Tax-Free and Taxable Transactions

A business sale and purchase transaction may be tax free or taxable.

Business transfer transactions may be tax free (principally as “reorganizations” under IRC §368) or taxable. See separate tab ‘Tax Free Reorganizations” for more in depth information and discussion.

Tax-free reorganizations

Generally, in a tax-free reorganization, the acquiring corporation’s stock is the principal consideration to be received. The selling corporation and its shareholders have no taxable gain as a result of the transaction, but the shareholders’ stock tax basis carries over to the new stock received as consideration. IRC §§354, 358. This tax-free treatment for shareholders is limited to the extent that they receive stock in exchange for stock and to the extent that the principal amount of indebtedness and securities received does not exceed the principal amount of the indebtedness and securities exchanged. IRC §354.

In a tax-free reorganization, the acquiring corporation inherits the selling corporation’s tax basis in its assets. IRC §362. That historic tax basis must be used by the buyer for depreciation, amortization, and resale purposes. Because all or a substantial portion of the consideration in a tax-free reorganization must consist of the buyer’s stock, the buyer must be prepared to accept the resulting equity dilution. Technically, a tax-free transaction is not tax free, but rather tax deferred, although the potential gain may never be taxed (e.g., charitable gifts may be made or a step-up in basis may occur at the shareholder’s later death).

If consideration includes cash or other assets (“boot”).

If the purchase price consideration of stock is combined with cash or other assets, or “boot,” the tax-free nature of the entire consideration (including the stock) must be tested, and, if it appears that the seller’s receipt of stock remains tax free, the selling party or parties must determine whether the boot is taxable as capital gain or as a dividend (normally taxed as ordinary income).

Taxable transactions

In a taxable transaction, the selling party or parties receiving consideration from the buyer will be taxed to the extent that the consideration received exceeds the tax basis of the assets, the stock transferred, or both. IRC §1001. If the transaction is a sale of assets, a double tax—one at the corporate level and one at the shareholder level (when the proceeds are distributed by the selling corporation)—may result.

Buyer’s basis

The buyer’s basis in a taxable transaction equals the purchase price (usually “stepped-up”) in the assets or stock purchased (IRC §§1011–1012). The buyer, of course, must be concerned with the availability of cash or other assets needed to fund the transaction. As is often the case, if the purchase price exceeds the tax basis in the seller’s assets or stock, the following tax consequences generally occur:

In a tax-free transaction, the seller benefits from tax-free treatment, and the buyer suffers detriment from the basis carried over.

In a taxable transaction, the seller suffers detriment from tax recognition, and the buyer benefits from the “stepped-up” basis.
Other important factors. Other factors will affect tax planning and the choice of structure for the transaction, such as the selling corporation’s net operating losses  and its earnings and profits status, the buyer’s ability to expense the selling corporation’s assets , the limitation on the deductibility of interest , the use of capital losses by the selling interests, and whether a shareholder of the selling corporation is itself a corporation to which deductions under IRC §243 may be available for dividends received.

If transaction involves a disregarded entity

When either corporate party owns a disregarded entity (one not treated as an entity separate from its owner), such as a single-member limited liability company or a qualified subchapter S subsidiary, and that entity is to be involved in the transaction, should review Treas Reg §1.368–2. See also IRS Letter Ruling 200236005; Immerman & Ashraf, Tax-Free Corporate Mergers Have Been Redefined for the LLC Era, 30 Corp Tax 8 (2003).

Evaluating Income Tax Consequences of Sale

[1] Identifying Basic Income Tax Issues

The two income tax issues for the seller arising under federal and California law from the sale of a business are (1) the amount of gain or loss realized and recognized [see [2], below], and (2) the character of the gain or loss as ordinary or capital income [see [3], below].

In the case of an asset acquisition, the sale of a business is not considered the sale of a single unit or interest. Instead, it is treated as the sale of the separate assets that, taken together, constitute the business [Williams v. McGowan (2d Cir. 1945) 152 F.2d 570, 572]. Therefore, the purchase price must be allocated to the separate assets being sold [Rev. Rul. 55-79, 1955-1 C.B. 370].

