THE TAXATION OF A BUSINESS SALE _____
Prepared by the Tax Department of GIBSON & PERKINS, PC Suite 204 100 W. Sixth Street, Media, PA 19063 610-565-1708 www.gibperk.com
Tax Issues in the Sale of a Corporate Business UNIT ONE - Introduction I.
The primary concern of both the Buyer and the Seller is generally the price.
To both parties this should mean “after tax” price.
C. The parties should also be concerned with creating a “clean” deal, i.e., with as few postclosing entanglements as possible. II.
Non-Tax Issues to be Resolved A.
Form of the Deal;
Form of the Consideration; and
The Price 1.
The determination of the Price is seldom a scientific process in the mind of the
A Buyer on the other hand tends to be more analytical in its approach.
Seller. 3. In determining the price, remember in both an Asset deal and a stock deal the price may be subject to adjustment at or close to the Closing Date (e.g., inventory on hand, accounts receivable, cash, level of liabilities assumed, etc.) 4. In determining the price, both parties should consider closely the “after tax” purchase price. a. Seller should be schooled to not look at the total number as much as the “after tax” number; also the time value of money in a deferred payment transaction should be considered, as well as the inherent risk in becoming the Buyer’s bank. b.
Buyer is of course most concerned with the basis of the assets acquired.
5. Both parties should also calculate the cost of doing the deal (attorney’s fees, acquisition audit, professional inventory, etc.), in determining the price. 6. Unfortunately, in many transactions, the price is agreed to by the parties before the professionals are involved. C.
The Form of the Deal 2
Stock Sale v. Asset Sale a.
Generally a Seller will prefer a Stock sale for two reasons.
(1) Seller receives capital gain treatment of the sale proceeds, as opposed to the “double tax” potential which results when a corporation sells assets and subsequently liquidates. (2)
Seller’s liabilities are generally assumed by the Buyer.
b. A Buyer will prefer an Asset transaction because the Buyer will receive a step-up in basis in the assets acquired equal to the purchase price, and the Buyer is more insulated from the liabilities of the Seller. 2.
Liability Aspects of Stock v. Asset Sale.
a. In an Asset Sale, it is generally assumed that the Buyer assumes none of the liabilities of the Seller, there are a number of exceptions to this rule, however. b. Liability obligations of a selling corporation may be imposed on the purchasing corporation if: (1)
There is an express or implied assumption of the liability.
The transaction amounts to a de facto merger or consolidation.
The purchasing company is merely a continuation of the selling
(4) The transfer is without adequate consideration and there has not been adequate provision for the creditors of the seller. (5) The purchasing corporation undertakes essentially the same manufacturing operation as the selling corporation (the “product-line” exception). D.
The Form of the Consideration.
1. All Cash - All cash is the preferred form of consideration from the Seller’s perspective. This will of course lessen risk and the need to prove the credit worthiness of the Buyer. 2.
Deferred Payment Notes. a.
This form of consideration makes the Seller at least in part the Buyer’s
bank. b. Will of course increase Seller’s risk and require the Buyer prove its creditworthiness. c.
The increased risk means a higher price.
d. Seller should realize a Note secured by the business assets is poor security indeed since the ability to take back a failing business will mean the assets are already dissipated and will not be consistent with plans of retirement. e. position. f.
Further, if a bank is providing financing, they will most likely take a priority Also there is a certain inherent anxiety associated with being a Note
holder. 3. Assumption of Debt. The assumption of debt of the seller will of course count as additional consideration; but may not be easy to accomplish to the satisfaction of the seller. 4. Stock of the Buyer. If the buyer is a publically traded company, the stock of the buyer may be a good alternative to cash consideration; see Unit Six for a discussion of the favored tax treatment that may be available for mergers, and consolidations, stock for asset, and stock for stock reorganizations. 5.
Employment Agreements and Rental Agreements.
Post- closing employment agreements and consulting agreements are in certain situations a good way to compensate the selling ownership group; even if the consideration is classified as ordinary income, since in the context of a C corporation the consideration will not be subject to â&#x20AC;&#x153;double taxationâ&#x20AC;?, which results from a sale of assets and subsequent liquidation. E.
1. Both the buyer and the seller will generally want a deal which limits their post closing entanglements with each other. 2. These types of entanglements could include assumption of debt, indemnification of loss resulting from pre-closing activities of the seller; payments under installments agreements and employment contracts, and contingent sales prices and earn out agreements. II.
Taxation of a Business Sale A.
Taxation of the Sale of Stock-
a. Shares, partnership, and LLC membership interests are generally capital assets, and the owner generally realizes capital gain or loss [see IRC Sec. 1221]. b. Buyer must generally accept carry over basis in the assets owned by the entity acquired. c. However, there are important exceptions to capital gain treatment, and also carry over basis treatment. 2.
Taxation of an Asset Sale 4
a. The sale of the business assets normally results in the recognition of gain or loss measured by the difference between the amount realized and the basis of the assets in the hands of the seller [see IRC Secs. 336, 337, 1001]. b. The character of the gain will depend on the type of asset sold, i.e., whether it is ordinary income property, a capital asset, or a Code Sec. 1231 asset; in the hands of the seller. (1) Ordinary income results from gain from the disposition of inventory, consideration allocated to covenant not to compete, and consulting agreements. (2) “Section 1231 property” is business property or any depreciable property used in a trade or business. (a) If a taxpayer’s gain on sale of Sec. 1231 assets exceeds its section 1231 loss, then all Sec. 1231 gains and losses are treated as capital gains or capital losses to the extent of depreciation recapture. (b) If a taxpayer’s losses on sale of Sec. 1231 assets exceed its section 1231 gains, then all Sec. 1231 gains and losses are treated as ordinary gains or ordinary losses. (c) When Sec. 1231 property is subject to depreciation recapture, the amount of the Sec. 1231 gain is an amount by which the gain exceeds the amount recaptured; the recaptured amount is taxed at ordinary income tax rates.1 (d) A taxpayer who has a net section 1231 gain for the tax year must treat the current year’s net section 1231 gain as ordinary income to the extent of recaptured net section 1231 losses realized in the five preceding tax years. (3) Capital assets are any assets other than inventory and property held primarily for the sale to customers in the ordinary course of business; notes or accounts receivable acquired in the ordinary course of business, depreciable business property, real property used in a trade or business, a copyright or similar
Gain realized from the disposition of Section 1245 (depreciable personal property used in a trade or business) property is treated as ordinary income to the extent that the adjusted basis of the property exceeds the recomputed basis of the property (cost less depreciation allowed or allowable). In regard to Section 1250 property (depreciable real property used in a trade or business), gain realized is treated as ordinary income to the extent that post 1969 depreciation allowances exceed straight line depreciation; also note that under MACRS, all depreciation on real property must be computed under the straight line method; and as result, all depreciation claimed is classified as “un-recaptured Section 1250 gain” and subject to a maximum capital gains rate of 25 percent. 1
property in the hands of the person who created it or whose basis is determined by reference to the taxpayer who created it. c. If the Seller is a C corporation, the income from the sale will be taxed at the corporate level. d. If the seller is a “pass through entity” (i.e., an S Corporation, partnership, or LLC taxed as a partnership), the income realized pursuant to the sale of assets will pass-through to the owners based on their individual ownership interest; the character of their individual shares of the gain realized will be the same as the character in the hands of the entity. e A subsequent distribution of the proceeds of the sale in liquidation of a corporation normally results in the recognition of gain or loss to a shareholder measured by the difference between the amount distributed and the basis of the shareholder’s shares; however, it should be noted that in the case of pass through entities the gain realized pursuant to the asset sale will increase the shareholder’s basis offsetting the gain realized upon liquidation. [see IRC Sec. 331 (a), 1001; see also Treas. Reg. Sec. 1.3311]. f. If a limited liability company or partnership is liquidated, no gain or loss is realized by the members or partners except to the extent the “money” received in the liquidation exceeds the member’s or partner’s adjusted basis in the partnership immediately prior to the liquidation. If a distribution of money exceeds the member’s or partner’s adjusted basis, the excess is treated as gain received as though the partner had sold or exchanged his or her partnership interest. B.
The Taxation of the Sale Proceeds. 1.
The Taxation of Income Realized Taxed to Individuals. a.
Tax on Ordinary Income
(1) Ordinary income is taxed to individual taxpayers by applying the appropriate tax rate to their taxable income. There are seven tax rates for individuals they are 10, 12, 22, 24, 32, 35 and for individuals with taxable income in excess of applicable thresholds 37%. (2) The applicable threshold amounts for 2018 are $600,001 for married filing jointly and surviving spouse filers, $500,001 for head of household filers, $500,001 for unmarried taxpayers other than head of household and surviving spouse filers, and $300,001 for married taxpayers filling separately. All threshold amounts are subject to an inflation adjustment. b.
Tax on Capital Gain.
Individuals pay income tax on the net total of all their capital
gains. (2) Short-term capital gains are taxed at a higher rate: the ordinary income tax rate. The tax rate for individuals for "long-term capital gains", which are gains on assets that have been held for over one year before being sold, is lower than the ordinary income tax rate, and in some tax brackets there is no tax due on such gains. (3) The tax rate on long-term capital gains is 20% for single filers with incomes over $425,801 ($479,001 for married couples filing jointly), 15% for single filers with incomes between $38,601 and $425,800 ($77,201 and $479,000 for married couples filing jointly), and 0% for single filers below $38,600 ($77,200 for married couples filing jointly). c.
Tax on “Net Investment Income” of Individuals.
