The owners of a business must consider many tax issues in connection with its sale. These include the structure of the transaction as a sale of assets or stock, the amount of gain arising from each structure, the character of the gain as ordinary or capital, and the resulting tax liability. From the foregoing, the owners may determine the net economic benefit inuring to them as a result of the sale. Owners will sometimes use this information in negotiating an increased purchase price, or some other form of “gross-up”, to arrive at the after-tax figure for which they would be willing to sell the business.
After 2012, the tax cost of selling a business increased for higher-income taxpayers. In the case of individuals, the top rate for ordinary income increased to 39.6%, while the top long-term capital gain rate increased to 20%.
In addition, a new 3.8% surtax is imposed on an individual’s net investment income (“NII”) for the year. This tax presents another cost which must be considered in determining the net economic result of a sale.
The impact of the surtax is best appreciated by reviewing a typical deal structure.
The sale of a business includes several components. First, is the sale of either equity or assets by the owners of the “target.” In the case of an asset sale, the selling entity may then be liquidated. In either case, the consideration received usually includes money and/or notes. Owners who were active in the target may receive consulting/non-compete agreements from the buyer. Sometimes, these individuals own the property on which the business was conducted; as part of the transaction, they may lease or sell the property to the buyer.
NII: What Does It Include?
As it relates to the sale of a business, NII includes the net gain attributable to the disposition of property, other than property held in a trade or business which is not a passive activity as to the taxpayer. It also includes income from interest and rents, unless such income is derived in the ordinary course of a trade or business which is not a passive activity as to the taxpayer.
Do C Corps Escape the Surtax?
Since the tax only applies to the NII of individual taxpayers, the sale of assets by a C corporation does not trigger the tax. However, the distribution of the sale proceeds in liquidation of a shareholder’s stock will trigger the tax.
In addition, the gain recognized on the sale of C corporation stock by an individual will also be subject to the tax.
Pass-Through Entities and “Material Participation”
Gain realized by an S corporation or partnership on a sale of assets is passed through and taxed to its owners. An owner’s NII includes the gain attributable to the entity’s sale of property held in a trade or business that is a passive activity as to the owner. The determination of whether the property sold was held in a trade or business that is a passive activity is made at the level of the individual owner, not at the entity level.
Thus, the determination of whether the surtax applies to a shareholder’s allocable share of the gain from an S corporation’s sale of assets depends upon whether the corporation held the assets for use in its business and whether that business was a passive activity as to the shareholder; i.e., whether the shareholder “materially participated” in the business.
A taxpayer is treated as materially participating in a business activity if the taxpayer is involved in the operations of the activity on “regular, continuous and substantial” basis.
If the business activity was passive as to the shareholder, then the shareholder’s allocable share of the gain from the asset sale shall be subject to the surtax. However, if the business was not passive as to the shareholder, the gain is not subject to the tax, except to the extent it is derived from the sale of assets not used in the business. This may result in a situation where a passive shareholder is liable for the surtax on his share of the gain from an asset sale, while an active shareholder is not.
In the case of an equity sale, a sale of an ownership interest in a pass-through entity may result in NII subject to the surtax if the entity is engaged in a trade or business that is a passive activity with respect to the seller. In general, however, if the seller materially participated in the business, the gain recognized by him shall be subject to the surtax only to the extent of the gain which would have been treated as NII if the entity had sold all of its assets (including goodwill) for fair market value immediately before the sale of the interest.
An owner’s NII from the sale of a business will also include his share of interest income arising from the sale, including interest on an installment note or interest imputed on other deferred payments of purchase price, as well any gain recognized under the installment method on the receipt of the deferred payment.
Additionally, if the seller retains ownership of the real property on which the business operated, and leases that property to the buyer, the rental income will likely be subject to the surtax since the rental of real property is generally treated as a passive activity. This is especially true for property that requires little activity.
As for payments to be made to the owner under any consulting agreement, these will be subject to the 2.9% Medicare tax on self-employment income, and not the tax on NII. However, if this consulting income exceeds a certain threshold, the excess will be subject to an additional 0.9% Medicare tax.
Conclusion: Plan Ahead
The best time to plan for the sale of a business is well before the sale. This advice applies to the tax on NII. The surtax rules are complex, but the tax may be addressed, at least partially, in a number of ways; the owner’s level of activity may be adjusted, the owner’s equity may be shifted to lower-income family members, the owner’s other investments may be used to offset NII. While some of the planning alternatives may carry an economic cost, it behooves the taxpayer to consider them since some combination thereof may help reduce the surtax.