Purchasing a New Business

Ten Forty + Quality Tax Preparation & Financial Services 281-397-7777 Fax 281-397-7443 Tax Tip How to handle purchasing a new business If you buy a business that the owner operated as a sole proprietorship or a single­member LLC treated as a sole proprietorship for tax purposes, your purchase transaction is automatically an asset purchase for tax purposes. The reason you have an asset purchase is that tax law considers the proprietorship to directly own all the business assets. You are buying the assets directly from the owner. You can also arrange an asset purchase deal for a business that has been operated as a corporation, a partnership, or a multi­member LLC treated as a partnership for tax purposes. In this scenario, the seller would generally prefer to sell his or her ownership interest rather than the assets, for two reasons: 1. Selling an ownership interest generally divorces the seller from any ongoing exposure to business­related liabilities. 2. The taxable gain from selling an ownership interest that has been held for more than one year is generally treated as a lower­taxed long­term capital gain. In contrast, you as the buyer will usually prefer to purchase the business assets rather than an ownership interest, for two reasons: 1. An asset purchase generally allows you to avoid exposure to unknown or undisclosed business liabilities. 2. The tax basis of the assets can be stepped up (increased) to reflect the purchase price that you pay for the business. The step­up gives you bigger depreciation and amortization deductions for buildings, furniture, equipment, and intangibles and reduces taxable gains when assets like inventories or receivables are sold or converted into cash. Background: Asset Purchase Tax Results In an asset purchase, you allocate the total purchase price to the specific assets that you acquire. The amount you allocate to each purchased asset becomes the tax basis of that asset. The price you allocate to depreciable and amortizable assets (such as furniture, fixtures, equipment, buildings, software, and intangibles such as customer lists and goodwill) becomes the tax basis that determines your post­purchase depreciation and amortization deductions for those assets. When you eventually sell a purchased asset or convert it into cash, you will have a taxable gain if the amount you receive for the asset exceeds its tax basis (the allocated purchase price plus any post­purchase improvements minus any depreciation or amortization deductions). If you operate the purchased business as a sole proprietorship, or as a single­member LLC treated as a sole proprietorship for tax purposes, or as a partnership or multi­member LLC treated as a partnership for tax purposes, or as an S corporation, the gains and losses will be passed through to you and reported on your personal federal income tax return. For depreciable real estate held for over one year after the purchase, gains attributable to prior depreciation deductions are taxed at a maximum individual federal rate of 25 percent on your personal return. For other depreciable or amortizable assets (such as furniture, equipment, purchased software, and purchased intangibles), gains attributable to post ­purchase depreciation or amortization deductions are taxed at higher ordinary income rates. (The current maximum federal ordinary income rate for individuals is 39.6 percent.) Any remaining gains from real estate, depreciable or amortizable assets, and most other business assets held for more than one year are generally treated as lower taxed long ­term capital gains. (The current maximum individual federal rate for long­term gains is 20 percent.) Gains from selling receivables and inventory are taxed at higher ordinary income rates, as are other assets held for one year or less. If you operate the purchased business as a C corporation, the corporation pays the tax bills from post purchase operations and asset sales. All types of gains recognized by a C corporation are taxed at the same federal income tax rates, which range from 15 percent to 39 percent (subject to a maximum average rate of 35 percent). However, gains recognized by a personal service corporation are taxed at a flat 35 percent rate. There is a taxable loss if the amount received for the asset is less than its tax basis. Losses from the sale of business assets generally are fully deducted in the year of the sale. How to Make Tax ­Smart Purchase Price Allocations With an asset purchase deal, the most important tax ­saving opportunity revolves around how you allocate the total purchase price to specific assets. To the extent possible, you want to allocate more of the price to: assets that generate deductions against ordinary income (such as inventory and receivables), assets that can be depreciated relatively quickly (such as furniture and equipment), and intangible assets (such as software, customer lists, and goodwill) that can be amortized over 15 years. You want to allocate less to assets that are depreciated over long periods (such as buildings), and land (which cannot be depreciated at all). Follow the Required Residual Allocation Method Under the federal income tax rules, you must use the so ­called residual method to allocate the total purchase price to the specific assets that you’ve acquired. Step 1. Allocate the price first—dollar for dollar—to any cash and CDs included in the deal and to the fair market value of any government securities, other marketable securities, and foreign currency holdings. These kinds of assets are not usually included in asset purchase deals, so you may be able to skip this step. Step 2. Allocate the price remaining after Step 1 to general business assets included in the deal (receivables, inventory, furniture and fixtures, equipment, buildings, land, and so forth). Allocations in this step are made in proportion to each asset’s fair market value but cannot exceed fair market value. Step 3. Allocate the price remaining after Step 2 to intangible assets other than goodwill. Such intangibles can include covenants not to compete, technology and knowledge­based intangibles, secret processes, specialized software, business systems, customer lists, favorable contracts, workforce in place, franchises, copyrights, patents, and the like.11 Allocations in this step are made in proportion to each asset’s fair market value