(1) Individual taxpayers are subject to a “net investment income tax” (“NIIT”), also known as the unearned income Medicare contribution (UIMC) tax. (a) For each tax year, the tax is equal to 3.8% of the lesser of: (i) net investment income for the tax year; or (ii) the excess (if any) of: modified adjusted gross income (MAGI, defined below) for the tax year, over the “threshold amount.” (b) The “threshold amount” which is: (i) $250,000 for joint returns and surviving spouses, (ii) $125,000 for separate returns, and (iii) $200,000 for all other individuals. (c) For this purpose, “MAGI” means adjusted gross income (AGI), increased by the excess of: (i) the amount of income excluded under the foreign earned income exclusion over (ii) the amount of any deductions (taken into account in computing AGI) or exclusions with respect to the excluded income in (i) that are disallowed under Code Sec. 911(d)(6). (2) For purposes of the 3.8% net investment income tax (“NIIT”), “net investment income” (NII) is the excess, if any, of: (a)
the sum of:
(i) gross income from interest, dividends, annuities, royalties, and rents collectively, “Sec. 1411(c)(1)(A)(i) income”— unless those items are derived in the ordinary course of a trade or business to which the NIIT doesn't apply (i.e., a non-passive, nontrading activity),
(ii) other gross income derived from a trade or business to which the NIIT applies (“other passive or trading income,”) and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the NIIT doesn't apply; over (b) the allowable deductions that are properly allocable to that gross income or net gain. (3) Gain or loss from disposition of partnership or S corporation interests under the net investment income tax. (a) For purposes of the 3.8% net investment income tax, in the case of a disposition of an interest in a partnership or S corporation, gain or loss from the disposition is included in “net investment income” (NII) only to the extent of the net gain that the transferor would take into account if the partnership or S corporation had sold all its property for fair market value (“FMV”) immediately before the disposition. (b) The purpose of Code Sec. 1411(c)(4) is to allow gain attributable to non-passive activities to be excluded from the calculation of the NIIT on the disposition of an interest in a partnership or S corporation. (c) Proposed regulations, which are proposed to apply to tax years beginning after Dec. 31, 2013, but which taxpayers may apply to tax years beginning after Dec. 31, 2012, under Reg § 1.1411-1(f) provide rules for calculating how much of the recognized income tax gain or loss from a disposition of an interest in a partnership or S corporation is taken into account under the NIIT. 2.
The Taxation of Income Realized Taxed to C Corporations. a.
Taxation in General –
(1) A C Corporation is taxed on the taxable income of the corporation at a flat rate of 21%, including for personal service corporations. b.
Taxation of Capital Gain –
(1) A C Corporation must include both long term and short term capital gain in its gross income to the extent the gains exceed capital losses for the tax year. .
(2) As a result, the capital gains of a C corporation are generally taxed at ordinary income tax rates. 8
UNIT TWO – Stock Transactions I.
Sale of Stock - C Corporation. A.
In General –
1. Since the shares are capital assets, the shareholder usually recognizes a capital gain or loss [see IRC Sec. 1221]. 2. B.
Buyer must generally accept carry over basis.
However, there are important exceptions to capital gain treatment: 1. Ordinary income may result if the stock is “Section 306” stock [IRC Sec. 306(a), (c)], unless the sale completely terminates the seller’s interest in the corporation [IRC Sec. 306(b)(1)(A)]. 2. If the stock is “Section 1244” stock (meeting statutory criteria for small-businesscorporation stock), ordinary loss may be recognized [IRC Sec. 1244(a), (c)]. 3. To the extent that the consideration received is not for the transfer of shares, ordinary income may result. For example, consideration for a covenant not to compete executed in connection with the sale would not be treated as consideration for the transfer of a capital asset, and ordinary income would result [Sonnleitner v. C.I.R., 598 F.2d 464, 466 (5th Cir. [T.C.] 1979)]. C.
Code Sec. 306 Stock
1. Tax Treatment - The sale or other disposition of “Sec. 306 stock” defined at Sec. 306(c), generally results in ordinary income treatment for some or all of the proceeds. 2. Definition. Sec. 306 stock is defined in Code Sec. 306(c) as stock that is in one of the following categories: (1) Stock received as a nontaxable stock dividend, other than common issued on common. Reg §1.306-3(c). (2) Stock other than common stock received in a corporate reorganization, or divisive distribution, in which gain or loss was to any extent not recognized, if the effect of the transaction was substantially the same as the receipt of a stock dividend or if the stock was received in exchange for Sec. 306 stock. (3) Stock that has a basis in the hands of the shareholder disposing of it that is determined with reference to the basis of Sec. 306 stock. Under this rule, common stock could be characterized as Sec. 306 stock. Reg §1.306-3(e). (4) Any stock other than common received in a tax-free corporate transfer after August 31, 1982, under Code Sec. 351, if the receipt of money instead of the stock would be treated as a dividend to any extent. Code Sec. 306(c)(3). 10
Taxation of Disposition a.
General Rule â&#x20AC;&#x201C;
(1) If Sec. 306 stock is disposed of (other than by redemption), the entire amount realized for the stock is treated as ordinary income to the extent that the fair market value of the stock sold, on the date distributed, would have been a dividend if the distributing corporation had distributed cash equal to the stock's fair market value instead of the stock. (2) Any excess of the amount received over the sum of the amount treated as ordinary income plus the adjusted basis of the stock disposed of is treated as gain from the sale of a capital or noncapital asset. However, no loss is recognized. Code Sec. 306(a)(1); Reg Â§1.306-1(b). (3) The amount treated as ordinary income on the disposition is not a dividend and doesn't reduce the corporation's earnings and profits. However, in the case of individuals and other non-corporate taxpayers, the amount treated as ordinary income under Code Sec. 306(a)(1) is treated as dividend income and therefore taxed as part of net capital gains under Code Sec. 1(h)(11). (4) IRS may allow these amounts to be treated as dividends for other purposes its specifies. Code Sec. 306(a)(1)(D). Other purposes for which the ordinary income may be treated as dividends include the corporate treatment of the dividends. b.
A disposition, other than a redemption, of the shareholder's entire interest in a corporation (taking into account constructive ownership) to a person whose stock ownership is not attributable to the shareholder under the constructive ownership rules. D.
Code Sec. 1244 Stock
1. An individual may take an ordinary loss deduction for loss sustained on the sale, exchange, or worthlessness of small business stock (referred to as "Code Sec. 1244 stock"). a. The maximum amount deductible as an ordinary loss in any tax year is $50,000 ($100,000 on a joint return). b. For purposes of determining a net operating loss, any loss treated as an ordinary loss on Code Sec. 1244 stock is treated as a business loss of the taxpayer. 2. For stock to qualify as Code Sec. 1244 stock, it must be stock of a domestic corporation (including preferred stock) issued after November 6, 1978, and which meets the following requirements (Code Sec. 1244(c)): a. The stock must have been issued to an individual stockholder or his partnership in exchange for money or other property but not stock or securities (while the 11
stock may be issued to a partnership, only individuals who are partners at the time the stock is acquired may take an ordinary loss). b. The issuing corporation must be a “small business corporation”, meaning that at the time the stock is issued the aggregate amount of money and other property (taken into account at its adjusted basis) received by the corporation as a contribution to capital, and as a paid-in surplus not only for the stock in question but any previously issued stock does not exceed $1 million. Note: Qualification as a small business corporation under the S corporation rules does not automatically qualify a corporation's stock for Code Sec. 1244 purposes c. During the corporation's five most recent tax years ending before the date the stock is sold by the taxpayer, more than 50 percent of the gross receipts of the corporation was derived from sources other than royalties, rents, dividends, interest, annuities, and gains from the sales of securities (the corporation must be largely an operating company, meaning that ordinary loss treatment under Code Sec. 1244 is not available to corporations with little or no gross receipts, Reg. §1.1244(c)-1(e)(2)). 3. Code Sec.1244 ordinary loss provisions apply to both C corporations and S corporations provided the stock otherwise qualifies, however, note that increases in stock basis caused by the pass-through of income items cannot be considered in determining the Code Sec. 1244 ordinary loss. E.
Exclusion for Qualified Small Business Stock.
1. Taxpayers, other than corporations, may exclude all or in some case a percentage of the gain realized on the disposition of “qualified small business stock” held for more than five years [IRC Sec. 1202(a)]. 2. A percentage of the gain from the sale or exchange of a “qualified small business stock” is excluded from income. The exclusion is a.
50 percent if the QSBS was acquired before Feb, 18, 2009;
b. 75 percent if the QSBS was acquired after Feb, 17, 2009, and before September 28, 2010; c.
100 percent if the QSBS was acquired after Sep. 27, 2010.
3. “Qualified small business stock” is stock in a C corporation that is originally issued after August 10, 1993, if (i) the corporation is a “qualified small business”, (ii) the stock is acquired by the taxpayer at its original issue in exchange for money or property or as compensation for services provided to the corporation and (iii) the corporation meets certain “active business” and “qualified trade or business” requirements [IRC Sec. 1202(c)(1); see IRC Sec.1202(c)(2), (d)]. 4.
A “qualified small business” is:
a. A domestic C corporation that does not have at the time of the issuance of stock, assets in excess of $50,000,000 and the aggregate gross assets of the corporation after the issuance of stock (including amounts received from the issuance) do not exceed $50,000,000, and b. The corporation agrees to submit reports to the I.R.S. and shareholders required to carry out the purpose of section 1202 [IRC Sec. 1202(d)(1)]. c. “Aggregate gross assets” means the amount of cash and the aggregate adjusted bases of other property held by the corporation [IRC Sec. 1202(d)(2)(A)]. d. The basis of contributed property is determined as though the basis were equal to its fair market value at the time of contribution [IRC Sec. 1202(d)(2)(B)]. 5. The “active business requirement” is met if at least 80 percent (by value) of the assets of the corporation are in the active conduct of 1 or more qualified trades or businesses [IRC Sec. 1202(e)(1)]. Assets used in start-up activities [IRC Sec. 95(c)(1)(A)], research and experimental activities [IRC Sec. 174], and in-house research expenses [IRC Sec. 41(b)(4)] are treated as used in the active conduct of a qualified trade or business [IRC Sec. 1202(e)(2)]. 6.
A “qualified trade or business” is any trade or business other than:
a. A trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal assets of the trade or business is the reputation or skill of 1 or more of its employees. b.
A banking, insurance, financing, leasing, investing, or similar business.
A farming business, including the business of raising or harvesting trees.
d. A business involving the production or extraction of products of character with respect to which a deduction is allowable under IRC Sec. 613 or 613A. e. F.
A business of operating a hotel, motel, restaurant, or similar business.
Rollover of Capital Gain from Small Business Stock
1. A non-corporate taxpayer may elect to roll over capital gain from the sale of “qualified small business stock” held for more than six months if other qualified small business stock is purchased during the 60-day period beginning on the date of sale. 2. The replacement stock must meet the active business requirement for the sixmonth period following its purchase. 3. Except for purposes of determining whether the active business test six-month holding period is met, the holding period of the stock purchased includes the holding period of the stock sold. 13
4. Gain will only be recognized to the extent that the amount realized on the sale exceeds the cost of the replacement stock. 5. rolled over. II.