[2] Determining Amount of Gain or Loss

For purposes of federal and state income taxation, the amount of gain or loss recognized by a seller on the sale of any property is the difference between the amount realized from the purchase price (including the fair market value of any note received, or any mortgages or deeds of trust the buyer assumed) that is allocated to the asset, and the seller’s adjusted income tax basis for the asset [I.R.C. §§ 1001(a), (b) (computation of gain or loss), 1011 (determination of adjusted basis); Rev. & Tax. Code §§ 18031 (gain or loss determined in accordance with federal law), 24901(b) (amount realized includes fair market value of other property received)]. Often sellers prefer stock sales to asset sales and the seller can achieve capital gain treatment. Buyers tend to pursue assets sales as discussed below. On occasion a buyer may prefer a stock sale where the target corporation, for example, holds a favorable contractual, lease or property right that cannot be transferred or negotiated. In such cases, a stock sale may be the only alternative for a buyer to keep the contract.

[3] Determining Character of Gain or Loss

Determining the character of gain or loss on the sale of a business should reflect the tax interests of the buyer and seller, even though those interests may conflict under certain circumstances. For example, the characterization of gain from the sale of a business as capital rather than ordinary is advantageous for high-income noncorporate taxpayers. For these taxpayers capital gains are taxed at lower rates than those applicable to ordinary income [compare I.R.C. § 1(j)(2)(A)–(E), (i)(2), (3) with I.R.C. § 1(h)]. No similar advantage, however, is available to corporate taxpayers selling a business. For corporate taxpayers, the tax rate for capital gains is the same as those for ordinary income [compare I.R.C. § 11(b) with I.R.C. § 1201]. That said, for federal income tax purposes, corporations are subject to a flat tax of 21 percent [I.R.C. § 11(b)]. Thus, this rate is nearly the same as the individual capital gain rate. Some advantage may be available to the corporate taxpayer if it has capital losses than may be offset only against capital gain [I.R.C. § 1211(a)].

To characterize gain from the sale of a business as capital gain, a seller would allocate as much of the purchase price as possible to goodwill or other intangibles such as trademarks or trade names, going concern value, or covenants not to compete, which are usually treated as capital assets [see I.R.C. § 1221; but see I.R.C. §§ 197(f)(7), 1221(a)(2) (goodwill and other intangibles eligible for amortization are depreciable business assets and not capital assets)].

A buyer, however, is likely to want to allocate the bulk of the purchase price to inventory or depreciable fixtures machinery, or equipment. This allocation provides higher immediate deductions (and more immediate capital cost recovery) either because of an increased cost of goods sold [see Treas. Reg. § 1.61-3(a)] or increased depreciation deductions [I.R.C. §§ 167, 168]. This type of allocation, however, increases the ordinary income to the seller [see I.R.C. § 1221(a)(1), (2) (stock in trade, inventory and depreciable business property are not capital assets)], and thus a natural friction between the buyer and seller. Even though a buyer who acquires goodwill in a business may be eligible to amortize the cost, the 15 year amortization period makes the amortization deduction less attractive than depreciation or cost of goods sold deductions [compare I.R.C. § 197 with I.R.C. §§ 167, 168].

[4] Allocating Purchase Price to Each Asset
[a] Burden on Parties to Purchase and Sale

Ordinarily, the parties in a purchase and sale have the burden of establishing the amount of the purchase price allocated to each of the assets being sold, including intangible assets such as goodwill. The amount that they allocate to each asset should bear a reasonable relation to the asset’s fair market value.

[b] Applicable Asset Acquisition

A special method of allocating value among various assets in the sale of a business must be used if there is an applicable asset acquisition [I.R.C. § 1060]. An “applicable asset acquisition” is any direct or indirect transfer of assets in which (1) the assets constitute a trade or business, and (2) the buyer’s basis in the assets is determined wholly by reference to the consideration paid for the assets [I.R.C. § 1060(c); see Rev. & Tax. Code § 18031 (federal income tax law applies in California with respect to the gain or loss on disposition of property—IRC §§ 1001–1092, unless otherwise provided]. A group of assets constitutes a trade or business if use of the assets would constitute an active business for purposes of I.R.C. § 355 (regarding distribution of stock of a controlled corporation)], or if goodwill or going concern value could attach to those assets [Treas. Reg. § 1.1060-1(b)(2)(i)]. A transaction that is part purchase of assets and part like-kind exchange [see I.R.C. § 1031; see also Ch. 24, Exchanges of Real Property] is also subject to these restrictions [I.R.C. § 1060(c)].