but cannot exceed fair market value. Step 4. Allocate any price remaining after Step 3 to goodwill. Goodwill is the most intangible of intangible assets, and it often cannot be valued with any degree of precision. Therefore, there is no fair market value cap on allocations to goodwill.12 Finesse the Residual Allocation Method Rules The four steps outlined above may seem cut­and­dried, and in a way, they are. Given a set total purchase price and set fair market values for the assets being acquired, the price allocation will always be exactly the same. But appraising the fair market value of business assets is more of an art than a science. In many cases, there can be several legitimate appraisals that vary for the same assets. The tax results from one appraisal may be much better for you than the results from another. The good news: nothing in the tax rules prevents buyers and sellers from agreeing to use legitimate appraisals that result in acceptable tax outcomes for both parties. Settling on appraised values simply becomes part of the negotiation process. That said, the appraisal that is finally agreed to must be reasonable. Example of Tax­Smart Purchase Price Allocation Tax Masters, LLC (TML), is a single­-member LLC that is treated as a sole proprietorship for tax purposes. Sara, the owner of TML, tentatively agrees to sell all her assets to you for $1.5 million. The assets consist of client receivables; fully depreciated furniture, fixtures, and equipment; a small building and the underlying land; client lists; and client goodwill that Sara has developed over the years. Sara wants to minimize the purchase/sale price allocated to the receivables and the fully depreciated furniture, fixtures, and equipment assets, because gains from those assets will be treated as ordinary income and taxed at the maximum 39.6 percent federal rate on her personal return. Gains from the other assets will be long­-term capital gains that will be taxed at only 20 percent or 25 percent. Sara obtains an appraisal from a qualified professional, who estimates the following fair market values for TML’s assets: Receivables $ 250,000 Fully depreciated furniture, fixtures, and equipment 100,000 Building 250,000 Land 500,000 Customer lists 175,000 Goodwill 225,000 Total $1,500,000 Using this appraisal and the required residual allocation method, Sara must allocate the first $1.1 million of the purchase/sale price to the receivables and tangible assets in the amounts shown above. She then must allocate the $175,000 to the customer lists. The last $225,000 must be allocated to goodwill. Sara is happy with these allocations, because 77 percent of the total purchase/sale price is allocated to lowertaxed capital gain assets (building, land, customer lists, and goodwill). You, as the prospective buyer, want to allocate more of the purchase/sale price to the receivables (which will be quickly collected and written off for tax purposes); the furniture, fixtures, and equipment (which can be depreciated relatively quickly for tax purposes); and the intangibles (which can be amortized over 15 years for tax purposes). You want to allocate less to the building (depreciable over 39 years, which is a really long time) and the land (non­depreciable). So you insist on getting another appraisal that gives you better tax results. As a compromise, you and Sara agree to use a second legitimate professional appraisal that looks like this: Receivables $ 275,000 Fully depreciated furniture, fixtures, and equipment 175,000 Building 250,000 Land 350,000 Customer lists 200,000 Goodwill 250,000 Total $1,500,000 When you use this second appraisal, more of the purchase price is allocated to the receivables; furniture, fixtures, and equipment; and amortizable intangibles, which makes you happy. Sara is still satisfied because a healthy 70 percent of the sales price is allocated to lower­taxed capital gain assets (building, land, and intangibles). This is the art of the deal in action! Avoiding Unwanted IRS Attention As the buyer of business assets, you (or your business entity) must independently report to the IRS—as must the seller (or his or her business entity)—the purchase/sale price allocations that you and the seller use. You do this by attaching IRS Form 8594 to your respective federal income tax returns. The IRS can then decide to inspect the two forms to see whether you and the seller used different allocations. This can happen, unless it is prohibited because the buyer and seller agree to the same allocation in writing. If the IRS sees different allocations, it raises the risk of an audit. That audit might expand beyond just the asset purchase transaction. Not good! So it’s in your best interest to ensure that the seller reports the same allocations on his or her Form 8594 as you report on your Form 8594. Consider including this as a requirement in the asset purchase/sale agreement. When you start a business by buying the assets of a seller’s business, you want to allocate the price that you pay to those assets that give you the best tax results. Your first target should be receivables and inventory, because you can turn them into cash quickly and write off the corresponding basis. Your next choices are those that you can write off the quickest. You will want an appraisal to support your allocations. And you will want the seller to report to the IRS on IRS Form 8594 the same dollar allocations as you report. You likely should make this a requirement in the closing agreement. Before you purchase a new business please call us to discuss and review your purchase with you. Tax season is here. Go to www.tenfortyplus.com and complete your online organizer (under forms and documents). Make your appointment using our online appointment system. Call 281-397-7777 and get a user id with password set up so you Regards, Joseph C Becker EA www.tenfortyplus.com 281-397-7777, Fax 281-397-7443 joeb@tenfortyplus.com Contact Us There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following: • Pension or IRA distributions. • Retirement. • Significant change in income or • Notice from IRS or other deductions. Revenue department. • Job change. • Divorce or separation. • Marriage. • Self-employment. • Attainment of age 59½ or 70½. • Charitable contributions • Sale/purchase of a business property in excess of $5,000 • Sale or purchase of a residence or other real estate.