The basis of the newly purchased stock must be reduced by the amount of gain
Sale of Stock of an S Corporation A.
Seller’s Gain or Loss on a Stock
1. The amount of gain or loss will equal the shareholder’s adjusted basis in his or her stock subtracted from the total consideration received in the transaction. 2.
The stock is generally a capital asset.
3. The stock basis is equal to capital contributions plus pass through income or reduced by pass through losses and distributions. 4.
Stock basis is adjusted to immediately prior to the disposition.
5. Stock is adjusted for current year pass through items of income, loss (including suspended losses, deductions, nontaxable distributions, and other items listed in Code Sec. 1367(a)). 6. B.
The remaining stock basis is then used to determine the gain or loss.
Allocation of Pass Through Items in Year of Sale
1. The allocation of income or loss in the year of sale can be allocated between the sellers and the buyers under either (i) the per share per day method, or (ii) the specific accounting method based on actual income or loss pre and post-sale. 2. The specific accounting method requires the agreement of all the shareholders who held stock throughout the tax year. An election statement must also be filed with the corporate tax return. C.
Selling Shareholder’s Suspended Losses
1. The deductibility of pass through losses is limited by the shareholder’s stock basis. The gain on the disposition of the shareholder’s stock does not increase basis for purposes of freeing up suspended losses. As a result, the losses will expire. 2. Losses limited by the “at-risk” rules under Code Sec. 465, can be claimed by a shareholder to the extent of the gain recognized upon the disposition of the stock. 3. Suspended losses limited by the passive loss rules become deductible if the taxpayer disposes of his or her entire interest in the passive activity in a fully taxable transaction to an unrelated party. Suspended credits are not triggered by such a disposition but may be carried forward indefinitely. D.
Effect on AAA 14
1. The Accumulated Adjustments Account (“AAA”) which represents income of the corporation passed through to the shareholders but not distributed after 1982.
The AAA is not personal to the shareholders.
The purchaser of S corporation stock inherits a pro rata portion of the AAA.
Effect on S Status
1. A sale of stock in an S Corporation could result in the loss of the S election if an ineligible shareholder is a part of the purchasing group. 2.
The tax year is split between S corporation short year and C corporation short
year. 3. Following the termination of S corporation status, the shareholders are allowed to withdraw previously taxed S corporation earnings from the AAA during the post-termination transition (i.e., the period beginning on the last day of the S corporation tax year and ending on the later of one year after that date or the due date of the tax return with extensions). F.
Stock Acquisitions by S Corporations 1.
Acquisition of S Corporation Stock
a. An S corporation can acquire 100% of the stock of another S corporation without losing pass-through status with the target. b. This treatment will result if the parent elects for the wholly owned target to be treated as a “qualified Subchapter S Subsidiary” (“Qsub”). c. The subsidiary must meet all of the other qualifications of an S corporation (i.e., one class of stock, domestic corporation, etc.)
For federal income tax purposes, the QSub is treated as if it didn’t exist.
It does however maintain its separate legal status.
Acquisition of C Corporation Stock
a. An S corporation can acquire 100% of the stock of a C corporation without losing its S corporation status. b.
Unless a Qsub election is made, the target must remain a C corporation.
c. If the Qsub election is made, the target corporation is deemed to be liquidated into the parent S corporation on a tax free basis. (1)
The basis in the C corporation’s assets will not be stepped up.
(2) The Code Sec. 1374 built in gain rules apply to the target corporation’s appreciated assets.
d. It is possible to combine a Qsub election with a Code Sec. 338(h)(10) election (see below). III.
Sale of LLC Membership Interests
A. The sale of membership interests in a limited liability company taxed as a partnership will generally result in capital gain to the seller. B. There is an exception to the extent that any portion of the sale which is attributable to his or her share of the LLC’s “unrealized receivables” and “inventory items”. That portion is determined as if the LLC had sold all its property at fair market value for cash. 1. The term “unrealized receivables” includes not only unrealized accounts receivable but also certain property to the extent that gain realized upon sale or exchange of the property would be re-characterized or recaptured as ordinary income. 2. The term “inventory items” includes property that would not be treated as a capital asset or Code Sec. 1231 asset if sold by the LLC or partnership; this could include a copyright or artistic work. C. The buyer’s basis in his or her acquired interest (“outside basis”) is equal to the consideration paid for the interest (this will include the buying member’s share of liabilities assumed); the buyer is also entitled to have the LLC make an election under Code Sec. 754, which will adjust the basis of the LLC assets for the difference between the member’s outside basis, and the buying member’s proportionate share of the adjusted basis of the LLC’s assets (“inside basis”). IV.
Preserving Corporate Tax Attributes A.
1. A corporation’s use of NOL’s and built in losses after an “ownership change” is limited under Code Sec. 382. 2. The Code Sec. 382 rules do not actually reduce the amount of the NOL, but only the extent that it can be utilized post ownership change in a particular tax year. B.
1. After an “ownership change” (see below), the amount of income that a corporation may offset each year by pre-acquisition NOL carry forwards is generally limited to an amount determined by multiplying the “value of the equity of the corporation” just prior to the ownership change times the “federal long-term tax-exempt rate” in effect on the date of the change (Code Sec. 382(b)(1)). Any unused limitation may be carried forward and added to the next year's limitation. 2. In addition, NOL carry forwards are eliminated completely unless the “business continuity” requirements for reorganizations (Reg. §1.368-1(d)) are satisfied for the two-year period following the ownership change. 16
Sec. 382 Change of Ownership Rules
1. The special limitations on NOL and credit carry forwards apply only if there has been an “ownership change” by so-called 5% shareholders2 during the “testing period” (generally a three-year period). 2. Two kinds of ownership changes can trigger the income limitation: (i) a change involving a five-percent shareholder and (ii) any tax-free reorganization (other than divisive and (F) reorganizations). 3. In either case, one or more of the five-percent shareholders must have increased their percentage of ownership in the corporation by more than 50 percent over their lowest prechange ownership percentage (generally within three years of the ownership change) (Code Sec. 382). 4. The change is calculated by first determining the increase in the percentage of stock owned by each 5% shareholder over the lowest percentage of stock owned by that shareholder during the testing period. a. All increases in the percentage of stock owned by 5% shareholders are then added together and if they total more than 50 percentage points, the special limitations on carryovers and built-in losses automatically apply. b. Percentage ownership interests are determined by comparing the value of stock owned against the value of all outstanding stock. Code Sec. 382(a), Code Sec. 382(g). c. Because an increase in stock ownership is measured by reference to the lowest percentage of stock owned by a 5% shareholder at any time during the testing period, if a shareholder disposes of loss corporation stock and later in the testing period reacquires all or part of it, the increase from the subsequent acquisition is taken into account in determining whether an ownership change has occurred (even if the percentage ownership on the last day of the testing period is less than that on the first day.) 5. No ownership change in certain stock transfers. In determining whether an ownership change has taken place, do not count any stock received or acquired in the following transactions: (I) stock acquired by reason of death; (ii) stock acquired by gift or transfers in trust; (iii) stock received in satisfaction of a pecuniary bequest; (iv) property transferred between spouses or incident to divorce; (v) stock acquired by reason of divorce or separation. In each of the referenced cases the transferee is treated as having owned the stock during the period the transferor held it. Code Sec. 382(l)(3)(B).
A “five percent shareholder” is a person who owns 5% of the corporation’s stock prior to or as a result of the transaction.
Example. For three years preceding January 2, Year 1, the stock of a corporation was owned by three individuals: Allan owned 100 shares, Black 50 and Clancy 50. On January 2, Year 1, Allan sold 60 shares to Black. This was an owner shift since Black is a 5% owner but it was not an ownership change since Black owned 25% (50/200) of the stock before and 55% (110/200) of the stock after. This is a 30%, not a 50% change. On January 1, Year 2, Allan buys Clancy's 50 shares. This is an owner shift resulting in an ownership change. On the testing date Black owns 55% of the stock, an increase of 30 percentage points over his lowest percentage ownership (25%). Allan owns 45%, an increase of 25 percentage points over a low of 20% (40/200). The group of 5% owners consisting of Allan and Black have therefore increased their ownership percentages by 55% (30% plus 25%). This is so, even though the combined holdings of Allan and Black were not less than 75% at any time during the testing period.
1/1, Year 1
1/2, Year 1
1/1, Year 2
The Testing Period
1. The testing date is the date when a loss corporation must determine whether an ownership change took place. 2. A testing date is triggered immediately after any owner shift, or issuance or transfer of an option (including contracts to acquire stock and indirect transfers of an option) with respect to stock of the loss corporation that is treated as exercised under the ownership, control or income tests. Reg §1.382-2(a)(4)(i). 3. A testing period is generally the three-year period preceding a testing date. But, if there has been an ownership change within the three-year period, the testing period does not extend back beyond the date of this change. E.
How to Calculate the Limitation
1. For any tax year ending after the change date, the amount of a loss corporation's taxable income that can be offset by a pre-change loss cannot exceed the “Code Sec. 382 limitation” for that year. 2. The Code Sec. 382 limitation for any tax year is the key. It is an amount equal to the loss corporation's value immediately before the ownership change, multiplied by the federal long-term tax-exempt rate published by the IRS. 3. If the limitation for a tax year exceeds the taxable income for the year, the amount of the limitation for the next tax year is increased by the amount of the excess. The limitation is also increased by certain built-in gains. 4.
A pre-change loss includes: 18
a. for the tax year in which a change occurs, the portion of the loss corporation's NOL that is allocable (figured, except as provided in the regulations, on a daily pro rata basis without regard to recognized built-in gains or losses) to the period in such year before the change date, b. change, and c. F.
NOL carry forwards that arose in a tax year preceding the tax year of the certain recognized built-in losses and deductions.
Value of Old Loss Corporation.
The value of the old loss corporation is the value of the stock of such corporation immediately before the ownership change. G.
Long-Term Tax-Exempt Rate.
The long-term tax-exempt rate shall be the highest of the adjusted Federal long-term rates in effect for any month in the 3-calendar-month period ending with the calendar month in which the change date occurs. H.
The Continuity of Business Requirement.
1. Unless the continuity-of-business-enterprise test is met during the two-year period starting on the change date, a loss corporation's NOL carry forwards (including any recognized “built-in” losses) are disallowed completely (except to the extent of any recognized built-in gains or Code Sec. 338 gain). 2. Generally, the doctrine of business continuity requires the loss corporation (or the surviving corporation) to continue the loss corporation's historic business or use a significant portion of the loss corporation's assets in a business. This is the same test applicable to a tax-free reorganization under Code Sec. 368. I.
