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How To Navigate New Tax Laws When Buying a Business
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Business New Haven
11/10/2003
By: Melissa Nicefaro
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Tax considerations play a crucial role in structuring the acquisition of business interests. Such transactions may include:
o Transfer of control from one group of owners to another;
o Transfer of ownership between current owners (typically in a buy-sell arrangement);
o Transfer of ownership to a new group of owners (e.g., a joint venture arrangement or merger)
Such transactions can be structured as taxable or tax-deferred. The nature of the business entity involved (sole proprietorship, corporation, partnership or limited liability company) determines the tax approach.
In a taxable transaction, the seller seeks to maximize after-tax proceeds from the sale. This normally requires long-term capital-gain treatment. The purchaser will want to make the maximum amount of the purchase price deductible over the shortest possible period. These goals can cause a tension between the parties. In general, items that produce a deduction to the buyer normally produce the most disadvantageous tax result for the seller.
Allocation of a portion of the price to business inventory, covenants not to compete or deferred compensation generates ordinary income to the seller. Frequently an allocation of price to depreciable personal property (equipment, furniture, machinery, other tangible personal property) will produce "depreciation recapture" so that the gain is taxable as ordinary.
Gain on the sale of depreciable real estate can cause a special 25-percent capital gain rate to apply. Where the transaction involves the sale of a partnership or limited liability company interest, the value of the underlying entity assets must be established to determine whether any portion of the gain will be taxable as ordinary income or at the 25-percent depreciable real estate rate.
Items that produce ordinary income to the seller will generally provide a deduction to the buyer. However, depending upon the nature of the acquired asset, the deduction may be immediate or may be taken over time. Tangible personal property can provide a deduction, generally over five or seven years. Business inventory provides a deduction when sold in business operations, depending upon the business' inventory method. A covenant not to compete can be deducted over a 15-year period, while depreciable real estate provides a write-off over 27 or 39 years.
Good will and other intangible assets can provide both parties with some benefit. The seller can treat this income as long-term capital gain, while the buyer gets a 15-year write-off. However, the buyer would lose some benefit due to the longer write-off period. Frequently, the tax harm to the seller and tax benefit to the buyer becomes an element of negotiation in structuring the transaction. This can cause a price adjustment so that both parties settle for something less than their best position.
Corporations that have not selected 'S' corporation status (normally referred to as 'C' corporations) have special problems. If the corporation wants to sell its business assets, there is a potential double tax - both a corporate-level tax on its gain and then a shareholder-level tax on funds distributed. The seller would typically want to sell the stock of such a corporation and incur a single long-term capital gain tax. However, buyers normally do not want to purchase stock since the corporate-level tax is the purchaser's responsibility.
Business acquisitions can be structured on a tax-deferred basis. These include corporate mergers, consolidations or reorganizations that follow specific tax rules. In addition, certain joint venture arrangements can be used to avoid current tax. In most of these situations, the seller will receive an interest in the acquiring business as consideration for the transfer.
Recent tax-law changes have altered the economic calculus of business acquisitions:
o The new law reduces ordinary income rates and maximum long-term capital-gain rates. The lower capital-gain rate permits a seller to receive more after-tax funds on a taxable transaction. This creates a disincentive to structure the transaction on a "tax-deferred" basis, particularly where sales consideration will be tied into one investment. Increased sale prices can cause the savings on a tax-deferred transaction to be attractive.
o The reduction in ordinary income rates causes the corresponding deduction benefit to be reduced for a non-corporate buyer. The buyer will likely still want to get deductible treatment for payment.
o New depreciation and personal property write-off rules permit a buyer to deduct more of the purchase price allocable to tangible personal property in the year of acquisition. One can deduct up to $100,000 of such personal property cost (so long as total acquisition price of such property does not exceed $400,000). Special bonus depreciation rules allow up to 50 or 30 percent (at the election of the purchaser) of the tangible personal property cost to be deducted. This leads buyers to insist on allocating the purchase price to these types of assets (to the detriment of the seller).
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