding s will prbably trigger a sales tax audit f the target business. If the buyer des nt d s, the State Bard f Equalizatin can cllect the tax, plus any ther taxes wed by the seller, frm either the seller r the buyer. Filing the request starts a three-year statute f limitatins; the SBE cannt assess the seller s sales tax liability against the buyer r the buyer s successr-in-interest after the three-year perid expires. 13. The Buyer s Liability fr the Seller s Other Taxes Incme and Franchise Taxes. Generally, the buyer f substantially all f the assets f a business fr value is nt liable fr the seller s federal incme and Califrnia incme and franchise taxes. Hwever, the buyer may be secndarily liable if the buyer des nt pay full value r assumes all f the seller s liabilities. In additin, in a bulk transfer f assets, tax authrities have the same rights as the seller s ther creditrs under the Unifrm Cmmercial Cde -- Bulk Transfers. If n bulk sale ntice is published, the buyer may be liable fr the seller s taxes (even if the buyer paid full value fr the assets). The buyer s ptential liability extends t the seller s incme and franchise taxes incurred during the year in which the sale ccurs -- even thugh the seller is nt required t file a tax return fr that year until after the clsing. The buyer can be liable fr federal emplyment taxes as well as incme tax. Califrnia Emplyment Taxes. In cntrast, generally the buyer is liable fr the seller s Califrnia unemplyment insurance cntributins. The buyer s liability fr the seller s Califrnia unemplyment insurance cntributins can be dc WS4.WHL : William C. Staley

23 eliminated if the seller btains a certificate f release frm the lcal ffice f the Califrnia Emplyment Develpment Department. A request fr a certificate prbably will trigger an audit f the seller s Califrnia emplyment tax returns. Part Three Stck Sales In a stck sale, the entity remains intact, with the business inside it. This is ften the best structure fr the seller. It raises planning issues fr the buyer. 14. Cmbining Stck Sales and Redemptins When the gal is t transfer all f Sharehlder A s shares t Sharehlder B, but B des nt have sufficient cash t buy them, it may be pssible t have the target crpratin buy sme f A s shares, reducing the purchase price t be paid by B fr A s remaining shares. Prblem: Dn and Ed each wns 200 shares f X Crp, a C crpratin. There are n ther sharehlders and Dn and Ed are nt related. Dn wants t buy Ed ut, but Ed wants $2 millin in cash fr his shares. Dn can raise $500,000. X Crp has $1.5 millin in available cash, but Ed and Dn are bth at the maximum reasnable cmpensatin and neither wants t risk a pssible taxable cnstructive dividend by bnusing ut a substantial sum. Slutin: X Crp redeems 150 f Ed s shares fr $1.5 millin. Immediately after the redemptin, Dn buys Ed s remaining 50 shares fr $500,000. Althugh the redemptin, standing by itself, wuld nt qualify fr sale treatment, when the redemptin by X Crp and the sale t Dn are cnsidered tgether, Ed is deemed t have cmpletely terminated his interest in X Crp and sale treatment applies. This structure is knwn as a Zenz transactin after the case f Zenz v. Quinlavin in which the curt held that sale treatment applied. The Service has accepted this decisin. Ed nw wns all f the utstanding shares and has a basis f $500,000 in them (assuming that Ed had a zer basis befre the stck purchase). In cntrast, if Ed had bught all f Dn s shares, Ed wuld have a basis f $2 millin in the shares. The bttm line: Ding a Zenz wastes basis. All stck redemptins waste basis. A sharehlder-t-sharehlder sale (r crss purchase ) will benefit the remaining sharehlder when he later sells stck r liquidates the crpratin and can use his increased basis t reduce gain at that time dc WS4.WHL : William C. Staley

24 15. Using a Cash Merger t Acquire Minrity Shares If the majrity sharehlders want t buy the shares f the minrity sharehlders, but it is nt feasible t negtiate a separate transactin with each minrity sharehlder, the fllwing cash merger shuld be cnsidered: The majrity sharehlder(s) f Target frm a new crpratin Newc t which they cntribute their Target shares. The majrity sharehlders arrange fr the merger f Target int Newc. In the merger, Newc s name is changed t Target s name and each share f Target is cnverted int a fractin f a share f Newc, but nly whle shares f Newc are issued. The minrity sharehlders wh wuld receive fractinal shares receive cash instead. The cnversin rati is designed t cash ut all f the minrity sharehlders. Example: Big wns 50 shares f Target. N minrity sharehlder wns mre than 4 shares. Big cntributes all 50 Target shares t Newc. Target merges int Newc with a 5-t-1 cnversin rati, s that Big s 50 Target shares cnvert int 10 Newc shares and each ther Target sharehlder receives cash in lieu f fractinal shares. The minrity sharehlders have a right t vte n the merger if they hld mre than 10% f Target s stck. The minrity sharehlders have a right t challenge the value assigned t their Target stck, but they d nt have a right t challenge the terms f the merger, including the cnversin rati. It will usually be advisable t apply fr a permit frm the Califrnia Cmmissiner f Crpratins. Fr federal incme tax purpses, the transactin is treated as a distributin which might be treated as a sale. The creatin f Newc and the merger f Target int Newc are disregarded and Newc uses Target s federal emplyer identificatin number, tax year and ther tax attributes. Fr Califrnia tax purpses, Newc cannt be ignred, s the transactin is treated as (a) an F rerganizatin (a mere change in frm) and (b) a distributin that is tested under the Califrnia sale treatment test dc WS4.WHL : William C. Staley