[c] Treatment of Applicable Asset Acquisition

In the case of an applicable asset acquisition, for purposes of determining the buyer’s basis in the assets and the seller’s gain or loss, the consideration received for the assets must be allocated among the assets in accordance with I.R.C. § 338(b)(5) (relating to stock purchases treated as asset acquisitions) [I.R.C. § 1060(a)]. Under I.R.C. § 338(b)(5), allocation is made by the “residual allocation method,” generally in accordance with regulations under I.R.C. § 338. The seller substitutes “consideration” for ADSP (aggregate deemed sale price) in making the allocation under the regulations, and the buyer substitutes “consideration” for AGUB (adjusted grossed-up basis) [Treas. Reg. §§ 1.338-6, 1.338-7, Treas. Reg. § 1.1060-1(c)].

Allocation—both to each of seven classes of assets, and among the assets within each class—is done according to the gross fair market value of the assets [Treas. Reg. § 1.338-6(a)(2), Treas. Reg. § 1.1060-1(c)(2) ]. To make the allocation, assets are first divided into the following seven classes [Treas. Reg. § 1.338-6(a)(2), Treas. Reg. § 1.1060-1(c)(2)]:

•Class I Assets. Cash and general deposit accounts, including savings and checking accounts [Treas. Reg. § 1.338-6(b)(1), Treas. Reg. § 1.1060-1(c)].
•Class II Assets. Actively traded personal property [see I.R.C. § 1092(d)(1); Treas. Reg. § 1.1092(d)-1, but without regard to I.R.C. § 1092(d)(3)] and certificates of deposit and foreign currency, even if they are not actively traded personal property. Assets in Class II include US government securities and publicly traded stock. Class II assets do not include stock of target affiliates, whether or not of a class that is actively traded, other than actively traded stock described in I.R.C. § 1504(a)(4) (certain preferred stock). This restriction excludes target affiliate stock from Class II when the target holds and 80 percent or greater interest in the target affiliate but a minority interest in target affiliate stock of the same class is actively traded [Treas. Reg. § 1.338-6(b)(2)(ii), Treas. Reg. § 1.1060-1(c)].
•Class III Assets. Assets that the taxpayer marks to market at least annually for federal income tax purposes and debt instruments. These assets include accounts receivable, mortgages, and credit card receivables from customers that arise in the ordinary course of business [Treas. Reg. §§ 1.338-6(b)(2)(iii), Treas. Reg. § 1.1060-1(c)]. Class III assets do not include debt instruments issued by persons related to the target at the beginning of the day following the acquisition date, certain contingent debt instruments [see Treas. Reg. §§ 1.1275-4, 1.483-4; I.R.C. § 988], but not those subject to the non-contingent bond method [see Treas. Reg. §§ 1.1275-4(b), 1.483-4 ] or which involve single nonfunctional currencies [see Treas. Reg. § 1.988-2(b)(2)(I)(B)(2)]), or debt instruments convertible into the stock of the issuer of other property [Treas. Reg. § 1.338-6(b)(2)(iii), Treas. Reg. § 1.1060-1(c)].
•Class IV Assets. Stock in trade of the taxpayer or other property of a kind that would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business [Treas. Reg. § 1.338-6(b)(2)(iv), 1.1060-1(c)].
•Class V Assets. All assets that do not fall in any of the other six classes [Treas. Reg. §§ 1.338-6(b)(2)(v), Treas. Reg. § 1.1060-1(c)].
•Class VI Assets. All Section 197 intangibles [see I.R.C. § 197] except goodwill and going concern value [Treas. Reg. § 1.338-6(b)(2)(vi), Treas. Reg. § 1.1060-1(c)].
•Class VII Assets. Goodwill and going concern value (whether or not the goodwill or going concern value qualifies as a Section 197 intangible) [Treas. Reg. § 1.338-6(b)(2)(vii), Treas. Reg. § 1.1060-1(c)].

The consideration is first reduced by the amount of the Class I assets. Any amount remaining after the reduction is then allocated to the remaining assets [Treas. Reg. § 1.338-6(b)(1), (2), Treas. Reg. § 1.1060-1(c)]. The remaining consideration is allocated to Class II assets in proportion to the fair market value of each Class II asset, then among Class III assets in proportion to the fair market value of each Class III asset, then among Class IV assets in proportion to the fair market value of each Class IV asset, then among Class V assets in proportion to the fair market value of each Class V asset, then among Class VI assets in proportion to the fair market value of each Class VI asset, and finally to Class VII assets [Treas. Reg. § 1.338-6(b)(2)(i), Treas. Reg. § 1.1060-1(c)].

