How to Avoid a Double Level of Taxation on the Sale of a C Corporation’s Business Assets – September 2015
A reoccurring tax problem in selling a C corporation owned business is the double level of taxation if the transaction is structured as an asset sale. First, there is a tax at the corporate level (35% maximum federal plus 8.84% California), and second, there is an additional tax when the corporation liquidates and distributes the sale’s proceeds to the shareholders (20% federal long-term capital gain, plus 13.3% maximum California, plus 3.8% Medicare Tax1). Finally, a state sales tax may apply to the asset sale. All of these taxes can make an asset sale of a C corporation’s business cost prohibitive. However, the acquiring corporation often wants an asset sale (and does not want a stock sale) because the acquirer wants to avoid hidden liabilities and wants a step-up in the income tax basis of the target corporation’s assets. Accordingly, an asset sale structure may be required to close the transaction. Thus, the target corporation needs to consider how to minimize and eliminate taxes in an asset sale. Below is a discussion on how to avoid a double level of taxation when there is an asset sale, thus enabling the sale of the target corporation’s business to occur.
The Target Corporation May Have Net Operating Losses to Offset Against the Sold Assets’ Sale Gain.
The target corporation can avoid tax on the target corporation level gain if that target corporation has sufficient net operating losses to offset the gain.
The Asset Sale can be Structured as Tax-Free, Where the Acquiring Corporation Delivers Its Stock to the Target Corporation’s Shareholders.
The tax-free reorganization rules of Section 3682 can be utilized so that the target corporation’s shareholders receive the acquiring corporation’s shares tax-free in the asset acquisition. The target corporation shareholders then receive long-term capital gain at a future date if they sell the acquiring corporation’s shares. Should the target corporation shareholders hold the shares until death (or until the death of their spouse if the shares are community property) then the received acquiring corporation’s shares can be sold by the target shareholders tax-free.
Have the Target Corporation Convert to an S Corporation to Avoid a Corporate Level Tax.
This will require the new converted S corporation to wait ten (10) years under current tax laws before the corporation does an asset sale under the Section 1374 built-in gain tax rules. Additionally, California still imposes a 1.5% tax on S corporation earnings.
Have Payments Paid to the Target Corporation’s Shareholders as Compensation.
Monies paid to the target corporation’s shareholders in their capacity as officers and employees are deductible currently under Section 162 by the paying acquiring corporation, and are subject to ordinary income and self-employment taxes to the recipient shareholders.3 Compensation payments to the target corporation shareholders must be reasonable based upon a facts and circumstances test. In order to justify compensation payments as reasonable: (i) the value of the services provided by the shareholder/employee should be evidenced; (ii) the shareholder/employee should perform actual services; (iii) the services performed should, in fact, be valuable to the acquiring corporation; and (iv) such services should be performed on a regular ongoing basis as the compensation is received. One difficult tax planning scenario that often arises is that some target corporation shareholders may not be involved in the target’s business, but still want to receive compensation based upon their pro-rata share ownership.
Have Payments Paid into Qualified Pension Plans.
The acquiring corporation could pay a portion of the consideration into the target shareholder’s qualified pension plan that benefits that target shareholder employee. Payments to a qualified plan not only avoids a double level of taxation, but also allows the deferral of the compensation to the recipient target shareholder and enables earning income tax-free on the deferred compensation assets in the qualified plan.
Allocate Part of the Consideration Paid to the Target Shareholders as Paid for a Covenant-not-to-Compete.
Payments for a covenant-not-to-compete are ordinary income to the recipient target corporation shareholders, and the payments are amortized by the paying acquiring corporation over fifteen (15) years.4 In order to qualify as a covenant-not-to-compete payment, the noncompetition payment amount must be reasonable.5
Have the Target Corporation Shareholders Sell Directly the Tradenames and Intellectual Property.
Periodic payments received by shareholders for trademarks and tradenames owned directly by the target corporation shareholders would be ordinary income to the recipient target shareholders, and not to the target corporation. Such payments would be currently deductible by the paying acquiring corporation as a Section 162 business expense if under Section 1253 such amounts are contingent on the productivity, use or disposition of the asset and are part of a series of payments payable at least annually or as part of a series of payments that are either substantially equal in amount or payable under a fixed formula.6 If the payments are not currently deductible then they are capitalized and amortized by the acquiring corporation under Section 197 over fifteen (15) years.