25 The same result can be achieved by rganizing Newc as a subsidiary f Target and merging Target int Newc. If Target hlds real prperty in Califrnia, this structure minimizes the risk f a technical change in wnership fr prperty tax purpses. 20 The tax basis f the remaining sharehlders in their shares des nt increase as a result. Like a redemptin, a cash merger wastes basis. A crss purchase is better fr the buyer. Using a Cash Merger t Effect a Management Buy-Out. Smetimes the minrity sharehlders will nt cmmit t allwing a prpsed management buyut. Fr management buy-uts with utside funding, cnsider the fllwing structure t enable management t avid tax n the exchange f their shares: Management and the mney parties frm Newc, the mney parties cntributing cash and Management cntributing their Target stck. Newc then buys Target shares frm sme f the nn-management hlders, increasing Newc s wnership f Target t ver 50%. Target then merges int Newc, with the remaining minrity sharehlders f Target receiving cash. 17. The Buyer s Interest Deductin in a Stck Deal If the buyer is an individual, a partnership r an S crpratin and the target is a C crpratin, the investment interest generally will be deductible, but the limitatins might defer r blck the deductin. If the buyer is a C crpratin, the interest generally will be deductible. Fr a crprate buyer which will have interest expense f mre than $5 millin in any year resulting frm acquisitins, a deductin disallwance rule might apply. C crpratins which issue lw interest ntes with yields t maturity f five pints r mre ver the applicable federal rate must cnsider the rules fr applicable high yield discunt bligatins. If the target is an S crpratin that will cntinue its S status, the buyer s interest deductin depends n whether the buyer materially participates in the business, the extent t which the target s assets are used in peratins, and whether the sharehlder has sufficient basis and amunts at risk. 20 See "Prperty Tax Reassessments" belw dc WS4.WHL : William C. Staley

26 If the target is a C crpratin which will elect S crpratin status effective after the clsing, the investment interest limitatins shuld cease t apply and the pass-thrugh rules shuld apply. Hwever, the guidance prvided by the Service t date des nt address this issue. SUMMARY Buyer Target Effect Individual, partnership r S crp C crp Deductible, subject t limitatins C crp Deductible up t $5M/yr S crp Deductible if buyer is active in business C crp that elects S crp after clsing Shuld be deductible as fr S crps The indebtedness might als be subject t recharacterizatin as equity fr tax purpses, eliminating deductin fr the interest payment (which wuld then be treated as a dividend). Buyers wh rely n the dividends-received deductin t fund a crprate buyer s debt service shuld be sure the Califrnia dividends-received deductin will apply. 18. The Sectin 338 Electin: Opprtunities and Risks The Sectin 338 Electin. Under Sectin 338(a) a crprate buyer f 80% r mre f a target crpratin s stck can elect t step up the basis in the target s assets by having the target taxed as if it had sld all f its assets n the date f the stck sale. Generally, the target crpratin r the buyer s affiliated grup pays the tax n target s gain recgnized n the deemed sale. The immediate tax cst f recgnizing the gain in the target s assets ften utweighs the benefits f the basis step-up (benefits that are realized nly ver the applicable depreciatin r amrtizatin perids r when the assets are sld). Hwever, if the target r the buyer grup incurs substantial lsses after the acquisitin, the lsses may absrb the gain n the deemed sale. The varius lss and credit limitatins shuld be cnsidered in planning t use lsses incurred befre the acquisitin date t absrb the gain n the deemed sale dc WS4.WHL : William C. Staley

27 The Sectin 338(h)(10) Electin. If the target is a member f an affiliated grup befre the sale and the buyer makes a Sectin 338 electin, an electin is available under which the target is treated as a member f the selling grup fr purpses f the deemed asset sale, s the selling grup absrbs the gain n the deemed liquidatin f the target. If this Sectin 338(h)(10) electin is made, the selling grup des nt recgnize gain n the sale r exchange f the target stck. This electin shuld be cnsidered when the target crpratin has a lw basis in its assets relative t their value and ne f three ther cnditins apply: The selling grup has lsses which can absrb the gain realized n the deemed sale f the target s assets; The crprate seller s utside basis in the target stck is apprximately equal t the target s inside basis in its assets (in this case, the seller s gain is the same with r withut the (h)(10) electin); r The crprate seller defers the (h)(10) gain with the installment methd and expects t have lsses t shelter the gain recgnized in future years. Sharehlders f S crpratin targets can make the (h)(10) electin t absrb the gain when the crpratin is sld, giving the buyer a crpratin with a steppedup basis in its inside assets. Califrnia franchise taxes are an imprtant issue when cnsidering the (h)(10) electin. Califrnia des nt recgnize cnslidated returns and has less favrable NOL carryfrward rules (even when they are nt suspended). 21 S Crpratin Buyers. If the buyer is an S crpratin but the seller insists n a stck deal, cnsider ding a stck deal and then make a Sectin 338 r 338(h)(10) electin and either a Q-Sub electin r merge r disslve the target crpratin int the buyer. The result: the buyer gets a basis equal t the purchase price and can retain its S status. 21 See "Using Net Operating Lsses" belw dc WS4.WHL : William C. Staley