Determining the Limitation on Built–in Losses
1. Built-in losses are unrealized losses of the old loss corporation that exist immediately before the ownership change. a. A corporation’s overall net unrealized built-in loss (NUBIL) equals the amount by which the aggregate tax basis of the corporation’s assets exceeds their aggregate FMV. b. However, built-in losses are deemed to be zero if the overall NUBIL is not more than $10 million or 15% of the FMV of the corporation’s assets immediately before the change, whichever is less [IRC Sec. 382(h)(3)(B)(ii)]. 2. If a corporation has an overall NUBIL that exceeds the lesser of $10 million or 15% of FMV threshold, post-change built-in losses are subject to the annual Section 382 limitation if
recognized within a five-year period beginning on the change in ownership date [IRC Sec. 382(h)(1)(B)(I), (3)(B), and (7)(A)]. 3. Depreciation, amortization, and depletion deductions for assets with built-in losses are subject to similar rules (IRC Sec. 382(h)(2)(B)]. a. In effect, post-change recognized built-in losses are treated in much the same manner as pre-change NOLs. b. Recognized built-in losses (RBILs) disallowed under these rules are carried forward in a manner similar to NOLs and are subject to the annual Section 382 limitation in the carry forward year (IRC Sec.382(h)(4)]. Example - On January 1, 2008, 100% of the stock of Just Wait, Inc. (JW), a calendar year corporation is sold. The ownership change results in an annual Section 382 limitation of $200,000. JW has no NOL carryover into 2008. However, the FMV of its assets as of the beginning of 2008 is $7 million while the aggregate tax basis of those assets if $10 million. Thus, JW had a NUBIL of $3 million. Built-in losses recognized during the five-year recognition period are subject to the annual Section 382 limitation. If JW recognizes a $500,000 ordinary built-in loss during 2008, it can use only $200,000 of that loss to offset any taxable income (computed before the recognized build- in loss) earned during the year. The unused RBIL amount is carried forward in a manner similar to an NOL and is subject to the annual Section 382 limitation in the carry forward years. J.
Section 384 - Limitation on Use of Pre-Acquisition Losses to Offset Built-In Gains 1.
a. Code Sec. 384 is triggered by two types of corporate transactions: (1) an acquisition of stock control within the meaning of 80 percent of vote and value or (2) an acquisition of assets in a reorganization described in § 368(a)(1)(A), § 368(a)(1)(C), or § 368(a)(1)(D) (i.e., a carryover-basis asset acquisition). b. If one of the corporate parties to such a transaction has a “pre-acquisition loss” (i.e., a loss-carryover deduction or a net built-in loss) and the other party has built-in gains (i.e., net assets with gross appreciation in excess of aggregate basis, including, for this purpose, pre-acquisition generated income items), § 384(a) prevents the post-fusion blending of such gains and losses for the five-year post-acquisition period prescribed in § 382(h)(7). 2. Definition of Control - “Control,” for this purpose, is defined by reference to § 1563, using more-than-50-percent levels in place of the 80 percent line, but ownership of both vote and value is required for this purpose. 3.
Overlap with Code Sec. 382
On its face, § 384 applies in addition to § 382, and the applicable committee reports echo Congress's intention to apply these provisions cumulatively (presumably, § 382 will apply first, and, to the extent any losses may be currently allowable thereunder, § 384 will then take hold to further limit the use of those losses. 4.
Section 384 can be illustrated by the following example in which loss company L is wholly owned by A and profit company P is wholly owned by B. Example L purchases all of the stock of P for cash (and does not elect § 338). While § 382 does not apply here (there being no ownership change of L), § 384 does apply, and so any gains realized by P within five years cannot be used in the L-P consolidated return to shelter L's pre-acquisition losses. If L elected § 338 with respect to P, § 384 would no longer apply, but P would be fully taxed on its recognized gains (which gains could not be included in the L-P consolidated return under § 338).If P purchased all of the stock of L for cash, both §§ 382 and 384 would apply here (presumably, § 382 goes first and is followed by § 384 for any “leftovers”). V.
Code Sec. 338 Stock Acquisition Treated as an Asset Transaction. A.
The Two Code Sec. 338 Elections
There are two separate Code Sec. 338 Elections that can be made in the case of a stock acquisition (i) the regular Code Sec. 338 Election, and (ii) the Code Sec. 338(h)(10) Election. B.
The Regular Code Sec. 338 Election
1. If a parent corporation acquires by purchase 80-percent control of a second corporation (the subsidiary) within a 12-month period, the parent may irrevocably elect to have the subsidiary treated as if it had sold and purchased its own assets 2. If the election is made, the subsidiary is treated as a new corporation after the date of acquisition of 80-percent control. The hypothetical sale is deemed to have occurred on the date of acquisition of control. 3. The subsidiary's tax year as the "selling corporation" ends on that date, its carryovers and other tax attributes disappear, and, as the "purchasing corporation," it becomes a member of the affiliated group including the parent on the day following that date. a. Gain or loss will be recognized by the subsidiary as though it had sold all of its assets at fair market value in a single transaction on the acquisition date. b. Recapture items will typically be taken into account on the final return of the "selling corporation." c. The election is to be made no later than the 15th day of the 9th month, beginning after the month in which 80-percent control is acquired. 21
4. The parent is not required to liquidate the subsidiary, but, if it does, it will succeed to the basis of the subsidiary as increased by the hypothetical purchase. 5. There are detailed rules to ensure consistency of treatment for acquisitions of stock or assets by and from members of an affiliated group of corporations (Temp. Reg. §1.3384T). a. A corporate seller may treat a sale of its 80-percent-controlled subsidiary as a sale of the subsidiary's underlying assets. b. The assets receive a stepped-up basis to fair market value, and the selling consolidated group recognizes gain or loss attributable to the assets, but there is no separate tax on the seller's gain attributable to the stock. c. This treatment also applies in situations when the selling corporation owns 80 percent of the subsidiary's stock by value and voting power but does not file a consolidated return 6.
Example 1: X corporation purchases in one transaction 90 percent of Y corporation's stock for $ 90,000. X owns no other stock in Y. The deemed purchase price, before adjustment for Y 's liabilities, is $100,000, being $90,000 multiplied by 100/90. This fraction consists of a numerator that corresponds to the percentage of all of Y 's stock, since there is no non-recently purchased stock, and a denominator that corresponds to the percentage of all recently purchased stock. Example 2: The facts are the same as Example 1, except that X corporation owns the other 10 percent of Y 's stock, which it purchased ten years earlier for $ 2,000. The deemed purchase price, before adjustment for Y 's liabilities, is $ 102,000, the grossed-up basis of the recently purchased stock, plus X 's historical basis in the non-recently purchased stock. C.
The Code Sec. 338(h)(10) Election 1.
If an election is made under Code Sec. 338(h)(10):
a. The target which was a member of a consolidated group is deemed to have sold its assets (and recognizes gain or loss on the deemed sale) while a member of the selling consolidated group. b. The sale or exchange of the target stock is ignored. Code Sec. 338(h)(10); Reg. §1.338(h)(10)-1. c. The target is treated as if, immediately after the deemed sale of its assets, it had liquidated. 2. This “liquidation” may, according to the circumstances, be treated for tax purposes as a reorganization, liquidation or redemption, or as a circular flow of cash. In most cases, the transfer will be treated as a complete liquidation subject to Code Sec. 336 or Code Sec. 337, which 22
generally make the liquidation of a subsidiary tax-free to both distributor and distributee. Reg ยง1.338(h)(10)-1(d)(4). 3. If a Code Sec. 338(h)(10) election is made, the target corporation may use the installment method to report its gain on the deemed asset sale. Reg ยง1.338(h)(10)-1(d)(8). 4. The election can also be made for targets that are not members of a selling consolidated group if the stock of the target is sold by the shareholders of an S corporation target. Reg. ยง1.338(h)(10)-1(c)(1). 5. The main differences between the consequences of a regular Code Sec. 338 election and a Code Sec. 338(h)(10) election are as follows: a. A conventional Code Sec. 338 election can result in tax to both the selling shareholder (on the actual sale of stock) and to the target itself (on the deemed sale of assets). b. In a Code Sec. 338(h)(10) election, if the target was a member of a consolidated group only the gain on the assets is recognized; the selling shareholder's gain on the stock will in most cases be entitled to nonrecognition under Code Sec. 337. c. In a conventional Code Sec. 338 election, gain recognized by the target on the deemed asset sale is taken into account after the target leaves the selling group. Such gain can therefore not be offset by loss carryovers or other deductions of either the buying group or the selling group (although it can be offset by the target's own carryovers). d. In a Code Sec. 338(h)(10) election, if the target was a member of a consolidated group, the gain on the deemed asset sale is recognized while the target is still a member of the selling group, and can therefore be offset by carryovers or other deductions of the selling group. e. For these reasons, a Code Sec. 338(h)(10) election is often a more useful technique than a conventional Code Sec. 338 election.
UNIT THREE – Asset Sales I.
Sale of Assets – C Corporation.
A. The sale of a corporation’s assets normally results in the recognition of gain or loss measured by the difference between the amount realized and the basis of the assets in the hands of the corporation [see IRC Secs 336, 337, 1001]. B. Since a C Corporation must include both long term and short term capital gain in its gross income to the extent the gains exceed capital losses for the tax year; as a result the capital gains of a C corporation are generally taxed at ordinary income tax rates. C. The subsequent distribution of the proceeds of the sale in liquidation of the target corporation will normally result in the recognition of gain or loss to a shareholder measured by the difference between the amount distributed and the basis of the shareholder’s shares [see IRC Sec. 331(a), 1001; see also Treas. Reg. Sec. 1.331-1]. II.
Sale of Assets – S Corporation. A.