Allocate a Portion of the Purchase Price as a Sale of Personal Goodwill by the Target Corporation Shareholders Rather Than as a Sale of Assets by the Target Corporation.
If the right facts present themselves, the target corporation shareholders could claim that a portion of the consideration paid for the target corporation’s assets is, in fact, for the direct sale by the target shareholders of those shareholders’ owned personal goodwill. A sale of personal goodwill by the selling target shareholders results in those selling target shareholders receiving long-term capital gain treatment for the personal goodwill sale (and such sale amount is then not taxed to the target corporation, thus avoiding a double level of taxation).
The documentation for the asset sale of personal goodwill should include a separate agreement for the sale of that personal goodwill by the target shareholders. The target corporation’s asset sale agreement should be a separate document indicating that the target shareholders are separately selling their personal goodwill and customer relationships. There should not be a covenant-not-to-compete (whether in a separate document or under an employment agreement) which shows the target corporation (rather than the individual shareholders) owning the target business’s personal goodwill. Finally, it is helpful to have an appraisal showing the fair market value allocation between personal goodwill and the other assets of the sold business.
The acquiring corporation will not be concerned with whether there is personal goodwill or if that goodwill is owned directly by the target corporation since the acquiring corporation under Section 197 will amortize that goodwill over fifteen (15) years under either scenario.
The sale of personal goodwill is based upon the target corporation shareholders having a direct relationship with the target corporation’s customers and that there is no existing covenant not to compete or employment contract which restricts such target shareholders from keeping personally such customer relationships. The leading case justifying a sale of personal goodwill is Martin Ice Cream7, where the shareholder did not have a non-competition agreement or an employment agreement with the corporation and the target shareholder was able to sell the customer records to the acquiring corporation. In another case, Bross Trucking8, the court found that the shareholder had the personal goodwill and customer relationships, and that shareholder’s personal goodwill remained separate from the target corporation’s assets.
A more difficult tax planning issue results if there are multiple shareholders with different relationships with customers. A pro-rata sale by the multiple shareholders of personal goodwill is more likely to be scrutinized by the IRS.
Personal goodwill sales work best where there are one or two shareholders of the target corporation and there is a business which stresses shareholders’ personal relationships with customers or where personal know-how or reputation is important (such as the sale of an insurance agency, manufacturer representative, trucking or delivery company, or other businesses where customer relationships are of paramount importance). Other types of target businesses that may produce personal goodwill are where the target shareholders are involved with the day-to-day management and operations of the business and that business has high volumes of customers.
If the Target Corporation Owns Real Estate Consider Utilizing a Section 1031 Tax-Free Exchange.
Many times the target corporation owns its own real estate directly or the target corporation uses real estate owned by an entity related to the target corporation’s shareholders (such as a partnership or limited liability company). This target corporation’s used real estate can be sold to the acquiring corporation on a tax-free basis by utilizing Section 1031, and the sales proceeds from that sold real estate can then be exchanged into other income producing real estate.
© 2015, Law Offices of Robert A. Briskin, a Prof. Corp. All rights reserved.
Nothing in this article shall be deemed legal or tax advice as to any person or transaction. Please feel free to contact Robert A. Briskin if you have any questions as to items in this article.
1 The 3.8% Medicare Tax is imposed on the amount of the shareholder’s income, based upon the shareholder’s adjusted gross income in excess of the threshold amount ($250,000 for a joint return and $200,000 for an unmarried individual). Unlike an S corporation stock sale, individuals owning C corporation stock have the Medicare Tax applied to them, whether or not that individual is an active or passive participant in the C corporation’s business.
2 All code section citations are to the Internal Revenue Code of 1986, as amended.
3 The acquiring corporation’s ability to deduct compensation payments could be limited in some cases by the “golden parachute rules” or by the $1 million limitation on deductibility for certain high level executive compensation.
4 See Section 197.
5 A payment for a covenant-not-to-compete must be reported to the IRS as a Class VI asset under Section 1060.
6 See Section 197(f)(4)(C) and 1253(d)(1).
7 110 T.C. 189 (1998). Also, see Norwalk, T.C. Memo 1998-279 where an accounting practice owned in corporate form was liquidated, and the Tax Court held that the accountant (and not the corporation) owned the client relationships and goodwill. However, see Solomon, T.C. Memo 2008-102 where the Tax Court rejected a shareholder claim of personal goodwill in the sale of a pigment company.
8 T.C. Memo 2004-107 (2014).