Taxation of Business Sales
The sale of a business involves the selling of separate assets. Since these assets may be taxed differently, the law requires that gain or loss be determined for each separate asset in the sale of the business. Property held short-term and receivables and inventory are subject to ordinary gain or loss. Assets held longer than 1 year are generally treated as §1231 assets, where the recaptured depreciation is taxed as ordinary income and any amounts over that may be taxed at the long-term capital gains rate.
Even if a business, per se, is not sold, it may be treated as a business if the assets have any goodwill or going concern value, or the assets would form a business as defined in IRC §355.
A partnership interest is considered a capital asset, but any gain or loss that is attributable to receivables or inventory is considered ordinary. IRC §743
Stock in a corporation is also considered a capital asset. However, if a corporation is liquidated, then any distribution to shareholders or other distributees are treated as if the assets have been sold to them. If a distributee is a corporation that owns a controlling interest in the distributing corporation, then the distribution may not be taxable. IRC §332
The purchase of a business requires that the consideration paid for it, which includes cash and any property, must be allocated according to the residual method, where the consideration value is allocated according to 7 classes defined by the tax code:
- Class I: cash and deposit accounts that can be immediately converted to cash on demand
- Class II: non-debt financial instruments, such as stocks, certificates of deposit, United States Treasuries, and foreign currency
- Class III: debt instruments, accounts receivable, and assets that must be marked to market annually for tax purposes
- Class IV: inventory or any other type of property held for resale to customers
- Class V: all assets not included in the other classes, such as land, buildings, equipment, and furniture and fixtures
- Class VI: all §197 intangible assets except goodwill or going concern value
- Class VII: goodwill and going concern value, since their value is determined by the amount of consideration paid for the business minus all other assets
Any asset that is includable in more than 1 class should be allocated to the lower numbered class, so if an asset is includable in Class II and Class III, then it should be allocated to Class II.
The amount of consideration for the business must 1st be reduced by the value of Class I assets, then by Class II assets, etc. The aggregate fair market value (FMR) of Class I assets through Class VI assets is then subtracted from the total consideration paid for the business and allocated to goodwill and going concern value. Although goodwill and going concern value are similar, goodwill is often used to refer to the value of the business's reputation, customers, employees, etc. Nonetheless, either can be calculated by the following equation:
Goodwill or Going Concern Value = Market Value of Business − Fair Market Value of All Other Assets (Book Value)
The allocations may not exceed the FMR of the property and may be further restricted by other parts of the tax code. However, the buyer and seller may agree to a different allocation. The agreement should be in writing and the allocation reasonable.
So if you sell a cleaning business for $15,000 that includes equipment with a FMR of $10,000, then $5000 of the purchase price is allocated to Class VII goodwill or going concern value.
Both buyer and seller must report the sale of business assets by filing Form 8594, Asset Acquisition Statement under Section 1060 with their tax return, which shows how the sale price was allocated to the 7 classes of assets and the aggregate FMR of those asset classes. If the assets consist of any Class VI assets, then both the buyer and seller must attach a schedule showing the type of agreement, such as whether it is for a covenant not to compete, a license agreement, or some other contract, such as a management or employment contract, for each Class VI asset and the amount allocated to that asset.
Allocating the Purchase Price among Assets
The worth of the business may be figured by calculating the net present value of future cash flows net of taxes. Although revenue and profits will depend on the business and how well it is managed, future taxes may be affected by how the purchase price of the business is allocated among the assets. The 7 classes of assets defined by the tax code progress from assets where the market value can easily be determined, such as cash or securities, to tangible property, such as tools and machinery, and then to intangible property, such as patents and trademarks, where the FMR of the assets are more difficult to determine, and then to goodwill, which can only be quantified by subtracting all the other assets from the purchase price. The cost of intangible assets and goodwill must be amortized over a 15-year period, whereas most other property, except for real estate, can be depreciated more quickly. Hence, the greater the proportion of the purchase price that can be assigned to quickly depreciated assets, the greater the value of the future cash flows of the business after taxes, and the more valuable the business.
Business expenses can be written off right away, and business property can be written down over their class lifetime, as defined by the IRS, but intangible property and goodwill must be amortized over 15 years. Additionally, the buyer could choose several methods of depreciation for most types of tangible property, thus giving the choice to depreciate most of the value quickly, or incrementally over the class life.