In General –
1. The sale of an S corporation’s assets normally results in the recognition of gain or loss measured by the difference between the amount realized and the basis of the assets in the hands of the corporation [see IRC Secs. 336, 337, 1001]. The gain and its character will pass through to the shareholders on a pro rata basis. 2. Example: Corporation X has always been an S corporation, so that it is not subject to the built-in gain rule. Its sole shareholder, Adams, has a basis for her stock of $ 100. The corporation's total assets have a basis to the corporation of $ 100 and a fair market value of $ 300. The corporation sell all of its assets for $ 300 and liquidates, distributing the $ 300 to Adams. The sale will create a taxable gain of $ 200, which will be taxable to Adams. Her stock basis will be increased to $ 300. The distribution in liquidation will result in no further taxable gain to Adams. If X had been a C corporation, it would have had a $ 200 taxable gain, without any adjustment to the stock basis of Adams. The distribution in liquidation would have resulted in a further taxable gain to Adams of $ 200 (minus the tax paid by X). B.
Built in Gain Rules-
1. The sale of assets may generate the built-in gains tax for S corporations that dispose of assets that appreciated in value during years when the corporation was a C corporation. Current IRC Sec. 1374 applies only to corporations that made S corporation elections after 1986. Former Code Sec. 1374 continues to apply to corporations that made S elections before 1987. 2. An S corporation may be liable for tax on its built-in gains if: (a) it was a C corporation prior to making its S corporation election; (b) the S corporation election was made after 1986; (c) it has a net recognized built-in gain within the recognition period; and (d) the net recognized built-in gain for the tax year does not exceed the net unrealized built-in gain minus the 24
net recognized built-in gain for prior years in the recognition period, to the extent that such gains were subject to tax. 3. Example: X Corporation converted from C to S status in 1991. At the time of its conversion, it owned Blackacre, which had a $ 200 basis to the corporation and a $ 300 value at that time. In 1992, X sold all of its assets, including Blackacre. The amount of consideration received for Blackacre was $ 400. The built-in gain of $ 100 is subject to a corporate tax, currently at 35 percent. X will, therefore, pay a tax of $ 35, and the balance of $ 65 will be taxed to the shareholders. At an assumed effective rate of 20 percent (on long-term capital gain) the shareholders will incur an additional $ 13 tax. The total tax burden attributable to the $ 100 of builtin gain will be $ 48, an effective rate of 48 percent. C.
Basis Increase â&#x20AC;&#x201C;
1. The gain recognized will also have the collateral effect of increasing the shareholders basis in their stock. 2. As a result, the subsequent distribution of the proceeds of the sale normally results in gain measured by the difference between the amount distributed and the basis of the shareholderâ&#x20AC;&#x2122;s shares which will be eliminated or reduced [see IRC Sec. 331(a), 1001; see also Treas. Reg. Sec. 1.331-1]. III.
Asset Sales by Limited Liability Companies and Partnerships
A. The sale of assets by a limited liability company taxed as a partnership or partnership will be taxed in much the same manner as the sale of assets by an S corporation. B. partnership.
Each member or partner will report their share of the income realized by the LLC or
The built-in gain rules of course do not apply to a LLC taxed as partnerships and
Allocation of Purchase Price. A.
1. Prior to the 1993 enactment of IRC Section 197, the purchaser in a taxable asset acquisition (or the corporate purchaser of stock in an IRC Section 338 allocation) was strongly motivated to allocate as little as possible of the purchase price to goodwill and going concern value. 2. That temptation is greatly diluted under current law because those assets give rise to the same deductible amortization as most kinds of purchased intangible assets. 3.
But the allocation game is not over.
4. The purchaser will still favor an allocation to certain types of assets. And the seller will often have a preference, not necessarily the same as the purchaser's. 25
Fixed Assets/ Leasehold Improvements/ Registered Vehicles
Sec. 1231 gain or loss; depreciation recapture treated as ordinary income; otherwise capital gain; loss treated as ordinary loss.
Basis equal to allocated purchase price; depreciated according the MACRS; Sec. 179 Expense Election may be available.
15 year amortization
Goodwill, Going Concern Value, Other Intangible Assets
15 year amortization
Sec. 1231 gain or loss; depreciation recapture treated as “un-recaptured Sec. 1250 gain”; otherwise capital gain; loss treated as ordinary loss.
Depreciable according to IRS depreciation on residential real estate is recovered over 39 years; residential rental property has a recovery period of 27.5 years, Land is not depreciable
15 year amortization
B. Buyer’s Allocation Bias - Thus, the purchaser will ordinarily want to allocate the purchase price in the following order of priority: 1. Items that give rise to a current deduction, such as inventory, tools and supplies, and employment and consultation agreements, and property that qualifies for the Code Sec. 179 deduction.3 2. Tangible personal property that is depreciable over a period less than 15 years, such as machinery and equipment. 3. All of the intangible assets that are included in the definition of ''Section 197 intangibles'', which are amortizable over a period of 15 years. 4. property. 5.
Any asset that is depreciable over a period in excess of 15 years, primarily real Land, which gives rise to no amortization or depreciation deduction.
expense deduction is provided to taxpayers who elect to treat the cost of qualifying property as an expense rather than a capital expenditure. The maximum Code Sec. 179 deduction is $500,000, for tax years beginning in 2010, through 2013. For tax years beginning in 2014, and thereafter, the limit is $25,000. The maximum Code Sec. 179 dollar limitation is reduced dollar for dollar by the cost of qualified property placed in service over an investment limitation. The limitation is $2,000,000, for tax years beginning in 2010 through 2013. For tax years beginning in 2014, and thereafter the investment limitation is $200,000. The definition of “qualifying Section 179 Property” is tangible Section 1245 property, depreciable under MACRS, and acquired by purchase for the active conduct of a trade or business. For tax years beginning in 2010 through 2013, certain qualified real property may also be treated as Sec. 179 property.
Sellerâ&#x20AC;&#x2122;s Allocation Bias â&#x20AC;&#x201C;
1. the seller.
The seller's allocation objectives will differ, depending on the type of entity that is
2. If it is a C corporation, it will ordinarily not be concerned with the distinction between capital gain and ordinary income, since the rate of taxation will be the same for both types of gain. 3. If, however, it has a capital loss from other sources, it will be motivated to allocate as much gain to a capital asset as will be offset by the capital loss. D.
C Corporation Shareholders â&#x20AC;&#x201C;
1. Also, if the shareholders of the selling C corporation are also employees or officers of the corporation, they may be motivated to allocate purchase price away from corporate assets, and towards covenants not to compete and employment and consultation agreements, thereby avoiding the double tax that may be incurred in a sale incident to the liquidation of the selling corporation. 2. Even more aggressive, tax practitioners should consider treating goodwill as an individually owned asset, not a corporate owned asset, which not only avoids double taxation, but also converts ordinary income into capital gain. E.
S Corporation Shareholders-
1. If the seller is an S corporation, it will want to allocate the highest possible amount to assets that give rise to capital gain, such as land, buildings, and goodwill, since the capital gain will be taxed at the shareholder level at a rate that is likely to be substantially lower than the rate applicable to ordinary income. 2. If the sellers are individuals who are selling their stock in a taxable stock deal, they will want to allocate as much as possible to the stock, giving rise to capital gain, and as little as possible to ordinary income items such as covenants not to compete and employment and consultation agreements. F.
1. The Service's first statutory weapon in contesting unreasonable allocations was IRC Section 1060, enacted in 1986 and amended in 1990. Section 1060 requires that the allocation of purchase price be made in accordance with Treasury Regulations and requires that both the purchaser and the seller notify the Service of certain allocations. 2. Although IRC Section 1060 is undoubtedly a valuable tool of the Service in monitoring allocations of purchase price, the temptation for the purchaser to distort the allocation, and the lack of incentive for the seller to negotiate otherwise remained.
3. This was particularly true with respect to attempted allocations away from goodwill and going concern value (not deductible at all under pre-1993 law), and in favor of covenants not to compete (currently deductible as paid under pre-1993 law). 4. Apparently, the audit activity required of the Service became unbearable. Accordingly, in 1993 Congress enacted IRC Section 197 which established a single tax rule applicable to purchasers with respect to virtually all kinds of intangible assets. a. The avowed hope of Congress was to simplify the tax treatment of the purchaser, eliminate much of the temptation to distort the allocation, and to cut down on the required audit activity of the Service. b. The current law, which is discussed in the succeeding subsections, is likely to have a beneficial effect in these respects, but the allocation game is not over, as will be observed in more detail in the subsequent discussion. G.
1. If the buyer and the seller agree in writing as to the allocation of any of the consideration, or as to the fair market value of any of the assets, they are bound by their agreement. 2. Thus, in those instances where the buyer and the seller have conflicting interests, it will ordinarily be advisable for the parties to negotiate an acceptable allocation and incorporate their conclusions in the written contract. 3. This might be the case, for example, where the seller will be benefited by the capital gain characterization of goodwill, but the buyer wants as little as possible to be allocated to goodwill. 4. If they do not agree in writing, it is likely that one or both of them will take an extreme position on their tax returns and the Service, in order to avoid being whipsawed, will be forced to contest both allocations. 5. Although the parties are ordinarily bound by their written agreement, the Service, understandably, is not. 6. The statute expressly sanctions the Service's disregard of the agreement if it determines that the allocation is not appropriate. H.
Allocation Under the Residual Method
1. Whenever the assets constituting a trade or business are purchased and sold in a taxable transaction, and the allocation of the purchase price is not governed by the written agreement of the parties, the allocation must be made in accordance with the so-called ''residual method'' that is set forth in Treasury Regulations.
2. Thus, if the purchase and sale contract simply sets forth an aggregate price to be paid for the acquired assets, the residual method must be used by both the purchaser and the seller to determine the amount to be allocated to each asset. 3. Also, if the allocation made by the parties in a written contract is determined by the Service to be ''inappropriate'', it is likely that the Service will employ the residual method to make a proper allocation. I.
Residual Method â&#x20AC;&#x201C; Categories â&#x20AC;&#x201C;
Under the residual method, all of the assets that are purchased and sold are divided into seven categories, in descending order of liquidity: Class I assets are cash, demand deposits and like accounts in banks, savings and loan associations and other depositary institutions. Class II assets are certificates of deposit, government securities, readily marketable stock or securities, and foreign currency. Class III assets are accounts receivable. Class IV assets are inventory. Class V assets are all assets not found in the other six classes, such as furniture, fixtures, equipment, machinery and real property. Class VI assets are intangible assets, other than goodwill and going concern value, that must be amortized under the 15-year period specified in IRC Section 197, such as workforce in place, information bases, patents, copyrights, and covenants not to compete. Class VII assets consist of goodwill and going concern value. J.
Allocation to Categories - The aggregate purchase price is first allocated to: 1.