In making the above allocations, the seller and purchaser must each adjust the amount allocated to an individual asset to take into account specific identifiable costs incurred in transferring that asset in connection with the applicable asset acquisition (such as real estate transfer costs or security interest perfection costs). Those costs increase (or decrease, as appropriate) the total consideration that is allocated under the residual method. No adjustment is made to amounts allocated to an individual asset for general costs associated with the overall asset acquisition or with groups of assets (such as non-specific appraisal fees or accounting fees). These costs are taken into account only indirectly through their effect on the total consideration to be allocated [Treas. Reg. § 1.1060-1(c)(3); see Treas. Reg. § 1.1060-1(c)(3)].

The allocation of consideration is based on the gross fair market value of the assets [Treas. Reg. § 1.338-6(a)(2), Treas. Reg. § 1.1060-1(c)(2)]. To substantiate proper valuation, and to reduce the chance of a successful challenge by the IRS upon a later audit, an independent, expert appraisal of the assets should be obtained near the time of the transaction. An appraisal is especially important when the parties do not have a binding allocation agreement.

Both the buyer and the seller must file IRS Form 8594, Asset Acquisition Statement, with the IRS with the following information about the asset acquisition [I.R.C. § 1060(b)]:

•The amount of consideration to be allocated to I.R.C. § 197 intangibles.
•Any modification of the amount to be allocated to I.R.C. § 197 intangibles.
•Any other information about any other assets transferred that the IRS deems necessary. Regulations require information concerning the amount of consideration in the transaction and its allocation among all assets transferred, and information concerning subsequent adjustments to consideration [Treas. Reg. § 1.1060-1(e)(1)(i)].

Form 8594 must be filed with income tax returns for the taxable year that included the first date assets are sold pursuant to the applicable asset acquisition [Treas. Reg. § 1.1060-1(e)(1)(ii)(A), effective for asset acquisitions occurring on or after March 15, 2001]. When an increase or decrease in consideration is taken into account in a later taxable year, the seller and the purchaser each must file a supplemental asset acquisition statement on Form 8594 with the income tax return for the taxable year in which the increase or decrease is properly taken into account [Treas. Reg. § 1.1060-1(e)(1)(ii)(B)]. An information return must also be filed in certain entity transfers, as discussed in [5], below.

[d] Allocation Inconsistent With Allocation in Parties’ Written Agreement

Any agreement between the parties as to the allocation of any amount of consideration to, or as to the fair market value of, any of the assets generally is binding on them [I.R.C. § 1060(a)], unless they would be permitted under existing legal authority [see Commr. v. Danielson (3d Cir.) 378 F.2d 771, cert. denied, (1967) 389 U.S. 858 (the “Danielson Rule”)] to refute the valuation or allocation, as because of mistake, undue influence, fraud, duress, or similar reason. However, the Tax Court has rejected the Danielson Rule in cases appealable to the Ninth Circuit [see Grossman v. Commissioner, T.C. Memo 1988-278 (“petitioners are permitted to submit additional evidence as to the contracting parties’ true intent when entering the contract. However, in order to overcome the written language of the contract, petitioners must show ‘strong proof’ that the terms of the written instrument do not reflect the actual intentions of the parties to the contract” citing G C Services Corp. v. Commissioner, T.C. 406, 412 (1979))]. The IRS, however, may challenge any valuations or allocations if it determines them to be inappropriate [I.R.C. § 1060(a); Treas. Reg. § 1.1060-1(c)(4)].

[5] Reporting Requirements for Additional Information

When a seller who is a 10-percent owner with respect to any business transfers an interest in that business and the seller (or a related person) enters into an employment contract, a covenant not to compete, a royalty or lease agreement, or other agreement with the buyer in connection with the transfer, the seller and the buyer must furnish any required information to the IRS [I.R.C. § 1060(e)(1); see I.R.C. § 1060(e)(3) (“related person” defined); see also I.R.C. §§ 267(b), 707(b)(1)]. A “10-percent owner” is any person who holds 10 or more percent, by value, of the interests in the business immediately before the transfer [I.R.C. § 1060(e)(2)(A); see I.R.C. § 1060(e)(2)(B) (constructive ownership rules); see also I.R.C. § 318]. This reporting requirement applies regardless of whether or not the transaction is an applicable asset acquisition that must be reported under I.R.C. § 1060 [see [4][c], [d], above], and, in the case of a stock purchase, whether or not an election is made under I.R.C. § 338 to treat the stock purchase as an asset purchase [House Conf. Rep., Pub. L. No. 101-508, § 11323].