The buyer has an interest to allocate part of the purchase price to tangible property, because it can be depreciated faster than amortizing the same costs over 15-year period. However, the seller must pay ordinary income tax on that portion of the price rather than benefiting from the long-term capital gain rate. By contrast, the seller would like more of the purchase price to be assigned to intangible property, since it will be treated as a capital gain, which is usually lower than the ordinary tax rate for high income taxpayers. On the other hand, apportioning some of the price from real estate to intangibles benefits both buyer and seller, since real estate can only be depreciated over a much longer time, up to 39 years for commercial property. Again, there are limits to this allocation, but there is wiggle room because most property cannot be priced precisely — only estimated.
However, the buyer and seller are not completely free to allocate the purchase price to specific assets, because the allocation is restricted by IRC §1060 and §338. Moreover, there is a conflict between the buyer and seller as to how the purchase price is allocated, since the allocation will determine the amount that will be deductible by the buyer and how much of the sale price will be treated as depreciation recapture, which is taxed as ordinary income, and how much will be treated as long-term capital gain to the seller. To avoid IRS scrutiny, the buyer and seller must agree to the allocation, since any mismatch may invite an IRS audit.
The purchase price of the business may include contingent payments, such as a percentage of revenue over a period of years. Such costs are added to the cost of intangible assets, as long as the payments exceed the FMR of all assets in the lower classes. These payments are amortized over the remaining amortization period of the initial business purchase. So, for instance, a contingent payment paid in the 4th year after the business was purchased can be amortized over the remaining 11 years of the amortization period.
The Sale of a Limited Liability Company or Partnership
When a limited liability company or partnership is sold, the tax code treats the sale as an untaxed deemed distribution to the members or partners, who then sell those assets to the buyer. Therefore, each member or partner would have a profit or loss, depending on their capital and profit-and-loss sharing ratios. The entity is deemed liquidated if at least 50% of the ownership changes.
If the purchase is for less than 50% interest within a 12-month period, then the LLC or partnership continues. The selling partner recognizes gain or loss according to the difference between the sale price and his outside basis. However, the buying partner may have a lower share of the inside basis, which will result in higher taxes later, unless the other members or partners adjust the inside basis of the entity to reflect the amount paid by the new partner; otherwise, the new partner should pay less for the interest.
Other Tax Considerations
Installment sales can lower the present value of the taxes paid by the seller and can allow the buyer to use less cash while still benefiting from the full depreciation and amortization of the purchase price. However, the price allocated to tangible property subject to depreciation recapture or to any inventory that would result in gain is subject to tax in the year of the sale.
If the seller finances the purchase price, then the seller must charge at least the applicable federal rate (AFR); otherwise, the IRS may reduce the purchase price, resulting in a higher imputed interest-rate. Because AFR's are published quarterly, the applicable interest rate will depend on the term of the installment sale and the date of the sale. The short-term AFR covers terms of 3 years or less; the midterm AFR covers periods not exceeding 9 years; while long-term AFR's cover longer terms. Even though the installment sale will cover a number of years, the interest rate for any period during the term must be at least equal to the AFR at the time of the sale.
If the buyer assumes expenses accrued by the seller, then the amount of those expenses are deductible by the seller in the year of the sale, but must be added to the purchase price. The buyer adds the expenses to the basis of the business, so the liabilities may not be deducted when they are paid. So if the seller sells property for $1 million, but has a $25,000 accrued liability for real estate taxes that is assumed by the buyer, then the sale price must be reported as $1,025,000, for which the seller can deduct the $25,000 liability assumed by the buyer. The buyer's basis in the property will be $1,025,000, but the buyer will not be able to claim a $25,000 deduction when the real estate taxes are finally paid.
Most purchase agreements include a covenant not to compete, so that the seller does not poach customers of the existing business. The seller will usually want to apportion some of the cost to the customer base rather than to the covenant not to compete, because the gain associated with the customer base is treated as a capital gain, while the covenant not to compete is subject ordinary income taxes. The buyer will generally be indifferent to this apportionment, since the customer base is treated as an intangible asset, while the covenant not to compete is treated as part of goodwill, which the buyer amortizes over the same 15-year period as intangible property.
Often, a former owner is hired as an employee or as a consultant to the new buyer, to ease transition to the new business. Paying for the services of the former owner will allow the buyer to deduct it as a compensation expense.