Class I assets, dollar for dollar.
2. The remaining purchase price is then allocated among Class II assets in proportion to their fair market values, among Class III assets in proportion to their fair market values, among Class IV assets in proportion to their fair market values, among Class V assets in proportion to their fair market values, and then among Class VI assets in proportion to their fair market values. 3. Class VII.
Any amount that remains is allocated among the intangible assets that comprise
4. The net effect of this residual method is to allocate no more than the fair market value to each asset that belongs in Classes I, II, III, IV, V, and VI, and to allocate all ''excess'' value to the intangible assets that comprise Class VII.
5. This forces the seller to itemize the allocation of purchase price to assets that are likely to be immediately taxable as ordinary income. K.
How Intangibles Are Amortized Under Section 197
1. Under Section 197, virtually all intangible assets that are purchased in a taxable transaction after August 10, 1993, and used by the purchaser in a trade or business are treated identically by the purchaser; namely, the cost properly allocated to each such asset is amortized over the 15-year period beginning with the month of the purchase. (An asset that is subject to this amortization rule is referred to in the statute and in this discussion as a ''Section 197 intangible''.) 2.
The deduction is apportioned ratably over each month in the 15-year period.
3. If the cost relates to a covenant not to compete, or the payment is contingent, it is added to the amortizable basis as of the beginning of the month when the payment is actually made. 4. Example: X Corporation, the purchaser, is a calendar-year taxpayer. On July 1, 1994, X closes a transaction in which X purchases all of the business assets of Y Corporation. As a part of the transaction, Y agrees not to compete with X for five years. X agrees to pay for the covenant at the rate of $ 1,000 in each of the next 60 months, beginning on July 1. By the end of 1994, X has paid a total of $ 6,000 to Y. Its deduction for 1994 is $ 200. (A full year's deduction would be $ 6,000 divided by 15, or $ 400; this amount is pro-rated for the partial year beginning on July 1.) L.
1. Virtually all intangible assets that are acquired for use by the purchaser in a trade or business or an activity engaged in for the production of income are subject to the amortization rule of Section 197. 2. This includes, among others, goodwill, going concern value, covenants not to compete, patents, copyrights, licenses, franchises, and know how. Certain intangible assets are specifically excluded, however. 3.
Excluded assets include the following:
a. Any interest in a corporation, partnership, trust, or estate. Thus, shares of stock in a corporation, although they constitute intangible property, are not subject to the rule of Section 197. b.
Any interest in land.
Certain computer software.
d. Any interest in a patent, copyright, film, certain licenses granted by governmental agency, and various other intangible assets, unless such assets are acquired in a transaction that involves the acquisition of a trade or business or a substantial portion thereof. 30
e. A franchise to engage in any professional sport, and any item acquired in connection with such a franchise. f. Most types of intangible assets that are created by the taxpayer, or by another person on behalf of the taxpayer, are excluded. M.
Disposition of 197 Intangibles â&#x20AC;&#x201C;
1. If a Section 197 intangible is disposed of, any realized gain is recognized at that time. Similarly, if only one Section 197 intangible is acquired in a particular transaction and is later disposed of at a loss, or becomes worthless, the loss is recognized at that time. 2. An important exception relates to a covenant not to compete. A covenant not to compete can ordinarily not be written off earlier than the expiration of the full 15-year period even if it is disposed of, or becomes worthless, prior to that time. If, however, all of the trades and businesses that were acquired in the same transaction with the covenant are disposed of, or become worthless, the remaining cost basis in the covenant may be written off at that time. 3. In addition, if two or more Section 197 intangibles are acquired in the same transaction and one of them is disposed of, or becomes worthless, prior to the expiration of the 15year period, any realized loss is not recognized at that time. Instead, the remaining basis of that asset is allocated to the other Section 197 intangibles in proportion to their respective remaining bases. 4. Example: On January 1, 2001, X Corporation purchases a business that includes three Section 197 intangibles, a patent with a cost properly allocated to it in the amount of $ 1,000, a covenant not to compete at a cost of $ 2,000, and goodwill at a cost of $ 3,000. On January 1, 2003, the patent becomes worthless. At that time, the remaining bases of the three assets are $ 867 for the patent, $ 1,733 for the covenant, and $ 2,600 for the goodwill. The loss on the patent is not deductible. Instead, the $ 867 remaining basis is allocated $ 347 (867 x 1733/4,333) to the covenant, and $ 520 (867 x 2,600/4,333) to the goodwill. N.
Additional Reporting Requirement
1. Both the purchaser and the seller in a taxable asset acquisition must notify the Service of the amount of the total purchase price that is allocated to Section 197 intangibles, and of any other information with respect to the other assets as the Treasury requires through its regulations. 2. This notification must be made by both the purchaser and the seller by filing a Treasury Form 8594 with their respective income tax returns for the taxable year in which the transaction takes place. 3. Also, if a 10-percent-or-more owner of the selling corporation, or certain persons related to the owner, enter into an employment contract, covenant not to compete, royalty or lease agreement, or other agreement, with the purchaser, both the purchaser and such person must supply such information to the Service as the Service may require. 31
Goodwill as an Individual Versus Corporate Asset
1. If goodwill is treated as a corporate asset, then the sale of goodwill will result in corporate taxation at the federal and probably also the state level. 2. If, instead, the goodwill is treated as an individual asset, then the corporate tax would be entirely avoided. 3. Thus, the first tax question is whether goodwill can be treated as an individual asset rather than as a corporate asset. 4. If the IRS re-characterized the purchase of individual goodwill as the payment for a non-compete covenant, then the shareholders would recognize ordinary income, not capital gain. 5. Thus, the second tax question is whether the purchase of goodwill might be treated by the IRS as the payment for a non-compete covenant. Note: For the purchaser, the tax treatment is the same, regardless of the above questions. 6. The purchaser is entitled to 15-year amortization whether it is buying a noncompete covenant or goodwill, and whether it is buying it from the corporation or from the shareholders. 7. The first tax question, whether a business's goodwill is a corporate asset or an individual asset, is a relatively hot issue in the tax law. P.
Payment for Goodwill Versus Payment for Noncompete Covenant.
1. The second tax question is whether the purchase of goodwill from individual shareholders is likely to be re-characterized as the payment for a non-compete covenant. This is also a relatively hot issue in the tax law, although there is a long history of case law addressing the question. 2. In some cases, the taxpayer won when his tax return position was consistent with his contractual allocation. 3. Interestingly, there may be no cases in which the taxpayer won when his tax return position was inconsistent with his contractual allocation. 4. Treating goodwill as an individual asset should not increase the odds of having the purchase of goodwill re-characterized as the payment for a non-compete covenant; that is, there is a long line of cases in which the IRS and the courts addressed whether payments for corporate goodwill were really payments for individual non-compete covenants. 5. The case law concerning allocations to non-compete covenants can be summarized as follows: a. Even if a non-compete covenant has substantial economic value to the buyer, the tax issue is not trying to objectively determine the value, but to determine what value the parties intended to allocate to the covenant. 32
b. The contractual allocation is highly probative in making this factual determination of intent--especially when the parties were well aware of the tax consequences. c. When the taxpayer reports an allocation consistent with the contractual allocation, then the standard of proof in court is simply the preponderance of evidence. When taxpayers lose in court, it is usually when they take a return position inconsistent with their contractual allocations. d. Courts are inclined to defer to contractual allocations, especially when the parties have countervailing interests. Even if they do not have countervailing tax interests, countervailing nontax interests would help validate the allocations. e. Treating goodwill as an individual asset rather than as a corporate asset should not increase the odds of having the purchase of goodwill re-characterized as the payment for a non-compete covenant.
UNIT FOUR – Other Issues I.
Treatment of Costs of the Deal A.
Current Deduction vs. Capitalization
1. When a buyer acquires a business, whether in an asset purchase or purchase of an ownership interest, the direct cost of the assets acquired must be capitalized. 2.
The treatment of “indirect costs” may be: a.
Allocated to assets acquired under Code Sec. 263(a) regulations;
Capitalized as a separate intangible under Code Sec. 263(a) regulations;
Capitalized as a Code Sec. 195 start-up cost;
Capitalized as a Code Sec. 248 or 709 organizational expense;
Expenses Capitalized Under Code Sec. 263(a)
Capitalization is required for the costs to facilitate the following transactions: 1.
Acquisition of assets constituting a trade or business;
2. Acquisition of an ownership interest in a business when the taxpayer and the acquired entity are related parties; 3.
Acquisition of an ownership interest in the taxpayer;
4. Certain business entity restructuring, reorganization, capitalization, and recapitalization transactions;
Formation or organization of a disregarded entity;
Acquisition of capital;
Writing an option.
Cost to Acquire or Create Intangibles
1. Code Sec. 263(a) regulations require the capitalization of amounts paid to acquire or create intangible assets. 2. D.
Such amounts are amortized over 15 years.
Cost Capitalized Under Other Code Sections
1. Costs of investigating a new business and other pre-opening costs are generally capitalized (and then deducted or amortized) under Code Sec. 195. 2. Costs of organizing a corporation or partnership are capitalized (and then deducted or amortized) under Code Secs. 248 and 709. 34
Installment Method of Reporting. A.
1. The installment method is a special way of reporting gains (not losses) from the sales of property when at least one payment is received in a tax year after the sale.4 2. Under the installment method, gain on the sale is pro-rated and recognized over the years in which payments are received. 3. The installment method must be used unless the taxpayer elects not to use it or is prohibited from using it.
The applies to both cash and accrual taxpayers.
The installment method is generally not available for: a.
Sales which trigger depreciation recapture under IRC. 1245 or 1250;
Most sales by dealers;
Sales of inventory;
Property subject to a revolving credit plan;
Sales of publicly traded property; or
Sales of depreciable property between related parties.
