Important Tax Considerations When Selling Your Business

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Ready to negotiate the sale of your business?  First you should sit down with your tax advisor to gain a general understanding of the major tax considerations and constraints that should be evaluated. Partnerships, LLCs, C Corps, and S Corps all have various entity-specific tax consequences that should be evaluated before making any decisions.

The decision analysis process, however, is now more complicated because the top long-term capital gain rate was raised to 20% versus 15%, and there is an additional 3.8% Medicare tax applicable to certain passive investors. In the case of LLC sale transactions, your choices are limited and the transaction will generally be accounted for tax reporting purposes as an asset sale. In the case of a corporation, depending on whether the entity is an S Corporation or you are selling one of the subsidiaries within a consolidated group, it can qualify as a deemed asset sale under Sec 338(h)(10).  If the entity is a C Corporation owned 80% by an affiliated group, it can also qualify for deemed asset sale provisions under Sec 338(g) election provisions.

Note: Please be aware that the tax return mechanics and reporting provisions under Sec 338(h) (10) versus Sec 338(g) are very different and need to be fully reviewed and analyzed before reaching any conclusion. Also, this blog does not discuss an election available under Sec 336(e) that might be more advantageous, for example, where an 80% or greater owned target subsidiary (i.e., must be a domestic entity) being acquired has high basis assets or has large unused net operating losses. (An article regarding the tax benefits of a Sec 336(e) election, including a general discussion on the recently passed final regulations which have relaxed certain provisions, will be forthcoming.)

Some of the factors that should be considered when the weighing pros and cons of various taxing regimes are as follows:

Issues Unique to an LLC Taxed as a Partnership

  • The potential importance of EIN retention. For example, the wrong sequence of formation steps to convert an entity from LLC to C Corporation status under state law can eliminate the taxpayer’s ability to retain its old EIN.
  • Hot asset reporting provisions which are subject to ordinary income tax regime generally applicable under the following circumstances:
    • Cash basis taxpayer (i.e., the cumulative cash basis deferral is taxed at ordinary tax rates)
    • Gain realized from the sale of substantially appreciated inventory items (i.e., FMV exceed tax basis by 120%)
    • Depreciation and amortization recapture to the extent of taxable gain applicable to depreciable tangible personal property and amortizable intangible assets (i.e., previously acquired intangibles being amortized under IRC Sec 197)
    • Understanding how the assumption of liabilities by the purchaser will affect the taxability of the overall consideration and who is entitled to taking a deduction for the payment of contingent liabilities.
    • If applicable, the taxability of negative tax basis due to previously deducted losses and cash distributions to bring the capital account balance back to zero
    • All long term capital gains (LTCG) realized from the sales transaction by passive members will be subject to the newly enacted 3.8% Medicare tax under Sec 1411, which is generally applicable to any taxpayer with modified adjusted gross income in excess of $250,000.

Issues Unique to S Corporations

  • Consider whether all shareholders have a long-term holding period position that qualifies for LTCG tax rate.
  • All long term capital gains (LTCG) realized from the sales transaction by passive members will be subject to the newly enacted 3.8% Medicare tax under Sec 1411, which is generally applicable to any taxpayer with modified adjusted gross income in excess of $250,000.
  • Was the company always an S Corporation or do you have net unrealized built-in gains double tax exposure under IRC Sec 1374 that you need to realize upon sale?
  • Do you have significant tax basis deferral subject to ordinary taxing regime stemming from accounting methods (i.e., cash basis, long-term contract method, installment sale reporting, etc.) and excess tax depreciation and amortization over book basis?
  • Understanding how the assumption of contingent liability will affect the overall taxability of your consideration
  • Is the application of a one-day note planning concept to isolate tax to your resident home state appropriate in your particular situation and respected by the state taxing authorities?
  • How much is the additional tax that you would be required to pay if you agree to a Sec 338(h)(10) election?  Depending on your company’s tax basis composition and tax attributes, including accounting methodology, you can generally negotiate an additional 1-3% plus tax gross-up on top of the already agreed upon total consideration for making the joint election requiring your legal consent.

Issues Unique to C Corporation

  • Does your stock investment qualify for partial gain exclusion provisions under IRC Sec 1202 (qualified small business stock) or Sec 1397C (Enterprise zone business)?
  • The gain realized on the sale of stock is subject to the newly enacted 3.8% Medicare tax under Sec 1411 that is generally applicable to any taxpayer with modified adjusted gross income in excess of $250,000.
  • Have you inventoried all the company’s tax attributes (e.g., NOLs and general business carried forward) and confirmed whether or not there is a limitation under Sec 382 provisions because of previous ownership changes?
  • If contract novation and EIN retention for contract performance history is not an important business issue on the table, it might be advantageous to explore an asset sale transaction. This strategy may be particularly appropriate for an equity-backed company with substantial NOLs and/or general business tax credits carried over that are not limited under Sec 382 limitation, or a company with high tax basis assets from previous acquisitions. Under these described scenarios you can negotiate a premium because of the tax benefit associated with an asset sale.
  • Negotiate the tax refund from NOL carried back years as part of the overall consideration. Quite often, because of the acceleration provisions with respect to unexercised stock options and deferred compensation arrangements, NOLs are generally created in the year of sale and can be carried back two years.
  • Be aware of unforgiving Sec 280G provisions that affect the deductibility of accelerated unvested stock options, deferred compensation and other employee benefits.  These provisions impose a 20% excised penalty under Sec 4999 to the recipient employee. Also, discuss with your tax advisors the safe harbor exception provisions available to you.
  • Be aware that only certain transactional expenses are generally deductible, such as: pre-LOI due diligence and a portion of the investment banking fees. As a rule of thumb for negotiation analysis purposes, use 70% of the investment banking fees as a deduction, which is the safe harbor deductible amount under recently passed IRS administrative rulings. Note: to take advantage of the aforementioned 70% deduction, the corporation will need to make certain elections in its corporate tax filings for the year of the transaction.  Please consult your tax advisor.

Other Tax Considerations Applicable to All

  • Familiarity with the installment sale reporting mechanic provisions, including maximum price consideration requirements imposed by IRS regulations
  • Being aware of unfavorable tax provisions under Sec 453A that impose interest payment due to the IRS with respect to installment sales obligations with unpaid principal balance at any given year-end in excess of $5M per shareholder
  • Related party sale provisions that could prevent LTCG tax treatment, depreciation and amortization eligibility, and installment sale basis reporting

Understanding the major tax provisions and hidden tax traps applicable to your particular situation is a critical first step in an effective negotiation process.  If you are interested in a pre-sale analysis and review of your specific tax situation, please contact your Aronson LLC tax advisor or Tax Director, Jorge L. Rodriguez, CPA at 301.222.8220.

About Jorge Rodriguez

Jorge Rodriguez has written 11 post in this blog.

Jorge L. Rodriguez serves as a director with Aronson's Tax Services Group. He has over 25 years of professional experience in providing federal and state tax compliance and advisory services in the Washington Metropolitan area. Jorge specializes in Subchapter C, S and K, including mergers and acquisition compliance reporting and transaction costs deductibility analysis maximization; formation and entity classification planning and conversion; accounting methods and periods elections and changes; Sec 382 analysis and study; ASC 740 planning and documentation compliance; all aspects of multi state tax and nexus determination issues; and U.S. inbound tax compliance-related services pertaining to domestic entities with foreign ownership and/or foreign entities engaged in effectively connected U.S. trade or business.

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