1. The amount of gain from an installment sale that is taxable in a given year is calculated by multiplying the payments received in that year by the gross profit ratio for the sale. The gross profit ratio is equal to the anticipated gross profit divided by the total contract price. 2. However, gain from installment sales of depreciable property subject to recapture under Code Sec. 1245 or Code Sec. 1250 is determined under a special rule. 3. Example. On December 1, 2013, Bob Smith sells vacant land that he has held for investment purposes for a number of years. His basis in the land is $12,000. The total contract price is $15,000. Bob receives a $5,000 down payment, with the $10,000 balance due in monthly installments of $500 each, plus interest at the applicable federal rate, beginning on January 1, 2014. His anticipated gross profit from the sale is $3,000. His gross profit percentage is 20% ($3,000 gross profit/$15,000 contract price). Under the installment method, Bob must report $1,000 ($5,000 x 20%) as long-term capital gain in 2013, $1,200 ($6,000 x 20%) in 2014, and $800 ($4,000 x 20%) in 2015. The interest is reported as ordinary income. 3. Gain from an installment sale is reported on Form 6252, which must be filed with the tax return in the year of sale and in each year payments are received. The gain calculated on 4
If the note is (a) secured (directly or indirectly) by cash or cash equivalent; (b) payable on demand; or (c) readily tradable, it is considered paid in the year of sale.
Form 6252 is carried over and entered on Schedule D of the taxpayerâ&#x20AC;&#x2122;s return or Form 4797, or both, as appropriate. 4. For nondealer dispositions of property that are not subject to the depreciation recapture provisions of Code Sec. 1245 or Code Sec. 1250, the amount of income reported from an installment sale in any tax year (including the year of sale) is equal to the payments received during the year multiplied by the gross profit ratio for the sale. Payments include all amounts actually or constructively received in the tax year under the installment obligation. 5. The gross profit ratio is the gross profit on the installment sale divided by the total contract price. The gross profit is the selling price of the property minus its adjusted basis. The selling price of the property is not reduced by any existing mortgage or encumbrance, or by any selling expense, but is reduced by any imputed interest. 6. The total contract price (denominator of gross profit ratio) is the selling price minus that portion of qualifying indebtedness which the buyer assumes or takes the property subject to that does not exceed the sellerâ&#x20AC;&#x2122;s basis in the property (adjusted to reflect commissions and other selling expenses). In the case of an installment sale that is a partially nontaxable like-kind exchange, the gross profit is reduced by that portion of the gain that is not recognized, and the total contract price is reduced by that portion of the like-kind property received. C.
Character of Gain on Installment Sale
The use of the installment method does not affect the characterization of the gain realized. D.
Sec 1245 and Sec 1250 Recapture
1. In the case of installment dispositions of real or personal property to which Code Sec. 1245 or Code Sec. 1250 applies, any recapture income must be reported in the year of disposition, whether or not an installment payment is received in that year (Code Sec. 453(I)). 2. The ordinary income amount reported in the year of sale is added to the property's basis, and this adjusted basis is used in determining the remaining profit on the disposition. 3. The remaining profit amount is used to compute the gross profit percentage to be applied to each installment payment. 4. Example: On December 1, 2002, a calendar year taxpayer sells his rental building for a total contract price of $100,000, plus interest at the applicable federal rate. He receives a note due in yearly installments of $20,000, plus interest, beginning January 1, 2003. His basis in the building is $20,000. Assuming that $10,000 of the $80,000 gain is real property recapture income (the amount of depreciation recapturable under Code Sec. 1250), the entire $10,000 is included in ordinary income in 2002 (the year of sale). The $10,000 is added to his $20,000 basis for purposes of determining the gross profit on the remaining gain. Gross profit is, therefore, $70,000 ($100,000 - $30,000). Of each $20,000 payment received in the following years, $14,000 is includible in income ($20,000 x ($70,000/$100,000)).
5. If a portion of the capital gain from an installment sale of real depreciable property consists of 25-percent gain, and a portion consists of 20-/10-percent gain, the taxpayer is required to take the 25-percent gain into account before the 20-/10-percent gain, as payments are received (Reg. §1.453-12). 6. Twenty-five percent gain is unrecaptured section 1250 gain, while 20-/10-percent gain is the portion of the gain that is taxed at those lower rates. NOTE: Since an installment buyer can finance the purchase out of the income of the business, the seller might demand and receive a higher price for an installment sale. This type of sale is also to the seller's advantage if there is a large gain on property other than inventory, because recognition of the gain can be deferred over the period of installment payments. However, the seller should be aware that the installment method may not be used to report the gain if the gain would otherwise be reported for federal income tax purposes using an accrual method of accounting. E.
Special Interest Rule for Nondealers of Property
1. A special interest charge may apply to an installment obligation that arises from a non-dealer disposition of real or personal property under the installment method if the sales price is over $150,000. 2. The interest charge does not apply to non-dealer dispositions of property used in the business of farming or personal use property. 3. For this purpose, personal use property is property that is not substantially used in connection with the taxpayer’s trade or business or in an investment activity. 4. Generally, the interest charge is imposed on the tax deferred under the installment method with respect to outstanding installment obligations. However, the interest charge will not apply unless the face amount of all obligations held by the taxpayer that arose during and remain outstanding at the close of the tax year exceeds $5 million. 5. If any indebtedness is secured by a nondealer installment obligation that arises from the disposition of any real or personal property having a sales price over $150,000, the net proceeds of the secured indebtedness will be treated as a payment received on the installment obligation on the later of the date the indebtedness is secured or the date that the net proceeds are received. 6. The interest is not reported on Form 6252, but rather is entered as an addition tax on the taxpayer’s return. For individuals, it is included in the amount to be entered on the line for “other taxes” on Form 1040. For corporations, it is entered on Schedule J of Form 1120. F.
Contingent Payment Sales.
1. A contingent payment sale must be reported on the installment method unless the seller elects not to use the installment method.
a. A contingent payment sale is a sale or other disposition of property in which the total selling price is not determinable by the close of the tax year in which the sale or disposition occurs. b. It does not include transactions with respect to which the installment obligation represents, under applicable principles of tax law: a retained interest in the property which is the subject of the transaction; an interest in a joint venture or partnership; an equity interest in a corporation; or similar transaction, regardless of the existence of a stated maximum selling price or a fixed payment term. 2. In a contingent payment sale, the basis of the property sold (including selling expenses, but not those of real estate dealers) is allocated to payments received in each tax year and recovered as follows: a. For sales with a stated maximum selling price, basis is recovered according to a profit ratio based on the stated maximum selling price; b. For sales with a fixed payment period, basis is recovered ratably over the fixed period; and c For sales with neither a maximum selling price nor a fixed payment period, basis is recovered ratably over a 15-year period. 3. Alternate methods of basis recovery may be required when the normal method would substantially and inappropriately accelerate or defer the recovery of basis. III.
Related Party Rules A.
Losses Not Allowed in Transactions Between Related Parties
1. Generally, a loss from the sale of property is not recognized when the parties to the transaction are â&#x20AC;&#x153;related persons.â&#x20AC;? 2.
The persons referred to in subsection (1) are: a.
Members of a family,
b. An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual c. Two corporations which are members of the same controlled group (as defined in subsection (f) of Section 267); d.
A grantor and a fiduciary of any trust;
e. A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts; f.
A fiduciary of a trust and a beneficiary of such trust;
g. A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; h. A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust; I. A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual; j. A corporation and a partnership if the same persons own—(A) more than 50 percent in value of the outstanding stock of the corporation, and (B) more than 50 percent of the capital interest, or the profits interest, in the partnership; k. An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; l. An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or m. Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate. B.
Resale After Installment Sale to Related Parties
1. In general. If (i) any person disposes of property to a related person (hereinafter in this subsection referred to as the “first disposition”), and (ii) before the person making the first disposition receives all payments with respect to such disposition, the related person disposes of the property (hereinafter in this subsection referred to as the “second disposition”), then, for purposes of this section, the amount realized with respect to such second disposition shall be treated as received at the time of the second disposition by the person making the first disposition. 2.
2-year Cutoff for Property other than Marketable Securities.
a. In general. Except in the case of marketable securities, paragraph (1) shall apply only if the date of the second disposition is not more than 2 years after the date of the first disposition. b. Limitation on amount treated as received. The amount treated for any taxable year as received by the person making the first disposition by reason of paragraph 1 shall not exceed the excess of—(A) the lesser of—(i) the total amount realized with respect to any second disposition of the property occurring before the close of the taxable year, or (ii) the total contract price for the first disposition, over (B) the sum of—(i) the aggregate amount of payments received with respect to the first disposition before the
close of such year, plus (ii) the aggregate amount treated as received with respect to the first disposition for prior taxable years by reason of this subsection. c. Fair market value where disposition is not sale or exchange. For purposes of this rule, if the second disposition is not a sale or exchange, an amount equal to the fair market value of the property disposed of shall be substituted for the amount realized. C.
Sale of Depreciable Assets Between Related Parties
1. Capital gain treatment is denied when depreciable property is sold or exchanged between “related parties.” 2.
A related party for this purpose is a person and all entities that the person controls.
3. For this purpose, an entity is “controlled” by a taxpayer if: (i) the taxpayer owns directly or indirectly more than 50% of the value of the stock of a corporation; (ii) the taxpayer owns more than 50% of the capital or profits interest of a partnership, and (iii) certain corporations that are members of a controlled group. D.
Accruing Interest and Expenses Owed to Related Taxpayers
1. When different methods of accounting are used by the related taxpayers, accrued interest and expenses owed to a related taxpayer may not be deducted until the time the interest or expense payment is includible in the gross income of the cash basis payee. 2. “Related parties” for this purpose include certain family members, members of a controlled group of corporations, controlling shareholders and controlled corporations, and owners of pass-through entities, such as a partnership and its partners, and an S corporation and its shareholders. A “personal service corporation” and any shareholder-employee are also considered related parties for this purpose, regardless of the amount of the corporation’s stock held by the shareholder employee.
UNIT FIVE â&#x20AC;&#x201C; Liquidation of the Target Corporation I.
Liquidation of a C Corporation A.
General Tax Treatment 1.
The Distributing Corporation
a. A corporation recognizes gain or loss when it distributes property in complete liquidation as if it had sold property to the distributee for its fair market value. b. Losses between related parties are generally disallowed, but this rule does not apply to losses realized in complete liquidation. However, losses realized upon distributions of disqualified property made not pro rata may not be recognized. 2. The Shareholder - The liquidation of a C corporation will result in capital gain to the shareholder based on the difference between the fair market value of the assets distributed and the adjusted basis of the corporate stock in the hands of the shareholder. Example 1: X is a C corporation with A as its sole shareholder. A has a zero basis in his X stock and X has a $ 1,000,000 basis in its assets. X sells its assets in 2000 to P for $ 4,000,000. P pays by delivering $4,000,000 cash. X must recognize $3,000,000 of taxable gain with respect to its receipt of the cash payment. If X immediately liquidates and distributes the $4,000,000 cash, A too will be subject to tax on the amount of gain realized, which is the difference between the fair market value of the property received less Aâ&#x20AC;&#x2122;s adjusted basis in his X stock ($4,000,000 - $0 = $4,000,000). This means that in 2000 A must recognize $4,000,000 of gain with respect to the cash distributed. B.
Liquidation of a Subsidiary
1. A liquidation of a subsidiary corporation is considered a mere change of form and therefore neither the parent shareholder nor the liquidating subsidiary recognize gain or loss. 2
The basis and tax attributes of the subsidiary transfer to the parent.
In order for this to apply, the following requirements must be met:
a. of liquidation.
The subsidiary must distribute the property to its parent pursuant to a plan
b. The parent must control at least 80% of the total voting power and total value of the outstanding stock of the subsidiary on the date of the adoption of the plan of liquidation, and at all times until the liquidation is completed. c. II.
The distributions must take place in one calendar year.
Liquidation of an S Corporation
The Corporation â&#x20AC;&#x201C; The tax consequences are the same as discussed above in regard to C
The tax consequences are the same as discussed above, however, because an S corporation shareholder’s basis in his stock is increased by the gain recognized by reason of the asset sale, the gain on the liquidation is reduced or sometimes eliminated. Example 2: Same facts except assume X is an S corporation with A as its sole shareholder. X must recognize $ 3,000,000 of taxable gain with respect to its receipt of the $ 4,000,000 cash payment. This flows through to B, whose basis increases from zero to $ 3,000,000. If X immediately liquidates and distributes the $ 4,000,000 cash, B's gain from the liquidation will equal $ 1,000,000 ($ 4,000,000 $3,000,000). III.
The Liquidation of Limited Liability Companies and Partnerships
A. If a limited liability company or partnership is liquidated, no gain or loss is realized by the members or partners except to the extent the “money” received in the liquidation exceeds the member’s or partner’s adjusted basis in the partnership immediately prior to the liquidation. B. If a distribution of money exceeds the member’s or partner’s adjusted basis, the excess is treated as gain received as though the partner had sold or exchanged his or her partnership interest. C. The term “money” includes cash, and marketable securities, as well as a decrease in the member’s or partner’s share of the partnership liabilities. D. The basis of property received in liquidation of a member or partner’s interest is the basis of the member or partner’s interest reduced by any money received in the same transaction. IV.
Installments Notes A.
C Corporations –
1. Liquidating corporations (other than certain liquidating S corporations, see below) that distribute installment obligations to shareholders in exchange for their stock must currently recognize gain or loss from the distribution. 2. However, even if the liquidating corporation was accrual-based, the shareholder that receives the installment obligation may use the installment method to report the gain from the exchange under certain circumstances. 3. An installment obligation from a liquidating corporation whose stock is traded on an established securities market is not a qualifying installment obligation. 4. However, a shareholder may use the installment method if the stock of the liquidating corporation is not traded in established markets, even if the obligation arose from the sale by the liquidating corporation of securities that are traded on the open market, provided the liquidating corporation was not formed or used to get around the prohibition on using the installment method for publicly traded stock.
5. Gain on the transfer of an installment obligation to a shareholder during liquidation is not immediately taxed to the shareholder. 6. Instead, the payments received under the installment obligation are treated as payments for the stock, and any gain is included in the shareholder's income as payments are received. 7. This rule applies if: (i) stockholders exchange their stock in the corporation in a Code Sec. 331 liquidation, (ii) the corporation, during the 12-month period beginning with the adoption of the plan of liquidation, had sold some or all of its assets under the installment method, (iii) the corporation, within that 12-month period, distributes the installment notes acquired in connection with those sales to the shareholders in exchange for their stock, and (iv) the liquidation is completed within that 12-month period. 8. This rule does not apply to obligations arising from a sale of inventory, stock in trade, or assets held for sale to customers in the ordinary course of business unless those assets are sold in a bulk sale. 9. In the complete liquidation of a subsidiary in which gain or loss is not recognized by the parent or the subsidiary, the distribution of the installment obligations will not cause recognition of gain or loss. B.
S Corporation Liquidations.
1. If an installment obligation is distributed by an S corporation in a complete liquidation, and the receipt of the obligation is not treated as payment for stock under the 12-month rule stated above, then the corporation generally recognizes no gain or loss on the distribution. 2.
This is true even for accrual basis S corporations.
UNIT SIX – Tax Free Reorganizations and Boot Strap Acquisitions I.
Types of Reorganizations A.
1. A corporation recognizes no gain or loss on the exchange of property solely for the stock or securities of another corporation if the corporation is a party to a reorganization. 2. Under § 368(a)(1), reorganizations include seven (and only seven) forms of corporate adjustments: a.
Statutory mergers and consolidations (Type A);
Acquisitions by one corporation of the stock of another corporation (Type
Acquisitions by one corporation of the assets of another corporation (Type
Transfers to controlled corporations (Type D);
Recapitalizations (Type E);
Changes in the form or place of organization (Type F); and
Insolvency reorganizations (Type G).
In general, these categories, in turn, can be classified into three functional
a. Fusion, or acquisitive, reorganizations, whereby one corporate enterprise absorbs the stock or assets of another corporation (Types A, B, C, and, to some extent, D and G); b. Fission, or divisive, reorganizations, whereby a single corporate enterprise is divided into two or more separate entities through a process of corporate mitosis (Type D, taken in conjunction with the provisions of § 355; and c. Internal readjustments or reshufflings in the capital structure of a single corporate enterprise (Types E and F). B.
1. Generally, no gain or loss is recognized by the transferor on the transfer of property pursuant to the plan of reorganization. 2. However, gain is recognized on the transfer of money or other property that does not qualify for non-recognition treatment (“boot”).
3. The basis of the stock and securities received by a corporation in a reorganization is the same as the basis of the property transferred, adjusted for any gain or loss recognized on the exchange and the value of any money or other property (‘boot”) received. 4. The property acquired by the transferee corporation does not take a carryover basis, however, if it consists of stock or securities in a corporation that is a party to the reorganization. C.
Continuity of Interest
1. The continuity-of-interest doctrine has a multifaceted character, depending on the context in which it arises. 2. At the corporate level, the major focus is on the business enterprise and its continuation, under modified forms, following the corporate readjustment. 3. At the investor level, the relevant factors are the nature and extent of investors' continued participation in the corporation's control, earnings, and assets, as well as the relationship of their interests to those of other shareholders and security holders after the transaction has been consummated. 4. Thus, the nature of the consideration received in the transaction (stock, debt, or other property), the remoteness of the ownership interests from the underlying assets of the business, the proportion of old owners who continue their participation after the transaction, the length of time the investor interests continue (holding-period aspects), and the special features and problems of debt securities all form important aspects of the continuity-of-interest concept. II.
Type A Reorganization – Statutory Merger or Consolidation
A. Under § 368(a)(1)(A), a statutory (i.e., under the controlling state statute) merger or consolidation is the oldest of, and the prototype for, the various reorganization forms. B. In a merger, one corporation absorbs the corporate enterprise of another corporation, with the result that the acquiring company steps into the shoes of the disappearing corporation as to its assets and liabilities. C. Consolidations typically involve the combination of two or more corporations into a newly created entity, with the old corporations going out of existence. In both of these transactions, however, shareholders and creditors of the disappearing transferor corporations automatically become shareholders and creditors of the transferee corporations by operation of law. D. It should be noted that the transferor corporations in statutory mergers or consolidations disappear as legal entities, resulting in a technical dissolution of the acquired corporations. III.
Type B Reorganization Stock for Stock Acquisition –
The acquisition by one corporation of stock of another corporation, in exchange solely for all or a part of its own or its parent's voting stock, if the acquiring corporation has control of the other immediately 45
after the acquisition, whether or not it had control before the acquisition may be effected on a tax deferred basis. IV.
Type C Reorg – Stock for Assets
A. “Type C reorganization,” as defined by § 368(a)(1)(C), is an acquisition by one corporation (the acquiring corporation) of substantially all the properties of another corporation in exchange solely for voting stock of the acquiring corporation or its parent (in a triangular Type C reorganization) or in exchange for such voting stock and a limited amount of money or other property. B. Although there are differences in form, a Type C reorganization may have economic consequences substantially the same as those of a Type A reorganization (statutory merger or consolidation), but the statute lays down more explicit rules for the Type C reorganization—notably, the fact that the consideration must be voting stock plus, in some instances, a limited amount of money or other property. A Type C reorganization also has consequences similar to a Type B (stock-for-stock) reorganization followed by a liquidation of the acquired corporation but is slightly more flexible in allowing a limited amount of consideration to be used in addition to voting stock. C.
The salient features of § 368(a)(1)(C) are the following:
1. The acquiring corporation must acquire “substantially all” of the properties of another corporation. 2. The acquisition must be either solely for voting stock of the acquiring corporation (or its parent) or solely for such voting stock plus, if certain conditions are met, a limited amount of money or other property. 3. The acquiring corporation may transfer part or all of the acquired assets to a corporation controlled by it. 4. The transferor must liquidate under the plan, unless the Service waives this requirement (and waiver will be a rare event). 5. If a transaction meets the requirements of a Type C reorganization but is also described in § 368(a)(1)(D) (Type D reorganization), it must be treated as a Type D reorganization. V.
Boot Strap Acquisition.
A. A bootstrap acquisition, which is commonly used in family or other closely held corporate settings, consists of a shareholder selling a portion of his or her stock to a new shareholder, followed by the corporation using its own funds to redeem the remainder of the seller’s shares. B The sale-and-redemption technique is useful when the terminating shareholder wants to extract certain specific assets from the corporation as part of a sale transaction. It can also be effective if the selling shareholder is to be paid over a term of years with a corporate note funded by future business earnings.
C. This technique of combining a sale and a redemption was upheld in a 6 th circuit case, Zenz v. Quinlivan, and subsequently approved by the IRS (Rev. Rul. 55-745). D. A combined sale-redemption is eligible for capital gain treatment, provided the two transactions are pursuant to a single plan and accomplished in reasonable time proximity (U.S. v. Carey; Rev. Rul. 75-447 and 77-226). However, to the extent appreciated property is distributed from the corporation to the redeemed shareholder, gain is recognized at the corporate level [IRC SEC. 311(b)(1)].